Bargain Shares: Beating the market Part I

In fact, all four portfolios are beating their benchmark FTSE All-Share index by quite some margin, highlighting the long-term gains that can be delivered using this Ben Graham inspired balance sheet based approach to investing. That’s not to say it’s a one-way street to riches. Investing never is and there have been some poor performers over the years. That’s the nature of investing.

However, my stockpicking system has an uncanny knack of unearthing absolute cracking investment opportunities, the financial gains from which more than compensate for losses on holdings that fail to deliver and so produce the market-beating portfolio returns. That in itself underlines the need to maintain a diversified portfolio of holdings as my 2015 portfolio highlights. Despite being hit hard when I crystallised losses on leather goods producer Pittards (PTD) and stamp and collectibles company Stanley Gibbons (SGI), the portfolio has still produced a three-year total return of 42.2 per cent, more than double the 19.6 per cent total return on a FTSE All-Share index ETF.

Even that only tells part of the story because two of the 10 companies in the 2015 portfolio have since been taken over, and just under a year ago I banked a thumping 264 per cent gain on AB Dynamics (ADBP), a UK designer, manufacturer and supplier of advanced testing systems and measurement products to the global automotive industry ('Taking profits', 18 Apr 2017). Factor in cash dividends paid, this means that if you had invested £1,000 in each of the 10 companies in February 2015 you will have realised £7,720 in cash to date and still retain five holdings which are currently worth a combined £6,500.

The same is true of my 2017 portfolio, which had beaten the market by 19 percentage points in the past 13 months even though one of the holdings – Tiso Blackstar (TBGR), a South African-focused investment company with media interests – has proved a drag. I have taken profits on three holdings which, when added to cash dividends paid, has released £3,834 for every £10,000 invested in the 10 constituents. This means that for a net investment of £6,166 you are currently holding shares currently worth £8,636.

All these calculations are on an offer-to-bid basis, and I have not factored in any interest income accrued on the cash proceeds from dividends and divestments. Moreover, the eye-catching investment returns would have been enhanced further by recycling cash dividends to buy more shares in the open market, highlighting the potential to compound up gains, or by taking advantage of the repeat buying opportunities I have subsequently highlighted for the retained holdings.

The reason this stockpicking system has worked well over the years is because it uncovers companies whose assets are being undervalued by the market, but are likely to be re-rated as and when trading prospects improve. That’s because investors generally value companies on a multiple of their net profits, so once profits start to gain momentum – as several of the companies below are now exhibiting – then this will be the catalyst for a share price re-rating and one that leads to a higher price-to-book value, too.

BATM move into sustainable profitability

BATM Advanced Communications (BVC:25.25p), a provider of medical laboratory systems and network solutions, has delivered the move into profit I was anticipating when I included the shares, at 18p, in my 2017 Bargain Shares Portfolio, producing full-year underlying cash profit of $2.2m (£1.6m), and a modest operating profit on revenue up 18 per cent to $107m. Reported profit was inflated by $5.5m-worth of gains on property disposals.

Buoyed by a raft of contract wins, BATM’s cyber security and networking division produced its first year-on-year revenue increase for six years and contributed operating profit of $867,000 on revenue up 28 per cent to $49.4m. A rising order book supports expectations of the positive momentum continuing, too. For example, BATM won a five-year contract worth $35.8m (£25.7m) to provide information communication technology (ICT) services to an agency of a government defence department, and has recently won a $4m contract to supply a cyber communication technology solution to another government defence department, the fourth such award.

Chief executive Dr Zvi Marom told me during our results call that he expects follow-on orders after the completion of that contract this year. He also sees potential for other proof-of-concept (POC) trials to lead to firm orders, and justifiably so given that government defence agencies are seeking to secure their communications and prevent cyber attacks on their infrastructure.

The same is true for BATM’s network virtualisation technology business, which has established partnerships with a number of telecoms operators and managed service providers. Having conducted several proof of concept trials, Dr Marom expects “significant orders in 2018”. A collaboration with NXP Semiconductors (Nasdaq:NXPI) and Arm, whereby BATM is the only global software vendor to provide network virtualisation functionality to Arm architecture and Intel platforms, highlights not only the strength of the offering, but also the potential.

