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Riding small cap bumper gains

Riding small cap bumper gains
October 24, 2016
Riding small cap bumper gains

Aim-traded UK defence group Cohort (CHRT:350p) has announced a reorganisation of its operations which will see defence consultancy division SCS integrated into other parts of the business. The unit generated revenues of £18.1m of group revenues of £112m last financial year, but margins were only 6.6 per cent, a reflection of a tightening of consultancy fees paid by its main customer, the UK Ministry of Defence. The impact of this has been to increase the proportion of lower-margin work carried out by SCS following the end of several profitable projects, particularly the cessation of activity in Afghanistan. The reorganisation of SCS will cost Cohort around £2m, but will generate annual cost savings of £1.6m, so it makes sense to do so.

Importantly, trading in Cohort’s other businesses remains buoyant. A nine-year extension worth £12m to its managed IT service contract at RAF Waddington highlights ongoing strong trading at Cambridgeshire-based subsidiary MASS, a specialist systems house with a focus on electronic warfare operational support, cyber defence and secure information systems. Analysts at Edison Investment Research expect £60m worth of contract renewals and new orders to convert across the group in the financial year to end April 2017, a credible prediction given that Cohort’s opening order book of £116m accounted for half of current year revenue estimates of £132m and has improved year-on-year since then. Expectations of a 20 per cent increase in Cohort’s full-year pre-tax profits to £14.3m, rising to £15.6m the following year, are well supported by the order backlog.

On this basis, expect full-year EPS of 26p, rising to 31.6p the year after, implying the shares are rated on 11 times earnings estimates. Moreover, buoyed by robust cash generation, net debt is expected to be cut from almost £20m to £5.2m during the financial year to end April 2017, so the board have scope to raise the dividend per share from 6p to 7p, as analysts predict.

Having initiated coverage on Cohort when its shares were priced at 214p ('Blue-sky buy', 6 Oct 2014), I subsequently advised top slicing two-thirds of your holdings at 415p ('On a roll', 15 Dec 2015), and my last recommendation was to run profits at 315p (‘In defence’, 6 Jul 2016). With a further 10 per cent upside to my target price of 387p, I am maintaining that stance. Run profits.

Dividends flow at Arbuthnot Banking

Investors have been cottoning onto the value on offer in the shares of Arbuthnot Banking Group (ARBB:1,449p). Arbuthnot realised £148m of cash proceeds at the end of May by selling down its stake in Secure Trust Bank (STB:2,380p), but its remaining holding is still worth £82m, a significant amount in relation to its own market capitalisation of £220m.

Arbuthnot used £53m of the cash windfall to acquire a prime property in the West End of London, comprising 22,500 sq ft of office space and 7,000 sq ft of retail space. The premises will in time enable its private banking arm Arbuthnot Latham to develop a presence in the West End, occupying part of the property for client purposes, but in the meantime it’s generating a useful annual rental income of over £1.8m

Shareholders are seeing some of the cash too. Having paid out cumulative dividends of 83p since I included the shares in my 2015 Bargain share portfolio at 1,459p, the board have declared a special dividend of 300p a share, payable on 18 November and at a cost of £45m. Please note that the shares have gone ex-dividend which is why the price adjusted at the end of last week. The directors can afford to make the bumper payout without impacting the bank’s financial position given that Arbuthnot has a core Tier 1 ratio of 40.5 per cent and a modest equity to assets ratio of 22.4 per cent.

The plan is to use the balance of the cash raised from the Secure Trust share sale to develop its private and commercial banking business, Arbuthnot Latham. The unit posted half year pre-tax profits of £4.5m on a 15 per cent hike in operating income to £19.4m. It’s well funded as customer deposits cover loans and advances to customers more than 1.4 times over and this liquid funding and balance sheet strength is highly supportive of the ongoing growth in loan balances. Deposits increased by 23 per cent in the 12 months to end June 2016 as the bank continues to attract new clients and at a lower deposit rate of 0.87 per cent.

As long as Arbuthnot Latham can recycle its £1bn of customer deposits into high quality lending and at an economic net interest margin, then it will be value accretive to shareholders. This ramp up in lending explains why analysts at Hardman & Co expect Arbuthnot’s adjusted EPS to increase from 24.4p in 2016, to 55.4p in 2017, rising again to 93p in 2018. Maintaining credit quality will be critical, so it’s reassuring that impairments represent a tiny 0.12 per cent of loans on an annualised basis, highlighting the quality of the book.

The bottom line is that if you followed my advice to buy in February 2015 you will have now banked 383p a share of dividends and still own shares worth around your buy in price of 1,459p. I still feel that Arbuthnot’s shares should be trading closer to book value of 1,552p. Run profits.

Assured gains

My value-based approach to investing has over the years uncovered dozens of small cap gems, and Aim-traded insurance sector investment company BP Marsh & Partners (BPM:198p) is undoubtedly one of them.

Since I initiated coverage at 88p ('Hyper value small-cap buy', 22 Jan 2012), the board have paid out 11.17p a share of dividends, so the holding is showing a total return of 138 per cent. Guidance is for a 10 per cent hike in the payout per share to 3.76p in the financial year to January 2017, an expectation well underpinned by the company’s ongoing strong investment performance.

