The risk:reward ratio on the former is far more favourable. More important than that, if the investment does not work out as planned and you end up crystallising a loss, you only need your capital to grow 11 per cent on a follow-on investment to recoup your original capital outlay if you bank a loss of 10 per cent on a poorly performing investment. However, faced with a thumping 25 per cent crystallised loss on the higher-risk shareholding, your next investment would need to grow by 33 per cent in value to recoup your original capital outlay.
In other words, by taking on a higher-risk investment offering higher rewards, you could end up needing a return three times greater on your follow-on investment to recoup your capital if things don't pan out as you had hoped. If this particular subject matter is of interest, I have outlined specific ways to actively manage investments to minimise risk in your portfolio in my new book Stock Picking for Profit.
This subject matter is certainly of interest to me right now, because a number of the asset backed companies I have recommended buying shares in this year have released results or trading updates in the past week. All are doing very well and require a reappraisal of the investment case.
Capitalising on LMS Capital
Half-year results from investment company LMS Capital (LMS: 78.5p) have only reinforced my view that the shares remain undervalued. To recap, I have been a fan of the company for quite some time.
I first recommended buying the shares at 54.5p in February 2011 ('Capital returns', 11 February 2011), repeated that advice when the price was 64p ('Time capitalise on LMS', 25 Jun 2012) and at 66p ('Happy capital returns', 17 December 2012). Following the first-quarter trading update, I reiterated the advice at 71.5p ('Target price smashed', 15 May 2013) and again earlier this month at 74.5p (‘Rewarding asset backed investments’, 4 July 2013).
The main reason I have been so keen on the company's shares is the fact that they were trading at a deep discount to net asset value even though LMS is in the process of selling off its holdings in investee companies in order to return cash to shareholders. Moreover, the board has been really shrewd by returning the cash via tender offers. These share buybacks have been priced bang in line with net asset value.
The company is in the process of returning £35m of its £43.8m cash pile to shareholders, which equates to 17.2 per cent of LMS Capital's net asset value of £203m at the end of June. Shareholders tendering in excess of their basic entitlement will receive approximately 2.1 per cent of the ordinary shares validly tendered in excess of this amount. Crest accounts will be credited with the tender proceeds next week. The tender price was set at 90p a share. Cheques will also be despatched at the same time in respect of investors with certificated ordinary shares. This is the second tender offer by LMS as the company repurchased 17.4 per cent of the issued share capital through a tender offer at 84p a share last autumn. Importantly, this method of capital return enabled shareholders to sell down further chunks of their holdings at book value without affecting the share price. It also means that shareholders have been able to sell back to the company 68 per cent of their original holdings at book value. This represents a significant premium to our own buy-in prices. For good measure we have also benefited from a rise in LMS's share price on the balance of our holdings.
US portfolio gains
The other reason I have been so keen on the shares is because we are also benefiting from uplifts on the value of the company's investments while this asset disposal programme is ongoing. For instance, in the latest six-month trading period, LMS booked a net gain of £12.6m on the portfolio, a sizeable sum in relation to the company's net asset value of £203m. It's worth noting that LMS doesn't hedge its currency exposure, so with investments in the US accounting for £107m of the investment portfolio of £167m, and the balance of the investments in the UK, this means that almost two-thirds of the portfolio is denominated in US dollars.
This is a really important point to note because, with the US economy outperforming the UK, and the US central bank far nearer to ending its quantitative easing (QE) programme than the Bank of England, this has put considerable pressure on sterling. In fact, the exchange rate has fallen from £1=$1.625 at the start of the year to £1=$1.538. In turn, this means that the company's US portfolio is worth 5.5 per cent more in sterling terms than at the start of the year. As a result, LMS booked an unrealised net currency gain of £7.4m on its portfolio in the latest half-year figures.
Moreover, I can see sterling coming under more pressure over the next six months as it becomes clearer that the Bank of England's monetary policy committee, under the leadership of the freshly appointed governor, Mark Carney, will be looking to pursue a policy of maintaining interest rates at record lows for years to come. This is good news if you are a homeowner in the UK, or if you hold assets in currencies that are likely to appreciate against sterling, like LMS.
Potential for valuation uplifts
There are likely to be further investment gains given the operational performance of the main companies LMS holds stakes in. For instance, LMS holds a £17m stake in UK-based Updata, a private company that designs, implements and manages networks for public sector clients under long-term contracts. Its wide area networks (WAN) offer secure, cost-effective, high-capacity broadband connectivity.
It's a business that is growing fast; revenues in the first half to end-June rose 70 per cent to £21.3m on the corresponding period last year. This reflects Updata's recent success in winning new contracts, many of which have been installed and came on stream in the period. Updata accounts for over 10 per cent of LMS's investment portfolio.
Another very promising investment is US-based Nationwide Energy Partners. The company specialises in the design, installation, operation and maintenance of private electric distribution systems for new housing communities. The business also offers full-service account management of electric and water utilities, including sub-metering systems, meter reading, billings and collections. It is a high-growth business; in the first six months of this year turnover increased by 38 per cent compared with the first half of 2012. This also reflects new contract wins. The shareholding in Nationwide Energy Partners is currently valued by LMS at £10.7m, or 6 per cent of the £167m portfolio.
LMS also won a holding in UK-based Entuity, a leading provider of network management software, enabling systems integrators and enterprise customers to deploy and manage complex networks, reduce network downtime and ensure network configuration compliance. Entuity supports hundreds of customers in over 50 countries worldwide. Products are mainly marketed through resellers, systems integrators and distributors. Three of the 'big five' in infrastructure management - BMC, IBM Global Services, and Oracle - either re-license, re-sell, or recommend Entuity's solution for their frameworks. In the past six months, Entuity's revenues increased 15 per cent.
In total, LMS's top 12 investments by value account for £123m of the company's £167m portfolio. This means it is relatively easy for the board to keep tabs on how the portfolio is performing, but also means that disposals will be easier to execute with these companies performing well.
Target price
I have reappraised the investment case of LMS in light of the ongoing disposal programme and the fact that there is greater investment upside on the portfolio than I had previously envisaged. Indeed, in the first six months of 2013, the company's net asset value rose from 85p to 90p. In light of this, it is not unreasonable to expect the shares to be trading far closer to book value than on a discount as has previously been the case.
So, offering 15 per cent upside to net asset value of 90p, and with some shareholders likely to reinvest the proceeds of the tender offer back into the shares to take advantage of the ongoing share price discount to net asset value, then I continue to rate LMS shares a buy trading on a bid-offer spread of 77.5p to 78.5p. My year-end target price of 90p looks well underpinned by further likely investment gains on disposals and sterling weakness to boost the US portfolio.
Please note that I will update the investment case on both Inland (INL: 32p) and WH Ireland (WHI: 59p) as soon as I have completed my research and analysts have released their updated estimates.
Finally, I updated the investment case on 11 small-cap shares in three other online articles yesterday: Small-cap wonders; Deep value plays and Small-cap trading buys. I have also analysed the investment case on four more small-cap companies in three other online articles today: Undervalued and Unloved; Running profits; and Indigovision shares slump on warning.
