It’s only fair to say that the backdrop for investing in the under-researched small-cap segment of the market has been incredibly benign this year. In fact, the FTSE Small Cap index has risen by 11 per cent, and the FTSE Aim index is up by almost 18 per cent, handsomely outperforming the 6 per cent gain on the blue-chip and mid-cap-focused FTSE 350 index.
The devaluation of sterling is certainly helping as a large number of the minnows of the stock market I follow are benefiting from a strong currency tailwind on their overseas earnings, while at the same time the economic recovery in continental Europe, the UK’s major trading partner, is buoying demand across end markets. I would also flag up that the ongoing easy monetary policy being pursued by the Bank of England continues to depress UK government bond yields well below what anyone would consider to be their natural rate, so forcing income-hungry investors up the yield curve and seeking higher returns in other asset classes including the equity market.
That’s not to say that I believe the case for such largesse is justified anymore as it is clear that the UK economy has not fallen off a cliff edge after the EU referendum, so making the case to prolong last summer’s emergency cut in base rates hard to justify. I also feel that with UK employment levels at a record high, the economy is strong enough to withstand tighter monetary policy. Also, a modest interest rate rise would be a signal of intent, and one that would undoubtedly reverse some of sterling’s depreciation, thus relieving the currency-led inflationary pressures which have led to the UK inflation rate overshooting the central bank’s target of 2 per cent.
That said, if the Bank of England wants to keep interest rates at record lows, and undermine the value of sterling, then it makes sense to continue to exploit the favourable backdrop this is creating for investing in certain parts of the equity market. The commercial property sector is the obvious starting point.
Hot property
Bearing this in mind, Aim-traded property investment company Palace Capital (PCA:385p) has just announced the £20m acquisition of a portfolio of properties in Newcastle-upon-Tyne comprising a 274-bedroom Jury’s Inn Hotel; a 85,000 sq multi-let office block whose tenants include UBS, Serco and the National Lottery Charities Board; a small retail element and the freehold of 145 apartments. The properties’ total net income of £1.76m equates to an attractive initial net yield of 8.6 per cent, which is way above the company’s cost of capital. Indeed, after accounting for interest costs on a £11.5m loan to part-fund the acquisition, it should generate a net contribution of £1.4m a year to Palace Capital’s profits, representing a 16.5 per cent return on equity.
It also means that the company has more than replaced the income lost on the 13 properties worth £12.6m it sold last financial year, which is why analyst Tim Dainton at brokerage Arden Partners expects EPS of 20.3p in the 12 months to the end of March 2018 to ramp up to 25.6p the following year, thus supporting expectations of the payout per share rising by 0.5p each year to 19p and 19.5p, respectively. On this basis, the shares offer an attractive prospective dividend yield of 5 per cent and are rated on 14 per cent below the company’s last reported net asset value (NAV), or a 10 percentage point deeper discount than the listed regional property sector average, according to analysts Julian Roberts and Martyn King at Edison Investment Research.
That’s a modest rating for a company that has doubled its NAV per share since 2013, and one that has modest levels of balance sheet gearing and the scope to enhance the portfolio value in the near term. For example, the company has submitted a planning application to convert Hudson House scheme in York, a 103,000 sq ft office block located close to the city’s railway station, into 127 apartments, 34,000 sq ft of offices, 5,000 sq ft commercial space and car parking. The sales market in the York and Harrogate area remains buoyant as buyers move from the outskirts to the town centres, thus offering potential for a significant uplift on the £15m value of the site when the planning decision is made in the autumn.
So, having initiated coverage on the shares last autumn at 335p ('A royal investment', 17 Oct 2016), and last advised running profits at 380p ('Running property gains', 19 Jun 2017), I am tweaking my target price up from 400p to 415p in light of the acquisition made, and analysts’ earnings upgrades. Buy.
High income telco play
I also feel that shares in Manx Telecom (MNX:180p), the incumbent telecoms operator on the Isle of Man, have been unfairly treated in recent months. I last rated them a buy at 197p ('Eight small-cap plays', 27 Mar 2017), since when the company has paid a final dividend of 7.2p a share, having first advised buying at 164p when the shares listed on London’s junior market ('High-yield telecoms play', 15 May 2014). A primary bull point at the time was Manx Telecom's substantial operating cash flow which not only supports a stable and rising dividend, but underpins investment in its data centres, superfast broadband, and fixed and mobile telecoms offerings.
That’s still the case as the company has not only paid out total dividends of 31.2p a share since listing in 2014, but analyst Andrew Bryant at Liberum Capital expects 5 per cent-plus growth in both this year’s and next year’s payout to 11.5p and 12.1p, respectively. The £13m cost of the current year dividend is covered 1.5 times by free cash flow based on Mr Bryant’s estimates. He also notes that the board is targeting total annual cash savings of £4m, half of which will start to accrue from headcount reductions in the current financial year with the balance reflecting lower maintenance capital expenditure. In other words, the progressive dividend policy looks well supported as does the potential for Manx to pay down net borrowings of £52m from improved cash-flow generation.
