Efficient Market Hypothesis (EMH) states that asset prices reflect all available information, the implication being that it is impossible to 'beat the market' consistently on a risk-adjusted basis since market prices should only react to new information.
However, if EMH truly worked, I shouldn’t be able to beat the market so consistently by taking advantage of valuation anomalies and uncovering hidden value in under-researched special situations. The outperformance of my Bargain Shares Portfolios over the past two decades is a case in point.
Of course, outperformance can be delivered simply by taking greater risk. That’s a fair point until you consider that the shares I select in my portfolios have a hefty 'margin of safety' built into their bargain basement valuations, which suggests that, if anything, the share price discounts to the companies’ intrinsic values more than mitigates the investment risk to such an extent that the risk:reward ratio is skewed towards a favourable outcome.
By the same token, the habitual first-quarter outperformance of the UK stock market by the listed housebuilding sector shouldn’t really happen if markets are operating efficiently. If they did then investors would simply buy the housebuilders in late autumn in anticipation of a run-up in share prices in the New Year. The fact that I uncovered this seasonal anomaly 16 years ago ('Time to take stock', 14 Nov 2003), but the excess sector return earned over an index tracker in the first quarter has actually increased in recent years – since 2004, the sector has outperformed a FTSE All-Share index tracker by an average of 10 per cent in the three-month period – indicates that investors are missing a trick. Indeed, even the one-off postgeneral election sector rally last December has not put the share prices of the FTSE 350 listed housebuilders off their stride, posting a 13.9 per cent average gain since the start of 2020 in a flat market.
In fact, the stock market offers investors a free lunch more often than you may think. For example, when the New York Federal Reserve was carrying out its permanent open market operations (POMO) as part of its quantitative easing programme by targeting the short-dated end of the US Treasury bond market at the end of 2010 (‘Treasury Watch’, 26 Oct 2010 – and ‘Fed’s winter wonderland’, 8 Nov 2010), it was as close as you could get to a one-way bet. That’s because the US central bank was buying in government bonds on specific dates that were widely known in advance as part of a short-term asset purchase programme, the impact of which was that liquidity flowed out of US government bonds into equity markets. As I pointed out at the time in the autumn of 2010, on days when the US central bank bought government bonds as part of its POMO, the S&P 500 had risen 12 times, been flat once and fallen (and only slightly) twice. As one-way bets go, it doesn't get much better than that. Well, actually it does, hence the purpose of this column. That’s because I have spotted another outstanding investment opportunity to exploit.
Playing the PGM metal complex
It will not have gone unnoticed to aficionados of the platinum group metals (PGM) complex that the price of palladium and rhodium, a mining by-product used as a catalyst in three-way catalytic converters in cars, have both soared since the start of 2020. In fact, the rhodium price has risen by 67 per cent to $9,200 (£7,095) an ounce (oz) in the past six weeks and has now quadrupled in value in the past 12 months in an incredibly tight market environment.
The price action is being driven by demand from the automotive industry in order to meet the stricter emission targets imposed by governments looking to reduce pollution levels. Rhodium is two to three times more effective than platinum in an auto-catalyst, hence its appeal to car makers. The price of palladium has risen by 14 per cent in the past six weeks, albeit it was up by 33 per cent by mid-January, and has surged by 180 per cent in the past 12 months, reflecting a market in deficit and one benefiting from demand from the automotive sector. These are known facts, so EMH suggests that investors should have already reacted to the information by adjusting their expectations favourably towards companies exposed to the PGM complex.
However, they have yet to do so in the case of Sylvania Platinum (SLP:41.5p), a cash-rich, fast-growing, low-cost South African producer and developer of platinum, palladium and rhodium. I included the shares, at 14.5p, in my market-beating 2018 Bargain Shares portfolio, banked dividends of 1.13p a share, and last rated the £113m market capitalisation company a strong buy when the shares were trading at 34p ahead of its second-quarter results for the year to 31 December 2019 (‘Mining for a golden nugget’, 29 Oct 2019). The price duly rallied to 45p, but has pulled back slightly even though the company’s second-quarter production results are now in the public domain. The market is not working efficiently for multiple reasons.
Five reasons why the market is not working efficiently
Firstly, and perhaps some investors are unaware of this, there is a lag between the recognition of sales in Sylvania’s quarterly accounts and invoicing following delivery. So, although the company’s average basket price increased by 13 per cent in both rand and US dollars in the final three months of 2019, the explosion in both the palladium and rhodium prices in the first three weeks of January 2020 (up by 33 per cent and 50 per cent, respectively) will lead to a major positive sales adjustment in the third-quarter results to 31 March 2019 because the actual selling price of the PGM delivered will be significantly higher than that recorded in the second-quarter accounts. The sales adjustment could easily account for 15 per cent of Sylvania’s third-quarter revenue, a sum that will drop straight down to its bottom line.