In the first half to end July 2016, BP Marsh increased its net asset value (NAV) per share from 243p to 253p after paying out a 3.42p a share dividend, maintaining an enviable track record that has seen NAV per share rise at a compound annual rate of 11.3 per cent since 1990. A key driver of the £4m investment gain booked on BP Marsh’s £53m equity portfolio in the latest six month period came from its 37.94 per cent holding in Besso Insurance, a top 20 independent Lloyd's broking group that has appointed investment bank Cannacord Genuity to carry out a strategic review. Discussions are ongoing with potential investors with a view to a sale, or investment in Besso. The value of BP Marsh’s stake increased from £18.1m to £20.1m in the half year, implying a valuation of £53m for Besso’s equity, or 8.8 times its forecast cash profits of £6m in 2016.

That’s still a low valuation relative to the 10 times cash profit multiple which investment firm Calera Capital acquired a majority interest in Robert Fleming Insurance Brokers, the international Lloyd's insurance and reinsurance broker. Attributing the same multiple to Besso’s likely cash profits this year would increase the value of BP Marsh's stake even further to £22.8m, a sum worth 78p per BP Marsh share.

The disposal of a stake in Aim-traded Randall & Quilter (RQIH) for £1m, or 25 per cent above carrying value, and the receipt of £7.3m from BP Marsh’s remaining stake in privately-owned global insurance broker Hyperion Insurance has swelled the company’s uncommitted cash balances to £7.9m, a sum worth 27p a share. The rock solid asset backing doesn't end there because BP Marsh’s loan portfolio of £15.2m, worth 52p a share, includes a £6m loan to Hyperion on which it earns annual interest of £450,000 and is due for repayment in October 2017, or sooner if Hyperion goes down the route of an IPO. So effectively, cash, loans, receivables and the stake in Besso account for around 150p of the company’s NAV, with the investment risk skewed to the upside.

Other holdings of interest include BP Marsh’s 11.94 per cent stake in Nexus Underwriting, an independent specialty Managing General Agency. This is showing big gains, rising in value by a further £1m to £7m in the first half this year, implying 75 per cent uplift on cost. Tim Coles, previously the boss of highly regarded Howden Broking Group, was appointed as chief executive last year with the mandate of developing Nexus into a business capable of writing $250m (£204m) of profitable speciality business within three years. He’s moving in the right direction as premium income is expected to rise from £56m in 2014 to £110m in 2016. BP Marsh’s investment in LEBC, an independent financial advisory firm that has been making hay in the post Retail Distribution Review (RDR) environment, is a valuable asset too and one with a carrying value of £11.5m, or 40p a share.

So, having last advised buying BP Marsh’s shares at 195p (‘In the ascent, 12 Sep 2016), I have tweaked my target price up to 230p to take into account the likely cash proceeds from the Hyperion loan and the potential for a successful exit from Besso. Buy.

Inland’s bumper profits

Shares in Inland (INL:60.25p), the specialist housebuilder and brownfield land developer, have proved volatile, albeit they are well ahead of the 55p level when I last advised buying (‘Deep value small-caps’, 12 Jul 2016) and are up 155 per cent since I initiated coverage at 23p in my 2013 Bargain share portfolio ('How the 2013 Bargain shares fared, 7 Feb 2014).

A key take for me in the full-year results were the comments made by chief executive Stephen Wicks who notes that “business has been largely unaffected by the Brexit vote and although it remains too early to deliver a definitive judgement, given the robust performance and ongoing supportive market backdrop, the board has good reasons to be confident in the outlook”. This mirrors similar comments by other housebuilders across the sector.

It’s worth flagging up that although Inland’s operating profits of £40.2m were slightly shy of the previous year’s record, the company continues to make bumper profit on land sales (flat at £17m), revaluations of its land holdings (gains of £18m compared to £14.5m in 2015) while at the same time its housebuilding arm makes a very useful contribution (profits of £11.2m compared to £13.8m in 2015). Moreover, profits would have been higher if a contractor had not run into difficulty which delayed 23 completions in the period. Inland currently has 321 units under construction across 10 sites, which highlights the momentum driving this part of the company’s activities. Forward sales of homes, where units have been reserved or where contracts have been exchanged, remain strong at £22.5m.

It’s also worth noting that Inland’s land bank now stands at a record 6,681 plots. The profitability of its projects is revealed by the adoption of EPRA accounting standards as net asset value of 57.5p is further augmented by a 33p a share gain on the unrealised value within projects, reflecting the increasing value of the land bank as the company goes through the different stages involved with the planning process.

On this basis, the shares are rated a third less than EPRA book value, a harsh rating for a company that operates in the affluent south of England housing market, has proved adept at picking up land parcels at smart prices, successfully adding value through the planning system, and then offloading 'oven ready' land to the major housebuilders. A rating of 10 times earnings excluding revaluation gains is hardly exacting either and the hike in the payout to 0.9p a share is a clear sign of the board’s confidence. Buy.

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Please note that I have analysed the investment case of 61 companies since the start of September, all of which are available on my homepage.