Of course, you need to know what to look for in the first place and be able to ascertain whether the valuations of the assets held are realistic. That's why I have written a dedicated chapter in my book outlining how I go about uncovering these undervalued stock market gems. But, even then, you still need buyers willing to pay the market price for the assets for the valuation anomaly to turn into a profitable investment opportunity.
In the past 18 months, I have managed to pick out a number of undervalued asset plays where the companies concerned have been highly successful in realising the full value of their assets. A classic example is Aim-traded investment company BP Marsh & Partners (BPM: 142p), an investment that has made us a 50 per cent return since last autumn. We will have to wait and see how the company deploys its huge cash windfall from the sale of 80 per cent of its stake in global insurance broker Hyperion Insurance Group to private equity company General Atlantic in a £29.2m deal. However, investors have clearly started to recognise the anomalous valuation on offer.
I remain positive on the shares, which still trade on a hefty 26 per cent discount to net asset value of 191p, even though BP Marsh now has net funds of £20m, worth 68p a share, and still holds a further 45p a share of equity and loans in Hyperion. General Atlantic has an option to purchase the balance of BP Marsh's stake for £7.3m when Hyperion undertakes an initial public offering (IPO) and, under certain conditions, there could be a further £2m cash payout for BP Marsh if Hyperion undertakes an IPO within 12 months. This not only means BP Marsh's net cash is worth around half its market capitalisation of £41.6m, but it also means investments in another eight investee companies, worth £16.7m or 57p a share, are nearly all in the price for free.
Targeting cash returns to shareholders
I also target companies that are likely to return substantial amounts of the cash raised from asset sales back to shareholders. That's because such capital returns inevitably act as a major share price catalyst as other investors recognise the anomalous valuation on offer, which narrows the share price discount to book value and reward us with significant gains by spotting the anomaly early.
For example, the board of Aim-traded carbon credit investment company Trading Emissions (TRE: 19.5p) has now returned 21p a share in cash since the start of this year, which fully vindicates my decision to include the shares in my 2012 Bargain Shares Portfolio at 25.25p ('How the 2012 Bargain Share Portfolio fared', 8 Feb 2013). In fact, for a net capital investment of 4.25p you are now sitting on paper worth 18p if you followed my advice at the time.
The subsequent capital returns also vindicate my decision to reiterate my buy recommendation when the shares were anomalously priced at 19.5p during the rout in equity markets 15 months ago ('Time to capitalise on LMS', 25 Jun 2012). I was so convinced of the investment case that I again advised buying the shares at 23.5p at the end of March this year ('Small-cap trading plays', 27 Mar 2013), shortly before I went on sabbatical to write my new book.
It proved timely a timely call, too, because if you followed that advice you will have now received a hefty 15p a share capital return in the summer, so your carrying value on the investment is only 8.5p a share - or half the current share price. Or, to put it another way, you have doubled your net capital invested in only six months. As investments go, it doesn't get much better than that.
The other important point to note is that anyone reinvesting the previous distribution of 6p a share in January back into Trading Emissions' shares has done incredibly well. And there is little reason to think things will be different this time if you banked the 15p a share distribution in the summer. That's because, if my sum-of-the-parts valuations prove on the ball, there should be ample further share price upside.
We shouldn't have long to wait, either, to reap the benefits because Trading Emissions is scheduled to release full-year results in early November. I fully expect the glaring valuation anomaly I have uncovered will become apparent to other investors when those results are released and, as a consequence, prompt yet another re-rating of the shares.
Assessing upside potential
By my calculations, Trading Emissions had a pro-forma net asset value of 52p a share at the end of March after factoring in the aforementioned 6p a share capital return. Book value consisted of a carbon credit portfolio with a negative liability of £14m, or 5.6p a share; a private equity portfolio worth £105m, or 42p a share; and net cash of £39m, or 15.6p a share. In April, the cash sum was bolstered following the drawdown of a €31m (£26m) loan by Trading Emissions' wholly-owned subsidiaries, TEP Solar Holdings and Solar Energy Italia. Of this sum, at least €26m was passed on to Trading Emissions. In other words, even after the payment of 15p a share at the end of July, the company's cash pile could potentially be around 9p a share.
It could be even more since a Letter of Credit issued by the company and held by the International Bank for Reconstruction and Development was returned to Trading Emissions in early September. This released around €4.8m, or £4m, from funds held as security under the original Letter of Credit. Trading Emissions no longer has any outstanding engagements with the World Bank. That sum is worth 1.6p a share alone and should have bolstered the cash pile to well over 10p a share.
This means Trading Emissions' shares, at 19.25p, are trading at a hefty 48 per cent discount to pro-forma book value of around 37p, of which over 10p could be in cash. Strip out net cash for the current share price and investments worth 27p a share are being valued at 9p, or a third of their book value. In my view, a discount of that magnitude is way too deep given the scope for additional capital returns, especially as the company is actively looking to dispose of its portfolio of carbon and private equity investments. A far more realistic estimate of fair value is 25p a share, which would still represent a share price discount to net asset value of 33 per cent.
Trading on a bid-offer spread of 18.25p to 19.25p, and with the prospect of yet more capital returns highly likely, I rate Trading Emissions' shares a deep value buy ahead of the full-year results in early November. Furthermore, if the company continues to make progress with its asset sales, I would not be surprised at all if it announces yet another distribution to shareholders at the time of those results.
Following a raft of announcements on companies on my watchlist, I am in the process of updating my advice on the following share recommendations: IQE (IQE:31p), Global Energy Development (GED: 100p), KBC Advanced Technologies (KBC: 84p), 32Red (TTR: 57p), Spark Ventures (SPK: 12.25p) and Town Centre Securities (TCSC: 218p). Please note my next column will be published at 12pm on Monday. I will also be publishing my 2013 US Dog Share Portfolio on Friday 27 September.
Also, in response to requests from dozens of readers, I have published an article outlining the content of my new book, Stock Picking for Profit: 'Secrets to successful stock picking'