Secondly, Sylvania has already banked a net profit of almost $24m (£18.5m) in the first two quarters of the financial year to the end of 30 June 2019 on net revenue of $59m. To put that performance into perspective, in the same six-month period of 2018 the company reported net profit of $6.95m on net revenue of $32m. Moreover, in the financial year to 30 June 2019, Sylvania reported net revenue of $70.5m and net profit of $17m, so the company has already earned more than in the whole of the prior financial year and has two quarters still to report. What this means is that Liberum Capital’s full-year net profit forecast of $20m on revenue of $76m will need adjusting sharply upwards, especially as there is no change in Sylvania’s production guidance of 74,000 oz to 76,000 oz, up from a record 72,000 oz in the 2018-19 financial year. This will become apparent when Sylvania releases its half-year financial results later this month.
Thirdly, Sylvania is producing an awesome amount of cash. The company’s cash balance surged from $26.6m to $33.8m (£26m) in the second quarter to 31 December 2019 even though the company paid out $2.9m in dividends to shareholders in November, corporation tax of $6.8m, and spent $1.5m on capital expenditure. The point being that even without taking into account the surge in PGM prices since the start of 2020, Sylvania is already producing an eye-watering $17.5m of quarterly operating cash flow, which translates into around $10m of net cash flow.
Furthermore, the current cash pile now equates to more than a fifth of the company’s market capitalisation of £117m, and is rising at a heady pace. Or, to put it another way, even if Sylvania only replicates its first-half performance in the second half to 30 June 2020, and clearly it will do far better given the surge in PGM prices this year, it could have a year-end cash pile close to $50m, a sum representing a third of its current market value. On this basis, the company is effectively being priced on a bargain basement two times net profits after adjusting for cash on the balance sheet.
Fourthly, the potential retrenchment by privately owned Samancor from some of Sylvania’s host mines may have concerned some investors, but the potential impact of the host's downsizing can be minimised by managing the change in the ratio of feed sources. Sylvania has two distinct lines of business: the retreatment of PGM-rich chrome tailings material from mines in the North West Province; and the development of shallow mining operations and processing methods for low-cost PGM extraction. The company’s dump operations comprise seven active PGM recovery plants that treat chrome tailings from surrounding chrome mines across the western and eastern limbs of the Bushveld Igneous Complex. The chrome tailings retreatment plant is located at Kroondal on the western limb, and is managed by Aquarius Platinum Corporate Services. Sylvania has faced similar issues before and successfully managed the situation.
Fifthly, with an average second-quarter basket price of $1,872 an oz three times higher than Sylvania’s all-in cash costs of $616 an oz, and that’s before taking into account a significantly higher basket price in the current third quarter, then even if the company processes a higher proportion of lower-grade dump material, which has lower PGM recovery rates than freshly mined sources, the business is so profitable already that the gap between the average basket price and cash costs could and should increase further.
Buying Sylvania’s shares ahead of what will be a storming set of financial results and likely analyst earnings upgrades in a few weeks time is a rock-solid investment with negligible downside risk. The share price is also tantalisingly close to signalling a major triple-top break-out on the charts on a confirmed move above the 45p closing highs in September 2019 and January 2020. For good measure, the 14-day relative strength indicator (RSI) has a reading of 50, so is in neutral territory, adding further substance to the break-out potential. Strong buy.
French Connection loses its bidder connection
Of course, not all investments pay off, the share price reversal of high-street clothing retailer French Connection (FCCN:22p), a constituent of my market-beating 2016 Bargain Shares Portfolio, being a case in point after the company terminated its formal sale process without a bidder emerging, and announced that it will report a loss before tax of £1m to £2m for the financial year to 31 January 2020. Both French Connection’s retail and wholesale businesses had a tough fourth quarter including the all important Christmas trading period. Please note that the pre-tax loss is stated after accounting for a £1.2m non-cash annual depreciation charge, so the company should report a small annual cash loss.
Understandably, some shareholders have headed for the exit, the impact of which is that the holding has clipped five percentage points off the total return on my 2016 Bargain Shares Portfolio. True, I can afford to take the hit as the portfolio is still up 82 per cent, but it clearly makes my decision to run a bumper 44 per cent paper profit when the company first came into play the wrong advice (‘Bargain shares: On the M&A beat’, 22 Oct 2018).
In the circumstances, French Connection’s management has little choice but to focus on its turnaround strategy, which involves right sizing the store portfolio, increasing online penetration, growing its US wholesale business and developing licensing arrangements. Trading a third below book value even though the year-end closing net cash pile should back up two-thirds of its market capitalisation of £21m, the de-rating has gone too far even after taking into account the challenging retail environment. Hold.
■ Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. The books are being sold through no other source and are priced at £16.95 each plus postage and packaging of £3.25 [UK]. Both books can be purchased for the special price of £25 plus discounted postage and packaging of only £3.95.
The books include case studies of Simon Thompson’s market beating Bargain Share Portfolio companies outlining the investment characteristics that made them successful investments. Simon also highlights many other investment approaches and stock screens he uses to identify small-cap companies with investment potential, too. Details of the content of both books can be viewed on www.ypdbooks.com.
Simon Thompson was named 2019 Small Cap Journalist of the year at the 2019 Small Cap Awards.
