Small Cap Value Report (Fri 29 Oct 2021) - BEG Red Flags, MTW, GYG

29th Oct '21 by Paul Scott

97 comments 9174 reads

Good morning, it's Paul & Jack here, with the SCVR for Friday. There's hardly any relevant news today, and I (Paul) have to pack up my airBnB and move to a hotel in Funchal now, so will sign off for the day. Have a good weekend everyone!

Agenda -

Paul's Section:

Begbies Traynor (LON:BEG) - Q3 Red Flag Report, interesting improvement, but rise in CCJs augurs badly. I broaden this into another ramble around topics like inflation & supply chains.

Gyg (LON:GYG) - bid talks with major shareholder are off, with a reasonable explanation given. The company confirms it shouldn't need to raise any fresh equity funding, despite uncertainty over contracts.

Jack's Section:

Mattioli Woods (LON:MTW) - wealth manager that has recently made a few acquisitions. The group reports revenue growth amid uncertain conditions. There are some signs of a decent company, one that can potentially continue to grow, but it looks fairly valued for now.

Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to cover trading updates & results of the day and offer our opinions on them as possible candidates for further research if they interest you. Our opinions will sometimes turn out to be right, and sometimes wrong, because it's anybody's guess what direction market sentiment will take & nobody can predict the future with certainty. We are analysing the company fundamentals, not trying to predict market sentiment.

We stick to companies that have issued news on the day, with market caps up to about £700m. We avoid the smallest, and most speculative companies, and also avoid a few specialist sectors (e.g. natural resources, pharma/biotech).

A key assumption is that readers DYOR (do your own research), and make your own investment decisions. Reader comments are welcomed - please be civil, rational, and include the company name/ticker, otherwise people won't necessarily know what company you are referring to.

Paul’s Section:

Begbies Traynor (LON:BEG) (I hold)

145p (pre market open) - mkt cap £220m

Q3 Red Flag Report & further rambling from Paul

These reports from insolvency practitioner Begbies Traynor are always an interesting brief read, so worthwhile for all readers to have a look.

There’s actually some good news this quarter - with a sizeable (14%) fall in the number of…

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Phil117

30th Oct '21

I think we are mixing different concepts. Forget the market for a second. Assume you have 2 private businesses of roughly similar size. One makes 50% Gross Margin and grows revenue at 10%. The other makes 25% Gross Margin and grows revenue at 5%. I’m super simplifying but surely its indisputable that the first business is the better, quality business and should the metrics stay the same will produce its owner a superior return. That is just mathematics and why the quality argument is logical. What you are saying is hang on. 1. If the first business costs 10 times more than the 2nd then surely it will have an impact on your eventual outcome. And 2. In any case it’s irrelevant because the first business must eventually mean revert through competition, obsolescence, scale or whatever. And the answer is that yes of course the entry multiple has relevance. There are levels where one will struggle to make a decent return. But in buying a low quality business cheap you can only hope for a small re-rating. A high quality business proves its worth through its financial performance irrespective of what Mr Market does at any given moment. And over time this will be recognised and in spades. And there are businesses that have that special sauce / moat that just don’t seem to mean revert. That’s obvious from people lucky enough to buy Coca-Cola or Disney or Hermes 40 years ago

Of course the yield is an important part of TER. But it all depends how that yield is generated. If the business is not covering its cost of capital or barely covering its cost of capital you are being bribed with your own money. You are giving VOD £100 to get back £7 but in the knowledge that the value of your original investment is being eroded. And that is why VOD is yielding 7%. Mr Market is essentially saying that the current dividend is unsustainable. And it is because VOD can’t cover its prodigious levels of investment and dividends without blowing up debt beyond what is comfortable ie it does not pay its way. Berkshire Hathaway by contrast pays no dividend and so what. As mentioned up thread by GrahamF it is able to reinvest capital at superior rates of return - although its now coming up against scale limits - and that delivers the TER. If someone needs income they can just sell stock as and when