In BATM’s bio-medical division, there are sound prospects for a unique patented hospital medical waste disposal system that reduces human exposure. Costing $100,000 per system, four units have been delivered to a major US hospital group since the autumn and, if successful, expect follow-on orders in the coming months. It’s worth noting that BATM’s bio-medical distribution revenue surged by 20 per cent to $42m last year, which Dr Marom attributes to the fact that “we are more highly valued by the big boys, that’s well connected to our own product development”.

Importantly, BATM is well funded as pro-forma net cash will be around $23.5m after receipt of the final proceeds from an overseas property disposal. There is substantial hidden value on the balance sheet as Egens, a leading biotechnology company, paid $2.9m for a near 5 per cent stake in BATM’s 95 per cent-owned subsidiary, an Italian manufacturer of medical diagnostics equipment. I wouldn’t be surprised to see other investors taking stakes in some of the BATM’s other businesses, thus highlighting the value of its intellectual property and providing further upside to my sum-of-the-parts valuation of 30p to 33p a share. Add to that scope for high-profile and multi-million dollar contract wins, and BATM’s move into profit looks sustainable. Strong buy.

PCF delivers robust growth

Aim-traded specialist bank PCF (PCF:31p) has reported a robust trading performance for the first five months of its financial year to the end of September 2018.

PCF has around 12,000 customers, three-quarters of which are on the retail side and borrow an average loan of £11,500, mainly to finance second-hand motor vehicles. The balance of lending is to small- and medium-sized enterprises (SMEs) that raise finance for commercial vehicles and plant with an average loan size of £30,700. PCF is not short of potential clients as new business originations have almost doubled from £28.2m to £54.5m on the same five-month period last year, and have boosted the lending portfolio from £127m to £172m.

The company is not short of funding, either, as it has already taken in £81m of retail deposits since getting its banking licence last summer. Given its savings product has a blended deposit interest rate of 2 per cent, well below PCF’s current cost of funding of 5.6 per cent, this highlights the potential to recycle low-cost deposits into higher-grade customer lending [that were previously deemed uneconomic], while maintaining a net interest margin of 8 per cent. A 12 per cent post-tax return on equity highlights the profitability of these lending activities.

Admittedly, chief executive Scott Maybury’s plan to double the size of the loan book to £350m by September 2020 may seem ambitious, but PCF’s balance sheet is adequately capitalised (tier one equity ratio of 26.3 per cent) to support a further £170m of retail deposits that will be required to support that lending target. If achieved, then banking analyst Robert Sanders at brokerage Stockdale Securities believes that PCF’s annual pre-tax profit will double to £10m by 2020, a chunky sum in relation to the company’s current market capitalisation of £65m. Retained profits earned in the interim should realistically boost net assets by half to £57.6m, suggesting a modest prospective price-to-book value ratio.

Of course there are risks, but the potential investment upside offers more than adequate compensation, which is why I included PCF’s shares, at 27p, in my 2018 Bargain Shares Portfolio. Expect another upbeat trading update at the time of the half-year results on Wednesday 23 May 2018. Buy.

U+I directors deliver

True to their word, the directors of U+I (UAI:200p), a specialist property developer and investor in regeneration projects, have delivered the record £65m to £70m of development gains in the financial year to the end of February 2018 that I had been banking on when I included the shares, at 205p, in this year’s Bargain Shares Portfolio.

Formed by the merger of Development Securities and Cathedral Group in 2014, U+I owns an investment portfolio worth £200m and a £6bn portfolio of complex, mixed-use, community-focused regeneration projects. For example, the company has secured planning consent, in partnership with the University of Brighton, to deliver a £300m mixed-use regeneration scheme along the Lewes Road in Brighton, incorporating the Preston Barracks site. The scheme comprises 369 new and affordable homes, 1,338 purpose-built student bedrooms in managed halls of residence, a new academic building for the University of Brighton and a 50,000 sq ft innovation hub for start-up and SME businesses.

After accounting for disposals made in the past 12 months, analysts Matthew Saperia and James Carswell at broking house Peel Hunt reckon U+I’s underlying net asset value (NAV) per share has increased from 278p to 300p, a performance that supports forecasts of a supplementary dividend of 12p a share, in addition to the final payout of 3.5p a share when the company releases full-year results on Thursday 26 April 2018.

Moreover, analysts at Peel Hunt also expect total dividends per share of 11.9p for the 2018-19 financial year, including a maintained full-year normal dividend of 5.9p a share, increasing to total dividends of 14.9p a share the year after. These forecasts look justified to me given that the directors are targeting cumulative development gains of £90m to £110m over the next two years to generate a 12 per cent annual post-tax total return. And it’s not as if the directors are generating these returns by overleveraging the company’s balance sheet as debt service costs are easily covered by the rental income on its investment portfolio.

