Small Cap Value Report (Weds 13 April 2022) - WJG, AMAT, MRK

Good morning! Paul & Jack here with Wednesday's SCVR.

Agenda - very quiet for news today, so we'll look back at one or two catch up items later -

Watkin Jones (LON:WJG) - an in line update, halfway through FY 9/2022. This is an impressive business, on a reasonable valuation, although I do have one concern about large Director selling in recent years. 

Jack's section:

Amati Aim Vct (LON:AMAT) - a quick look at this well-regarded AIM VCT, more for the market commentary than anything else. It could resonate with a few private investors and nicely encapsulates the current investment landscape. Food for thought, hopefully of use and worthy of discussion.

Marks Electrical (LON:MRK) - trading update from Monday - market share gains and record revenue for this online electrical retailer. The group wants to grow market share from c1.5% to 10% over time, which shows ambition. How well margins hold up will be important, and that could be affected by supply chains, inflation, and competition if similar operators start popping up. But the group is trading well, and FY23 has got off to a good start.

---

Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to review 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:

Watkin Jones (LON:WJG)

254p (yesterday’s close)

Market cap £649m

Trading Update

Watkin Jones is the UK's leading developer and manager of residential for rent, with a focus on the build to rent, student accommodation and affordable housing sectors The Group has strong relationships with institutional investors, and a reputation for successful, on-time-delivery of high quality developments.

We like the business model of WJG here at the SCVR. Developments are forward-sold to institutions, and there’s a long pipeline of projects, with good visibility. That removes much of the risk that other property developers suffer from. The building work is outsourced, and WJG has structured its activities so that cashflows are good, it has a strong balance sheet, and a divi yield of about 4% is paid. There’s lots to like. 

My only reservation, is that the key people could conceivably up sticks and set up on their own, in competition with WJG - because the value in the company is really the expertise and track record of its top people. For that reason, massive insider selling in 2017-19 of over £60m does worry me somewhat, which is why I decided to sell my WJG shares some time ago.

The Group provides the following trading update for the half year ended 31 March 2022 (the 'period' or 'H1-2022').  

Robust pipeline underpins confidence in full year delivery

My summary of today’s trading update -

Key point - confidence in performance for FY 9/2022

H1 revenues up, but profit down, as expected, due to higher proportion of (lower margin) land sales - doesn’t sound significant, as they’re confirming the full year outlook.

Cost increases being well managed - so far margins have been maintained, through negotiations with buyers - but has lengthened sales cycle.

Rising demand, strong interest from investors for WJG’s projects - a key point.

Development pipeline has risen from £1.4bn a year ago, to £1.8bn now - WJG gives a lot of information about its pipeline in investor presentation slide decks.

Net cash of £27m looks fine to me, WJG has robust finances, no issues there - I’ve just double-checked the last balance sheet, and it’s really good - in particular, a very healthy working capital position.

Cladding - mentions awaiting Govt decision on this, but I think it would have been useful to remind us what potential exposure WJG has, which is not mentioned today.

Dairy date - 17 May for interims, which will include an “in person” analyst meeting. Whilst it’s nice to see real life meetings returning, I think most people find webinars far more efficient, and of course PIs (private investors) often can’t get into London, or gain access to meetings. So continuing with webinars is vital for us, and needs to continue.

Valuation - is PER the right way to value a property developer? Some people prefer “build out value” - i.e. valuing a developer on its future projects. My view on WJG is that it has very good visibility with a multi-year pipeline, that PER is probably fine to value the shares. Also, it has established a reliable track record of delivering steady/rising earnings since it floated in 2016.

The StockReport shows a forward PER of 12.6, and forward divi yield of 4.0%, which strikes me as reasonable.

My opinion - I reckon this is a decent business, very well managed, and with a differentiated business model, which lowers risk considerably. So it’s a much better investment proposition than many other more conventional property developers.

As mentioned at the top, I do worry though that the long-term value of the company is really all about the top people being motivated to carry on, and the relationships with institutions that they have built. They know the property cycle better than anyone, so I think it pays to look at big Director selling, of which there has been a lot since WJG listed.

.

---

Jack’s section

Amati Aim Vct (LON:AMAT)

Share price: 152.5p

Shares in issue: 148,851,023

Market cap: £227m

Annual report for the year to 31 January 2022

For the past six months or so (possibly longer now), there appears to have been a divergence in index performance and the experiences of some investors. I’ve certainly written up some well-performing smaller companies whose share prices just don’t want to reflect operational progress.

There are some relevant comments in the annual report of Amati’s AIM VCT that suggests I’m not alone in this perception.

It has been a disappointing year for AIM investors with the Numis Alternative Markets Total Return Index falling by 3.5%. This was materially below both the Numis Smaller Companies (plus AIM excluding Investment Companies) Index which rose by 11.6%, and the Numis Large Cap index which rose by 19.5%.

The VCT’s total return for the 12 months to 31 January 2022 is -7.5%, compared to +38.9% in the prior year, and well below the FTSE 100 return. I’m not going to focus too much on the Amati AIM VCT too much, rather I’m interested in commentary that might have some readacross for private investors.