You spot these companies in advance by screening their metrics - I guess what Stockopedia tries to do - and then looking at track record. To go back to Fundsmith their companies have decades of track record through multiple business cycles. And then of course you consider whether their models are still relevant. I agree with the points up thread that as the economy seems to evolve ever faster this gets harder. But some things seem to stay the same. People like a drink, they use lifts, they brush their teeth, they like to be entertained, etc. I don’t think it’s rocket science. If someone offered you one stock to hold today that you had to hold for 10 years and it was a choice between Vodafone, NatWest or Diageo which would you choose. I know which one I think would offer the most upside at the least risk

I guess because brokers believe that Mr Market has overshot on the downside and that 7% yield is not a sign of its unsustainability but that VOD is too cheap. I guess they hope that the massive capex investment will eventually bear fruit. But then again they always have a BUY bias. But just look at that top line history. Revenue down to flat for years and years. An ultra competitive, capital intensive business. Barely has it upgraded to 4G and now it’s investing in 5G. But where is the benefit in the metrics. For consumers yes. For Netflix, Facebook sure. Regulators are blocking further consolidation. It’s always jam tomorrow. Is this a stock you want to bet on for that re-rating pop

Boon

Page9 is a laugh. Yes, it is 80% undervalued to peers. But the peer set are all well established, 9 or 10 digit enterprise values, and all profitable. Not the loss making tiddler like Cloudcall (LON:CALL)

simoan

As far as this discussion goes, IMO Vodafone (LON:VOD) is a really poor example of a value share, at least as I understand "value". If interest rates rise it will fall just like highly rated growth shares because in reality it is a utility i.e. it needs constant capex which leads to huge debt, no growth, and is highly sensitive to regulation by governments. This is maybe the reason it has been falling since the prospect of a near term rise in interest rates. I'm sure there are better, less utility like "value" shares, to choose for comparison.

It's a natural but dangerous thing to extrapolate the present into the future, but I'd say the chances of Vodafone (LON:VOD) outperforming in the next 10 years would likely mean the world has almost come to an end. In fact, I'd be surprised if if it still existed in its present form.

All the best, Si

cmpeckham

A lot of what you say is true, I agree with most of it, but despite what you say, the facts remain that (1) value has outperformed in most periods of history and (2) it has also outperformed over the very long term, despite the heroic performance of quality since the GFC and the collapse in long term interest rates. How do you explain that in your framework?

You seem like a smart guy, but I think you are misunderstanding how and why value has achieved this outperformance. You say "in buying a low quality business cheap you can only hope for a small re-rating". There is a partial truth in this but it's a misleading statement, because, I think, you are missing 2 key points:

1. Yes, often the return on a given stock is less than people see on their LTBH quality investments. But value isn't a LTBH stratgey. It has much higher turnover. So yes, one individual holding may show less return, but in the same timeframe you've achived that return multiple times. When you compare holding Vodafone, Natwest or Diageo for 10 years, it's a false comparison. Value investing isn't about holding for 10 years. It's about holding until the value is outed and then moving on.

2. Just as in quality investing, there will be many with multi-bagging returns. Take a look at Paul's case for Saga (LON:SAGA) as an example. Unlike many of his choices, it's a classic value investment, which he believes could easily 3 bag within a few years, despite its quality rank of 13 having a big red circle around it. The reason it could easily multi-bag is because mean reversion works both ways. It works negatively often for highly quality businesses, but positively often for poor quality ones, like Saga. Simply returning to average performance and an average multiple would see it multi-bag.

I'm not down on quality (I don't fight the market and I have several classic quality holdings. Of the 3 stocks you mention, the only one I hold is Diageo). But I question whether it will continue to outperform over the next decade. In assessing that, I think it's important to recognise and understand why it's value that has been the long term winner. For me, there are also some other key reasons to do with risk, but I'll leave it there.

timarr

But in buying a low quality business cheap you can only hope for a small re-rating. A high quality business proves its worth through its financial performance irrespective of what Mr Market does at any given moment. And over time this will be recognised and in spades.

