Exploiting a pricing anomaly

The company concerned is Aim-traded technology company IMImobile (IMO:170p), a business that helps companies engage with their customers across all mobile devices by offering smart software products based on proprietary technology. The technology is proving incredibly popular and is being driven by the rapid take-up of smartphones and tablets, and improvements in network speeds. Indeed, IMImobile's pre-close trading update at the end of March highlighted double-digit growth in both revenue and gross profit in the 12-month period, and "a strong pipeline of opportunities", according to chief executive Jay Patel.

Subsequent to that trading update the company has just announced that it has added support for Facebook Messenger on IMIconnect, a cloud communications platform that enables the rapid creation, delivery and orchestration of proactive and interactive messaging services. This bolsters IMImobile's growing blue-chip client base that already includes household names Vodafone, O2, Telefonica, EE, AT&T, France Telecom, Centrica, Coca-Cola, the AA, the BBC and major financial institutions.

The business is very profitable, too, as analysts predict it will deliver revenue of £60.8m in the financial year to the end of March 2016, cash profit of £10.6m, pre-tax profit of £8.4m and EPS of 10.2p. It's also has a cash-rich balance sheet with net funds around £13.5m at the end of the first half. Adjust for that cash pile and the company's fully diluted equity is in effect being rated on 8.5 times cash profit for the year just ended, a rating that fails to reflect prospects of IMImobile reporting double-digit revenue growth for some time to come. I am not the only when thinking this way as my colleague Alex Newman is equally convinced, having advised buying IMImobile's shares at the end of January at 150p ('All eyes on IMImobile', 28 Jan 2016).

Stock overhang cleared

But what sparked my attention right now is the fact that 1.33m shares, equating to 2.2 per cent of the total voting rights, went through the market on Tuesday at 157p. The fact that the share price has risen since then is a good sign that a stock overhang has been cleared. The seller was ToscaFund Asset Management, which trimmed its stake to 25.3 per cent, and the shares were bought by Liontrust Investment Partners, which now has a 12.9 per cent holding. Moreover, IMImobile's share price is testing prior resistance around 170p, and a move above this level would take it into blue-sky territory.

Clearly, it's all well and good being smart after the event, although I did highlight the investment potential a couple of months ago ('Bargain shares updates', 12 May 2016). However, as I alluded to at the start of this article, there is still a way of buying into IMImobile's chart break-out on the cheap. That's because Aim-traded investment company Gresham House Strategic (GHS:780p) owns 10.5m shares in IMImobile, a holding that equates to 17.4 per cent of the voting rights. At the current price the holding is worth almost £18m and accounts for 487p a share of the investment company's spot net asset value of 1,033p, according to my calculations. In addition, Gresham House Strategic has net funds of £11.5m on its balance sheet, a cash pile that reflects a placing and open offer that raised £14.8m for new investments at 900p a share last autumn.

This means that in aggregate cash worth 312p a share and the holding in IMImobile fully back Gresham House's share price. It also means that we are in effect getting investments in five other investee companies in the price for free. Or, to put it another way, strip out net cash of 312p from Gresham House Strategic's share price and equity investments worth 721p a share, including the stake in IMImobile, are being attributed value of just 468p a share, or 35 per cent below their open market values.

Gresham House Strategic: Portfolio breakdown (prices on 27 June 2016)

A free lunch

And it's not as if these companies don't have investment potential. I had a very enlightening lunch a few weeks ago with Tony Dalwood, chief executive of Gresham House (GHE:315p), the investment advisor to Gresham House Strategic. At that meeting he ran through the rationale behind Gresham House Strategic taking a 9.06 per cent stake in Northbridge Industrial Services (NBI:88p), an industrial services and rental group. Northbridge primarily hires and sells specialist electrical testing and oil and gas equipment to a global customer base including companies in the marine, natural resources, power reliability, data storage and utility sectors. In particular, revenue is generated from the sale and rental of load banks and packaged transformers and drilling tools for the oil, gas and geothermal sectors. Northbridge operates from hubs in the UK, Belgium, the UAE, Singapore, Australia and New Zealand.

Gresham House Strategic backed a placing and open offer of new shares at 75p in April as a cornerstone investor, having engaged with Northbridge's board and senior management team over a six-month period, and carried out extensive research into the recovery potential of the business. The key point here is that Northbridge's £5.6m fundraise, which I hasten to add was heavily backed by the directors own money, too, has removed some of the distress risk that had been undermining investor sentiment following the collapse in the oil price. It not only makes meeting debt covenants easier, but has provided Northbridge with cash to meet deferred consideration on prior acquisitions and enable the company to benefit from any new opportunities that may arise in relation to supporting hire fleet development and master service agreements.