There are not many companies that can offer prospects of an aggregate payout equating to 21 per cent of their market value over the next two years and grow NAV at the same time, but U+I is certainly one of them. Trading on a 33 per cent discount to the end of February 2018 NAV per share estimates, U+I's shares rate a great income buy and have potential for capital upside, too. Buy.

Mpac on a tear

Investors have started to cotton onto the undervaluation of Mpac (MPAC:175p), a small-cap company that sold off its underperforming tobacco division last summer, and other property assets, and is now producing robust growth from its niche packaging engineering business.

Mpac ended the 2017 financial year with net funds of £29.4m, a sum equating to over three-quarters of its market value of £38m and providing substantial firepower to scale up its fast-growing packaging engineering business – a supplier of high-speed packaging machines to healthcare, pharmaceutical and food and beverages companies. The division has just delivered full-year underlying operating profit of £1.3m on revenue up 29 per cent to £53.4m, a robust trading performance that makes its implied valuation of £8.6m an absolute bargain.

The key takes for me in Mpac’s full-year results were the 21 per cent increase in order intake to £61m, and the fact that momentum has continued into 2018, with the opening order book up 35 per cent to £34.4m year on year, a chunky sum in relation to this year’s likely revenue of £58.7m, based on forecasts from analysts Paul Hill and Hannah Crowe at Equity Development.

The important point is that as sales ramp up – the underlying market is growing at an annual rate of 5 per cent – the company’s margins will, too, which is why Equity Development forecasts an operating profit of £2.8m this year, surging to almost £4m on revenue of £64.6m in 2019. The respective EPS estimates are 9.9p and 14.1p, with the risk clearly to the upside given the potential for the directors, led by chief executive Tony Steels, to use Mpac’s hefty cash pile on selective earnings-accretive acquisitions. Furthermore, the board’s medium-term target is to raise operating margins to 10 per cent and deliver like-for-like sales growth of 10 per cent, highlighting the scope for profits to accelerate away on rising sales.

So, having included Mpac’s shares in my 2018 Bargain Shares Portfolio at 156p, I have no hesitation maintaining my positive stance given there is potentially 42 per cent more upside to my sum-of-the-parts valuation of 250p. Strong buy.

Volvere’s record results

Shares in Aim-traded investment company Volvere (VLE:1,000p) surged to within pennies of a record high after an eye-catching pre-close trading statement, thus justifying my buy recommendation, at 810p, last autumn (‘Exploiting hidden value’, 25 Sep 2017). I included the shares, at 419p, in my 2016 Bargain Shares Portfolio, so the holding is now up more than 125 per cent on an offer-to-bid basis.

The share price move is fully justified, too. That’s because the company’s latest NAV of £26m, or 656p a share, includes cash of £18.4m, so Volvere’s three investment holdings are effectively being valued at just £7.6m even though pre-tax profit for the 2017 financial year surged by two-thirds to £3.22m on record revenue of £43m.

The performance of Impetus Automotive, a provider of consulting services to the automotive sector in which Volvere has an 83 per cent stake, was the key driver. The business almost trebled its pre-tax profit to £3m on revenue of £27.1m, reflecting an improved client focus, staff efficiencies and a major contract for the management and delivery of a large automotive manufacturer's learning and development activities in the UK. Impetus is being chronically undervalued in Volvere’s accounts, accounting for only £3.3m of the company’s NAV, or just one times the subsidiary’s annual pre-tax profit. It could easily be worth £15m or more in a trade sale, or more than 400p a share in my view.

Moreover, Volvere’s businesses are cash generative, which is why the board was able to spend £3.46m buying back 10 per cent of the share capital last October. But cash on the balance sheet only declined by half that sum over the course of last year. Ahead of the full-year results on 25 May 2018, I would definitely run your bumper profits.

Bioquell’s record profits

It was difficult not to be impressed by the full-year results from Bioquell (BQE:330p), a provider of specialist microbiological control technologies to the international healthcare, life science and defence markets.

Revenue surged by 13 per cent to £28.5m in the company’s core bio-decontamination business, helped in part by favourable currencies – 80 per cent of divisional sales are overseas, so sterling’s weakness has provided a tailwind – but also by ongoing demand for products including: Bioquell QUBE, a novel, modular aseptic work-station incorporating hydrogen peroxide vapour (HPV) technology used to provide an aseptic environment for sterility testing and the production of toxic, intravenous oncology drugs; and an ergonomic fixed, wall-mounted bio-decontamination system.