You would think so, wouldn't you? Rob Arnott did some analysis in 2009, looking back, using what they called Clairvoyant Value, looking at what a clairvoyant investor should have paid based on the actual future returns:

The results for the entire period support the single period results reported in our earlier paper. In each of the 51 years—without exception—the market was able to assign higher valuation to stocks that subsequently exhibited faster growth than those that commanded lower valuation multiples. However, in the vast majority of the years, the market paid far more than the clairvoyant investor would have for growth stocks relative to value stocks.

https://citeseerx.ist.psu.edu/...

As Arnott says, growth stocks can outperform value stock for extended periods of time, but ultimately value stocks outperform not because they're better companies - they're not - but because people pay too much for growth. Maybe this time it's different, but the idea that suddenly a whole cohort of companies have evolved that are immune to the Invisible Hand seems pretty unlikely. In every generation there are a few superstocks but inevitably excessive earnings attract competition.

That said, I have no difficulty believing that growth stocks will continue to prosper over value stocks for the foreseeable future. Shades of Schumpeter's destructive-creationism are everywhere.

timarr

Thanks for the really interesting debate! As you say I think we may actually agree on more things than it seems. The last thing I would just say is that I do have a big issue with these backward looking value studies in that they assume perfect execution and transition from one opportunity to another. To steal from Buffet it assumes you go from one cigar butt to the next seamlessly. In reality that's a very tall order because the fundamentals of the business are often against you. Hence you are often left depending on the greater fool theory for your return (re-rating) or some exogenous factor which the business doesn't really control. History shows that very few people achieve anywhere close to a respectable track record with this method. For every 1 Saga that triple bags or a Reach or Premier Foods there are another 3 that go nowhere or worse. I agree though that it can make for a much more exciting form of investing. But risk adjusted I really question the potential returns unless you are super concentrated (and by definition taking on a lot more risk, not just from the concentration but because you are concentrated in Cigar Butts) and / or very lucky and / or exposed to Insider Information. I mean just look at the travails at Crystal Amber. A really smart, driven team. And yet they have not delivered. And I would say that's because they have lumbered themselves with one tough strategy

I wonder if what makes this debate harder to pin down is the old chestnut of "what constitutes value". To an investor in Tesla something like Diageo would perhaps be classed as a value stock. If that is the definition then I am more comfortable that value can outpeform Growth, with value more akin to 'Growth at a Reasonable Price'. To my mind when I hear value I think 'deep value'. It's Cigar Butt / Special Situations or low ROCE or Ex-growth Cash Cows. And here I massively struggle with the idea that investing in a portfolio of these can possible outperform GARP in a 'real world' setting i.e. without perfect hindsight and a lot of luck

Vodafone (LON:VOD) 's tragedy is that it's a utility as you say with all the associated capex but without the 'monopoly' element that many other utilities enjoy. In my view it's the worst of both worlds

You're right that higher interest rates should negatively effect all share valuation via the Discount Rate but I question why growth shares should suffer worse than value. If higher interest rates are a function of higher inflation then surely it comes down to pricing power and cost control. And here a capital light growth company with a strong brand might well be in a better position than a lumbering capital intensive value stock

As alluded to above I guess I really with struggle with the whole value / growth distinction. To my mind there are high quality shares and low quality shares. The former should relatively outperform the latter irrespective of the macro environment because they start from a position of strength through higher margins, better brand, lower leverage or whatever. Given the unknowability of the future I think you are safer navigating life's exogenous shocks on board a Quality Company than not. What constitutes Quality of course is then another discussion. To my mind Tesla is not 'quality' because it operates in an unattractive, capital intensive, highly cyclical, low margin sector. Like Airlines. Most companies and sectors are just not 'quality'. But the beauty is that as a PI you don't have to touch them

31st Oct '21

Don't worry, you're preaching to the converted. I agree! But then I'm not a "value" or "growth" investor. I apologise for getting involved as I have little interest in these kinds of high level discussions; I just wanted to comment on Vodafone (LON:VOD) which is an awful company. What we should concentrate on, and the reason this blog exists, is stock picking. Who cares whether a particular company is a growth or value proposition?