The fundraise was pitched at an attractive entry point for new investors because, even after factoring in the dilution effect from April's placing and open offer, Gresham House Strategic's buy-in price was in effect at a 40 per cent discount to analysts' estimates of Northbridge's net asset value. A cash profit to enterprise value multiple below five times, representing a 63 per cent discount to peers, according to Mr Dalwood, is equally attractive. Moreover, Northbridge has consistently generated a return on capital employed above its cost of capital, so any easing of the challenging market conditions is likely to see a strong operating margin recovery back to the long-term average.

Gresham House Strategic was allocated 2m of the 6m shares in April's placing and underwrote the open offer, too. It currently owns 2.36m of Northbridge's shares, which have a market value of £2.15m at the current share price of 88p, or significantly above April's 75p a share placing price.

Potential in media sector

And that's not the only investment with potential. Having picked up a small stake at the end of last year in Be Heard (BHRD:3.25p), a digital marketing group, Gresham House Strategic backed an £8m placing by the company in April to support the earnings-accretive acquisition of MMT Digital, a design, build and user experience agency based in the UK. As a result, Gresham House Strategic owns 11 per cent of the equity, a holding worth £2.36m.

The 4.6 per cent holding in Quarto (QRT:232p), a global illustrated book publisher and distribution group that was established in 1976 and has been listed on the London stock market since 1986 is also of interest. Over 60 per cent of Quarto's turnover comes from a backlist of over 9,000 titles, providing a stable revenue stream. The shares are rated on seven times earnings and offer a dividend yield of 4 per cent. Furthermore, Quarto has potential to acquire smaller niche operators at attractive multiples (between four to five times cash profit) and deliver growth by leveraging the distribution and purchasing base of a larger business. I understand that the company has a pipeline of identified acquisition opportunities worth over $25m (£17m).

The key here is that operational savings and boost to EPS from buying smaller publishing companies on attractive earnings multiples should drive a re-rating in Quarto's own shares. The new management team leading this strategy have already enjoyed some success, boosting cash profit at IVY Press, an illustrated book publisher, from £400,000 at the time of the acquisition last year to in excess of £1m in the first full-year under ownership.

I would also point out that there is upside potential in the two remaining holdings: £1m plus stakes in both SpaceandPeople (SAL:45p), a company that markets and manages promotional space for marketing campaigns and retailing in shopping centres and other high footfall locations; and UK fund manager Miton (MGR:23.5p). Spaceandpeople is rated on 8.5 times earnings estimates and offers a dividend yield of 5.3 per cent, and Miton is trading on only 10.5 times last year's cash-adjusted earnings after accounting for a cash pile worth 8p a share, and offers a 2.9 per cent dividend yield.

The bottom line

Gresham House Strategic's net asset value was 995p at the March 2016 year-end, and 985p on 6 June 2016, but I reckon that after factoring in movements in the portfolio since then, primarily the increase in IMImobile's share price, then spot net asset value is now 1,033p. So with the shares trading on a bid-offer spread of 775p to 780p, the share price discount is 25 per cent to spot net asset value. And once you adjust for 312p a share of cash on the balance sheet, the equity portfolio is in effect being valued on a 35 per cent discount to its underlying value.

As I stated at the start of this article, it's not often that you can buy into a likely chart break-out on the cheap, but with Gresham House Strategic's shares so undervalued then this is certainly the case with its investment in IMImobile. Moreover, with investors yet to cotton onto what has happened at IMImobile, partly because attention has been firmly focused on the EU referendum and spike in market volatility after the result, then there is an opportunity here to exploit the mispricing by buying into Gresham Hose Strategic at a bargain basement level.

Needless to say, I have no hesitation rating Gresham House Strategic's shares a buy at 780p and see no reason whatsoever why they should not be trading closer to book value, especially as the company's net asset value has held firm during the market rout this year, highlighting the potential to successfully apply private equity techniques to public companies as is the company's investment strategy. The aim is to create a portfolio of between 10 and 15 holdings in the small-cap segment of the market, a concentrated enough number of holdings to allow its investment managers to engage with investee stakeholders. The Northbridge share purchase is a case in point. Moreover, a cash-rich balance sheet provides the fire-power for its advisers to take further stakes in more undervalued small-cap situations and is highly supportive of this strategy.

There are rich pickings to be had right now for shrewd stockpickers to exploit in the Brexit fallout, and I feel that Gresham House Strategic is ideally placed to do so. It's also a strategy I plan to pursue in the comning weeks and months in order to highlight good-quality undervalued companies with decent trading prospects, irrespective of the domestic political and economic uncertainty that is currently undermining confidence. This is a stockpickers' market and the shares rate a solid buy.

Please note that I included the company as one of my Bargain shares for 2016 in this year's portfolio around the current price.