So, with gross margins rising by four percentage points to a healthy 52 per cent, and administration costs kept in check, Bioquell’s underlying pre-tax profit soared by more than 75 per cent to £2.9m, highlighting the operational gearing of the business. Moreover, having already made the investment in its product suite – planned capital expenditure of £2m for 2018 is well below the combined £2.4m non-cash charges for depreciation and amortisation of development costs – this means that a high percentage of profit is being converted into cash flow, so much so that net funds ballooned from £8.8m to £14.6m, a sum equating to 20 per cent of Bioquell’s current market capitalisation. That cash pile is set to rise yet again this year, which is why the directors are “considering returning further cash to shareholders by way of a share buyback this year".

Importantly, the market backdrop remains very positive. Chairman Ian Johnson notes: “A number of different drivers of growth, which are positively affecting our business, including the need for customers to achieve and maintain regulatory compliance, the increasing threat posed by antibiotic resistance, and continuing growth in research and small scale production associated with cell-based healthcare products.”

Analysts concur with his rosy outlook, which is why Chris Glasper of N+1 Singer predicts Bioquell’s revenue will rise from £29.2m to £30.9m this year to deliver cash profit of £5.5m, pre-tax profit of £3.2m and EPS of 11.1p. On that basis, the company’s enterprise value equates to about 10 times likely cash profits, representing a 40 to 50 per cent discount to peers, according to Mr Glasper.

So, having returned 152 per cent on an offer-to-bid basis since I included the shares at an average buy-in price of 125p in my 2016 Bargain Shares Portfolio, and last advised running profits after N+1 Singer upgraded its 2017 and 2018 pre-tax profit forecasts by 18 per cent-plus for both years (‘Exceeding expectations’, 15 Jan 2018), I still see scope for further earnings beats and share buybacks to drive the price higher. Run profits.

Oakley Capital’s disposals

Shares in private equity investment company Oakley Capital (OCI:165p) have put in a lacklustre performance since I last rated them a buy at 173p ('Corporate activity boosts Bargain shares', 31 May 2017), having originally included them at 146.5p in my 2016 Bargain Shares Portfolio, since when the board has paid out dividends of 6.75p a share.

However, a pre-close trading update has revealed that Oakley’s NAV per share increased by at least 5 per cent to between 243p and 245p in 2017, since when the board has announced that one of the funds it invests in is selling its 38.5 per cent stake in online dating company Parship Elite and its 9.9 per cent stake in Verivox, a leading consumer energy and telecommunications price comparison website.

The realisations represent an aggregate 26 per cent premium to their carrying value in Oakley’s accounts, which analysts at brokerage Liberum Capital estimate will boost NAV by £10.6m, or 5p a share. This implies the shares are priced on a 35 per cent discount to spot NAV, or 12 points deeper than its peer group average. That’s a harsh discount considering Oakley has a decent track record of exiting its investments at premium prices and holds some exciting TMT investments such as: European real estate websites including Casa.it in Italy and atHome.lu in Luxembourg; Italy's largest car insurance broker and price comparison website, Facile.it; and Plesk, a software platform that operates on more than 350,000 servers globally, supporting the operations of more than 10m websites and 18m email boxes.

Oakley is attracted to these business models because of the strong underlying structural market growth, their asset-light nature that leads to strong cash conversion, and the ability to accelerate performance through effective management, especially around marketing. I agree and strongly feel that Oakley’s 35 per cent share price discount to NAV is completely out of kilter with the track record of the funds it invests in, and the potential for further realisations at premium prices. Buy.

Walker Crips’ solid performance

I was on sabbatical working on my new book when small-cap stockbroker and asset and wealth manager Walker Crips (WCW:38p) reported half-year results at the end of November, but note that the share price has since drifted from 48.5p at the time and is now below the 43p level at which I rated the shares a buy last summer (‘Value opportunities’, 19 Jul 2017). The company’s solid operational performance certainly doesn’t warrant the pullback.

Indeed, underlying pre-tax profit increased by almost two-thirds to £394,000 on revenue up 16 per cent to £15.4m in the six-month trading period, buoyed by a £500m year-on-year increase in assets under management and administration (AUMA) to £5.3bn, and a good showing from the company’s structured products investment division. Discretionary and advisory funds increased by a quarter, and Walker Crips’ wealth management arm (accounting for 10 per cent of AUMA) is now seeing the benefits of its rising recurring revenue.