I don't find gross generalisations or macro waffle the least bit helpful, not that I'm accusing you of that :-). I keep hearing the US market is overpriced - this is a lazy generalisation. Maybe it is overall, but within it I can still find great companies on reasonable valuations, unlike the UK market, unless I want to hold mostly poor quality companies in old low/no growth industries. What about Intel on a forward PER less than 10 with a yield of 2.8%? What about Amgen on a forward PER of 12.6 and yield of 3.4% covered 2.5x. Or what about Qualcomm (the largest fabless semiconductor company in the world with many of the patents for 5G) on a forward PER of 16? On a long term basis I am finding it hard to get that interested in UK small caps currently when such good value is on offer in the US mega cap space.

davidjhill

Paul - I'm not muddling anything up. The actuarial deficit calculation was last done in 2019 and is almost due to be renewed. An actuarial calculation allows for a very significant margin of error over and above the real expected liabilities of a pension scheme. In Reach (LON:RCH) case and based on 2019 the deficit will also be completely eliminated in 5 years time.

On an accounting basis it will be eliminated in 12-18 months.

However, the actuarial deficit has not been changed since 2019 and so in the next triennial valuation both the changes in the "real value of the plan" plus any amendments in the discount rate and mortality rate etc will be factored in. I expect all 3 of those mentioned will be favourable to the 2019 deficit and there will have been £150m+ in contributions paid in as well.

So - the point is that the company generates cash that already significantly exceeds the current actuarial deficit requirements and will be eliminated in 5 years. I would expect the new actuarial liability calculation to reduce (and thus reduce the annual deficit payments out to 2027 as well). Therefore, I see no real risk to Reach (LON:RCH) as a company or a going concern from its pension liabilities. It is able to generate significant excess cash, pay dividends and continue to transfer to a digital revenue based organisation with no signs that the gradual decline in print will jeopardise those earnings.

And do not forget that content is king and Reach (LON:RCH) have that in abundance.

Note : Excerpt from the Pensions Regulator that back up my expectations and align with what we are also seeing in the accounting deficit reduction (ie it is constant across both).

"Schemes undertaking valuations at 31 March 2021 will have improved funding levels and deficits compared to those reported three years previously."

rmillaree

Reach (LON:RCH)

Davidjhill

I couldn’t really disagree more strongly with your assessment of the lack of reach pension risks davidjhill as a summary to present for others. The size of their pension scheme liabilities per the 2020 annual report is a mind boggling 2.8 billion and annual payments to pensioners are expected to carry on increasing materially for more than the next 10 years. Surely the danger here is not the current state of the deficit but what if the future returns on scheme assets don’t grow in line with scheme liabilities. What happens if the scheme assets take a 20% haircut at some stage , I am not saying it’s a likely an issue but how confident are you that scheme assets will continue to grow in line with liabilities?

A pension scheme of this size will use LDI mandates (liability matching) hedging. Given the size of the scheme it will almost certainly be a segregated mandate and therefore a pretty accurate hedge.

1st Nov '21

But to what extent are the risks derisksed here ? they mention a proportion of Ldi’s in the pension scheme asset totals but that’s approx only 1/3 of the total. If this scheme really isn’t an issue future risk wise it would nice to see that lack of risk confirmed by authoratative source.

edited

and that's part of what the actuaries do.

Let's do a very crude example for the sake of not writing a thesis here so excuse the simplicity.

The Actuary says that in 20 years time the company will have a liability of £100m. So the company can go and buy a 20 year UK Govt Gilt of £100m with a coupon of say 0%. In 20 years time when they need to meet the liability the Govt will be redeeming the Gilt at par so the asset and liability match completely. It doesn't matter what interest rates do or if the mark to market value of the gilt at some point during the period is 20 or 30% down because the scheme is holding the bond to maturity and unless the Govt default the asset is secure. Because the UK has a good credit rating then for prudence the company can also buy a CDS (credit default swap) that protects against any default quite cheaply and eliminate any residual credit risk.