The chairman of this portfolio of AIM investments writes:

Following a rise of almost 8% in the first half of the year, the performance of the portfolio fell away in the second half to close the year down 7.5%, on a NAV total return basis.

That suggests a pretty poor second half, and quite a change from the preceding period.

Some of this fall was for company specific reasons, in particular Polarean Imaging and Frontier Developments, while some was due to a sharp deterioration in sentiment. This stemmed from inflation rising to much higher levels than forecast by central banks, bringing with it the prospect of higher interest rates, rising bond yields and the withdrawal of liquidity through the ending of quantitative easing. This has led to some significant de-ratings of many growth companies. On top of this, there was the deepening crisis caused by Russia's military build-up around Ukraine.

That’s a range of factors investors will no doubt be familiar, having tried to make sense of recent share price performances.

And from the fund manager:

This has led to market sentiment changing, with high growth sectors such as healthcare and technology seeing material profit taking, whilst out-of-favour sectors including oil and gas, mining and banking, have enjoyed a return to form after a number of fallow years.

This sector rotation, in my view, explains much of the divergence between index returns and the recent experience of some investors.

Outlook:

Since the aggressive attack by Russia on the Ukraine, we have experienced extreme investor sentiments which have led to a dramatic fall in the FT Indices after our year end. Our well-balanced portfolio has not been immune to derating along with the market, even for those companies with high elements of service and technical expertise. With inflation, interest rates and energy prices rising, there are ongoing headwinds. Our portfolio contains a diverse range of well-resourced companies, mostly with high barriers to entry derived from intellectual property and specialist skills.

We know about these risks, but the VCT’s strategy in the last sentence is worth considering. It strikes me as a very sensible way in which to build a resilient, long term portfolio (short term share price fluctuations aside).

Furthermore:

It might be expected that the more challenging market conditions allow us to make new investments at lower valuations, and we anticipate having opportunities to take this advantage and deploy our recently raised funds during the course of 2022.

I also agree with this - such markets tend to present opportunities.

Conclusion

I’ll leave it there for now as I don’t tend to look at VCT’s, but I think the commentary is worth sharing. It suggests that if you’ve underperformed recently, that’s alright, as it might just reflect a temporary downturn in sentiment. It’s how you react to that (or in some cases don’t act) that’s important.

I’m curious to hear investors’ strategies at the moment - I’m sure others are too. Are you holding through thick and thin, or moving to cash? If the latter, what about inflation? Or perhaps you’ve put on your buying boots and are looking for bargains.

We might be heading for a quiet period on the markets over the bank holidays before the news flow ramps up again in June. It could be a good time to take stock.

---

Marks Electrical (LON:MRK)

Share price: 98p

Shares in issue: 104,949,050

Market cap: £102.9m

Trading update for the year to 31 March 2022 (released on Monday 11th April)

This is a fast-growing online electrical retailer. A quick visit to the website shows the kind of products: TVs, dishwashers, fridges, vacuum cleaners, etc.

It’s a recent IPO, coming to the market in November 2020, so the share price slide since then could just be part of the wider sentiment. There’s a lack of liquidity due to a small free float and the group’s founder, Mark Smithson, owning 71% of the company.

Results look good. Full year revenue is up 44% to £80.5m and up 19% in Q4 to £20.7m. Signs of operational leverage, with adjusted EBITDA margin up to 9%, in line with expectations. That’s much better than AO World, and whether or not the group can keep that margin growth going will be very important to valuation.

Closing net cash of £3.9m and positive trading momentum in March 2022, ‘with an exit growth rate in the final month of over 25% year on year’.

Marks says it is winning market share in the Major Domestic Appliance and Television markets, with brand awareness initiatives driving improvements in website traffic and increased fleet capacity improving the group’s free next day delivery capability. Trustpilot rating of 4.8 maintained.

Conclusion

Marks and Made.com (LON:MADE) share a similar dynamic, in that they are digitally native disruptors taking share from physical retail incumbents. When you’re in a traditionally low margin industry, having your enterprise set up the right way so that you are a lower cost operator can be a key differentiator - for example, Marks’ focus on brand building, next day delivery, and warehouse efficiency. A physical retailer with a large base of leased shops might find it hard to pivot and compete with that.

I’m not familiar with the story here, but Equity Development covers the company, so that always makes life easier! The idea that this company has been steadily expanding its market share over time doesn’t seem to come across in the pre-IPO revenue figures though, I wonder why. And margins were previously less notable.

My main question here is around the longer term durability of margins and earnings. Credit must go to the team for identifying the market opportunity and differentiated business model. There’s probably scope to continue growing and taking market share. But competition and higher costs could become a risk at some point.

That competition could take a while to arrive and really heat up in a way that might affect Marks’ growth trajectory though. Smithson wants to grow the group’s market share to 10%, up from 1.5%-2% today. So that could provide plenty of upside potential. Perhaps worth a closer look as it seems to be performing well, but the liquidity could be an issue for some, and consumer confidence and disposable incomes are also a consideration.