Offering a near 5 per cent dividend yield, priced on a modest 10 times annual operating profit to enterprise value (Walker Crips has net cash of 14p a share on its balance sheet), and rated on a 27 per cent discount to book value, there is value here. I am not the only one who thinks so as non-executive director Lim Hua Min purchased 200,000 shares around the current price last month. His lead is worth following. Buy.

Arbuthnot Banking profits set to surge

Arbuthnot Banking (ARBB:1,280p), a constituent of my 2015 Bargain Shares Portfolio, has confirmed trading has been bang in line with robust market forecasts that point towards pre-tax profit almost doubling from £4m to £7.7m in 2017 based on a 29 per cent rise in operating income to £53.6m, according to analyst Mark Thomas at equity research firm Hardman & Co.

I had expected as much given that the company’s private banking arm, Arbuthnot Latham, increased its underlying pre-tax profit by three-quarters to £4.9m in the first half, with loans rising by a third to £879m, a positive trend that I had anticipated would be maintained for the rest of the year.

I am reassured that the bank refuses to chase volume at the expense of relaxing its lending criteria, a point highlighted by a low level of impairments and a comfortable loan-to-value ratio on its residential and commercial property loan book. Moreover, Arbuthnot is well funded as customer deposits exceed its loan book by around 40 per cent, thus providing ample low-cost capital to recycle into future lending at an economic net interest margin. I see no reason why this sensible approach to lending should not continue to be productive, and so to do analysts who predict another step-change in Arbuthnot’s pre-tax profit to £14.3m this year based on operating income of £67.5m. On that basis, expect adjusted EPS to almost treble to 48.8p in 2017, rising to 86.7p in 2018.

The loan book aside, Arbuthnot also offers solid asset backing in an 18.6 per cent stake in challenger bank Secure Trust Bank (STB:1,550p), which alone backs up £52m of Arbuthnot’s £280m market capitalisation, and a prime London office property that’s worth £53m and contributed £1.8m rent.

Priced on a 17 per cent share price discount to book value of 1,533p, on a prospective PE ratio of 15 for 2018 and offering a 2.4 per cent dividend yield, I feel the rating does not reflect the stellar EPS growth that’s forecast for this year and beyond, a point I made last autumn (‘A trio of small-cap buys’, 31 Oct 2017). So, ahead of the full-year results on Wednesday 28 March, I rate Arbuthnot’s shares a buy.

Mountview Estates subdued

I have kept faith with residential property investment company Mountview Estates (MTVW:11,000p) since I included the shares in my 2015 Bargain Shares Portfolio around the current price level, since when the company has paid dividends equating to 10 per cent of the entry point.

Mountview's estate consists of 3,812 units subject to regulated tenancies, life tenancies, assured tenancies and ground rents. The strategy is to collect the rent on these properties, and when they become vacant sell them on the open market, sometimes after refurbishment. The properties are very conservatively valued which is why I was attracted to the company in the first place. In fact, Allsop’s September 2014 valuation surplus of £348m equates to 8,923p a share and that’s on top of Mountview's last reported book value per share of 8,910p.

The problem is that investors are just not warming to the hidden value on Mountview’s balance sheet, and a catalyst is lacking to make them do so. They may have reason to be cautious now as market conditions in the London property market, a segment accounting for half of Mountview’s portfolio by value, are testing to say the least, so dampening the prices achieved in the sales market and subduing the ripple effect into the southeast property market, which accounts for 16 per cent of the company’s portfolio by value.

It may also be the case that investors are being scared off by the prospect of a Corbyn-led Labour government coming into power and turning the screw on landlords. In the circumstances, I am calling time on the tightly held shares. Sell.

■ Simon Thompson's new book Successful Stock Picking Strategies will be published on 15 March and can be pre-ordered online at www.ypdbooks.com for the discounted price of £14.50, plus £2.95 postage and packaging, or by telephoning YPDBooks on 01904 431 213 to place an order. It is being sold through no other source. The book will be sold at its full price of £16.95 plus postage after 15 March.

Simon's second book Stock Picking for Profit can be purchased online at www.ypdbooks.com for £14.99, plus £2.95 postage and packaging, or by telephoning YPDBooks on 01904 431 213 to place an order. It is being sold through no other source