So headline numbers of £2.7bn in liabilities are really meaningless, because they are closely matched against assets that are not at the whim of being offside at the point the liabilities become due.

A bank mortgage book is similar. It might look huge but all those fixed rate deals at 0.8% for 5 years are all hedged with an Interest Rate Swap so the bank doesn't incur interest rate risk on them, though clearly they have credit risk which they offset by the collateralisation of peoples homes.

So we establish that absolute size is irrelevant - what matters is risk associated with the assets that match the liabilities, and whether the liabilities themselves are certain. The Actuary will calculate the liabilities and then assess the assets and determine any surplus or deficit. However, they will take a very conservative view on both, allowing for a large margin of error.

Now, a scheme that is in deficit may fall upon favourable market conditions whereby the value of the assets does go up considerably more and eliminate a deficit (under accounting rules). Here a company could then choose to re-jig the assets and fully liability match their scheme. At the moment these favourable conditions appear to be happening to Reach (LON:RCH) and if they have eliminated the deficit at an accounting level in 12 months alongside the extra contributions this gives them a lot of flexibility in ensuring large deficits don't build again in future. When the Actuaries perform the triennial valuation this should also be favourable as life expectancy has also fallen. In essence it appears to me that Reach (LON:RCH) management and trustees are managing the scheme well and thus I am not concerned about it having a detrimental impact on the business going forward.

Mortality rates are important and if the scheme were still open I would be more concerned because if we take a big jump forward in life expectancy then that increases the liabilities. However, given the scheme was shut this risk is considerably reduced. and decreases further with time.

I fully get everything you are saying here ref where the deficit is at and the measures in place.

The issue i have here is that i have seen deficits jump about like yo yo's over the years - so i have traditionally defaulted to the higher the value of scheme liabilities and the less mature a scheme the more the risk. Ie what happens if they for whatever reason they have to plug a gap of 20% of the value of scheme liabilities if the assets are unable to generate enough return to fund any increase in liabilities in the future - due to future returns on assets being not great. IMHO unless i see it in writing from authoritative source i am not presuming there is "little risk" that the deficit couldnt easily jump by another £300-£400 million due to future actuarial changes.

Note when you say this is mature scheme - its not as mature as i would like. For example norcros is pretty much at the point now where there cash the are paying out in payments each year to pensions is at or near maximum levels . The size of scheme liabilities has also dropped 10% ish for norcros over the last 5 years. It looks like reach has another 10 years where the cash payouts are still increasing so not really at the point yet where they are over the hill with regard to "peak cash outflow". Note its not all bad here is i think they have more in their pot that Norcros when you simply divide the asset size by yearly amounts being paid over the next 10 years . Note they pot they have does seem a little more conservative than that of norcros when you divide pot size by annual payments that are expected to be made over the next 10 years.

There is obviously a chance here i am worrying about nothing here - if they are getting more hedged each year and deficit is trending to nothing i don't doubt the scheme has massively de-risked already.

I think that is my key point. The level of de-risking that has gone on here already and what I see likely over the next 12 months (and post the next triennial review) at both an accounting and actuarial level points me to being comfortable with the scheme and thus I don't see it as a reason not to invest - or at least not to the discounted level the business currently trades at.

That said I'm happy to wait for the pension scheme mechanics to become much more apparent over the next 12 months or so.

PerpetualValue123

6th Dec '21

"I’ve yet to find any mainstream journalist that understands QE, so they’re generally still peddling the myth that Govt debt is high. Govt debt is actually quite low, by historic standards, once you net off QE (Govt debt owned by the Govt [the Bank of England])"

The Bank of England isn't owned by the Government. And you will not find any evidence for this. Please show me, if you find it.

Rusty2

The BoE says “We are wholly-owned by the UK government”

So who do you think owns it?

Small Cap Value Report (Fri 29 Oct 2021) - BEG Red Flags, MTW, GYG

Paul’s Section:

Begbies Traynor (LON:BEG) (I hold)

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