Perhaps, investors were slightly disconcerted by news of a fall in data centre revenue in the pre-close trading update ahead of half-year results on Tuesday 12 September. However, this had been previously flagged and is only down to a customer consolidating its data centre requirements following an acquisition. In any case, this business segment only represents 7.5 per cent of Manx Telecom’s total revenue, so some perspective is needed here as the company is still trading in line with analysts’ forecasts, which point to full-year cash profit rising modestly to £28m. After accounting for non-cash depreciation and amortisation charges of around £9.1m, and a net finance charge of £2.2m, this suggests a modest rise in full-year pre-tax profit to £16.7m and EPS of 14.5p. Or, to put it another way, there is nothing to suggest that the company will not hit current year earnings estimates, and raise its dividend yet again.
Offering a prospective dividend yield of 6.4 per cent, and rated on a reasonable nine times cash profit to enterprise value, I feel Manx Telecom’s shares are worth buying at 180p ahead of next month’s results. Buy.
Amino has the ammunition
In early May, I took the prudent step to top-slice a number of holdings including the Aim-traded shares of Amino Technologies (AMO:190p), the Cambridge-based provider of digital entertainment solutions for internet protocol (IP) TV, internet TV and in-home multimedia distribution ('Hitting target prices', 2 May 2017). The share price had hit my 220p target price, having risen by risen by 15 per cent since the company issued its third earnings beat since last summer ('In the ascent', 20 Feb 2017), and was showing a 191 per cent total return on my original recommended buy-in price of 83p ('Set up for a buying opportunity', 10 Jun 2013).
Since then Amino’s share price has retreated 14 per cent in a rising market, not that the company has disappointed as first-half results fully support the decision of analyst Oliver Knott at brokerage N+1 Singer to upgrade his EPS forecasts in February by 9 per cent for this year and next, to 13.9p and 14.4p, respectively. In fact, 62 per cent of N+1 Singer’s full-year pre-tax profit forecasts were covered in the first half alone, thus providing scope for outperformance if the factors driving the performance – favourable product mix, positive currency headwind on overseas earnings, and good cost control – are repeated in the second half, as seems likely.
Furthermore, Amino’s cash continues to build, more than doubling to £13.1m in the six months to the end of May 2017, a sum now worth 18p a share and supporting expectations of another 10 per cent hike in the annual payout per share to 6.7p, rising to 7.3p in 2018. On this basis, Amino’s shares are priced on a very reasonable cash-adjusted earnings multiple of 12.3 times – representing a 34 per cent discount to UK-listed technology hardware peers – and offer a forward dividend yield of 3.5 per cent, a valuation that should provide upside back to my 220p target price, and perhaps beyond that to N+1 Singer’s 243p fair valuation, and finnCap’s target of 260p. Buy.
A solid performance
Shares in Redditch-based Solid State (SOLI:530p), a supplier and design-led manufacturer of specialist industrial and rugged computers, battery power packs to the electronics market, microwave systems and advanced antenna products, have surged by 27 per cent on an offer-to-bid basis after I highlighted the investment case at 410p a month ago (‘A trio of small-cap buys’, 10 Jul 2017). It also helped that analysts Anne Margaret Crowe and Roger Johnston at Edison Investment Research produced a bullish note a week after my article was published.
As a result, Solid State’s share price has smashed through my initial target price of 480p and the shares are now rated on 16 times Edison’s EPS estimates of 33.1p for the 12 months to the end of March 2018, in line with the average rating of specialist manufacturing companies on Edison's list, but below the mean forward PE ratio of 18.2 for value-added distributors. There could be further share price upside for a number of reasons.
For starters, Solid State has a record order book worth £20.7m, up 16 per cent year on year, of which over two-thirds is due for delivery in the current financial year. So, with all parts of the business firing there is scope for the ongoing sales momentum to drive upgrades on what appear to be conservative earnings estimates. For example, its specialist electronic components and displays division is actually trading ahead of industry-wide growth forecasts, which point to a 4.3 per cent expansion in the 12 months to the end of March 2018. There is also the potential for the cash-generative company to utilise its cash-rich balance sheet and make an earnings-accretive acquisition, a possibility I discussed with the directors before I initiated coverage.
In the circumstances, it makes sense to run your hefty paper gains, especially as a chart break-out above the 540p price level could be on the cards. A 2.3 per cent prospective dividend yield offers income attractions, too. Run profits.
Finally, I initiated coverage this week on Strix (KETL:100p), a global leader in the manufacture and design of kettle safety controls, which floated its shares on Aim on Tuesday 8 August (‘Tap into a hot IPO’, 7 Aug 2017). This could be one of the IPO winners of the year, and not just because the shares were listed on an attractive single-digit earnings multiple and offer a 7 per cent prospective dividend yield. The 2,700 word in-depth article is available to read on my home page of our website, and requires an online subscription (available for only £20 a year for existing magazine subscribers).
