I am under no illusion about the gravity of the Covid-19 economic downturn, nor am I complacent about how the lives of millions of people will change permanently when the threat has passed. That has ramifications for a raft of companies and the industries they operate within. Many will not survive the recession. The loss of their contribution to economic activity, and that of millions of people who now find themselves facing financial hardship, will subdue the economic recovery when it comes. In fact, it could take several years for the global economy to return to previous record output levels as the secondary and tertiary impacts of the crisis feed their way through the system.
However, the stock market is forward looking and acts as a discounting mechanism to arrive at fair value of companies after factoring in the magnitude and duration of the likely earnings downturn – the general expectation is for a rebound in the third quarter of 2020 after a dramatic collapse in the second quarter – and the nature of the subsequent economic recovery. Bearing this in mind, expect the stockmarket to bottom out about three months before the economy does, as has been the case in nearly all other recessions.
The caveat to this rosy scenario is that it is impossible at this stage to quantify exactly when the threat of Covid-19 will pass, although the most sensible prediction is when a vaccine is developed and can be manufactured on a massive scale. The best we can hope for is by the year-end, but that doesn’t mean that countries will still be in lockdown, the cause of the economic damage. The other major ‘unknown’ is to what extent governments will ramp up their debt fuelled fiscal spending to turbo-charge the economic recovery. Rest assured they will as they simply can’t afford not to.
In the circumstances, the wild daily swings we are seeing in share prices of companies is only a reflection of the level of uncertainty investors face and the difficulty they have in ascertaining the fair value of companies right now. That said, it presents an opportunity for fundamental investors like myself who stress test the finances of companies, assess their ability to trade through downturns, and then exploit valuation anomalies by building in a large ‘margin of safety’ when stockpicking.
The strategy can reap healthy rewards. For instance, the share prices of cyber security software provider Kape Technologies (KAPE:160p) and mobile payment platform Bango (BGO:118p) have soared 60 per cent since I highlighted the valuation anomalies four weeks ago (‘Three buying opportunities’, 18 March 2020). I wasn’t the only one that spotted value – South Korean big data group NHN Corporation has just invested £6.5m in Bango’s data platform business, Audiens, and taken a 4.7 per cent equity stake in the company, too. I can easily see a further 25 per cent share price upside to both Kape and Bango, and perhaps more.
It’s only fair to stress that my stockpicking strategies don’t guarantee profits, but factoring in a healthy margin of safety is certainly one reason why my 2020 Bargain Shares portfolio has only shed 11.5 per cent of its value compared to the near 25 per cent drawdown in the FTSE All-Share and FTSE Aim All Share indices.
Kromek starts manufacturing medical ventilators
Sedgefield-based Kromek (KMK:20p), a radiation detection technology company focused on the medical, security screening and nuclear markets, has signed a licensing deal with Metran, a leading medical ventilator manufacturer in Japan, to support the fight against Covid-19. Kromek will commence production of medical ventilators before the end of April, producing 2,000 units within 12 weeks, for sale both in the UK and globally.
Given that the NHS alone needs another 8,000 ventilators to add to its current stock of 10,120, and there is an acute global shortage, then there is scope for the licensing deal to be expanded in due course. The global threat of Covid-19 will not pass until a vaccine is developed, and until then countries across the world are having to materially increase intensive care bed capacity and acquire medical ventilators. The deal is likely to prove a decent earner for Kromek – medical ventilators normally sell for around US$20,000 per unit – although the financial terms are confidential.
There is no issue with funding Kromek’s bumper order; the company had closing net cash of £7.7m at 31 October 2019, and was well on course to report second-half cash profit of £3.3m on revenue of £13.3m as it delivered on an estimated order book worth $90m. Moreover, with Kromek’s cadmium zinc telluride (CZT) cutting edge technology proving popular in state-of-the-art medical imaging systems, ‘dirty bomb’ detectors and border security screening at ports, airports and international rail terminals to counter terrorism risk, then demand from its core end markets remains robust.
Kromek’s share price is unchanged since I covered the first-half results (11 December 2019), during which time the FTSE Aim All-Share index has fallen by 18 per cent. There is considerable upside to my target price of 35p. Buy.
Gresham House’s value proposition
Aim-traded investment company Gresham House Strategic (GHS:950p) has been a top performer in recent years, but the portfolio has not been immune to the market rout, shedding 22 per cent of its value during March.
This highlights the important point that in significant ‘risk-off’ periods the valuations of less liquid small quoted companies are impacted far more than large-caps. That said, a negative shareholder return of 5 per cent for the 12 months to 31 March 2020 still outperformed all bar one of the open-ended UK smaller companies’ funds covered by Trustnet, and was almost 13 percentage points higher than the IMA average return for this universe.
The pullback in net asset value (NAV) per share from a high of 1,420p on 31 January 2020 to 1,112p now means that GHS’s shares, at 950p, are priced 15.5 per cent below NAV compared with a 3 per cent discount in December. Importantly, almost a fifth of the portfolio is in cash, so GHS has firepower to exploit any attractive buying opportunities.
It's latest portfolio additions include ULS Technology (ULS), a digital conveyancing platform for housing transactions which has launched a new product, DigitalMove, to improve the efficiency and speed of the process for consumers and advisers. GHS has taken an initial position in Van Elle (VANL), a piling and ground engineering specialist for the construction industry and a market leader in the rail sector ahead of a likely “tsunami of infrastructure spending in the years ahead”. The investment manager has also doubled its position in Centaur Media (CAU), backing the new chief executive’s strategy to rebuild margins after significant portfolio restructuring.
The rationale for making these and other investments is that by adopting “a conservative approach to financial leverage and deep insight into a company's value drivers, a material margin of safety can be created to enable investments into stocks with significant medium-term returns.” Of course, near-term outlooks have been impaired, but for companies “that survive this current crisis their market positions may be stronger, the competitive position easier and their cost bases leaner, primed for profit growth in the future”.
GHS’s value orientated approach, focused on company fundamentals, cash generation, downside scenario testing, and balance sheet strength, rings a chord with my own, one of the main reasons why I included the shares in my 2016 Bargain Shares portfolio. The holding has produced a 23.5 per cent total return since then, albeit it was far higher prior to last month’s drawdown.
As a result the cash pile is in the price for free, so GHS could suffer a 20 per cent fall on its portfolio and NAV would still back up 100 per cent of the share price. Not that I anticipate that happening, but it’s a decent ’margin of safety’ nonetheless. My view is that when the heightened equity risk premium embedded in small-cap valuations unwinds, expect a sharp narrowing of GHS’s share price discount to NAV to be augmented by a recovery in portfolio valuations and a decent flow of dividends, too. Buy.
Business as usual for Jarvis Securities
Chief executive Andrew Grant of Aim-traded Jarvis Securities (JIM:419p), a financial services outsourcer and retail client stockbroker, has taken the unusual step of writing to shareholders directly to personally provide reassurance on Jarvis' position in light of Covid-19. His insight is highly supportive of the investment case I outlined (‘Targeting value plays’, 16 March 2020), and worthy of further comment.
Mr Grant notes that the market volatility has led to an increase in trading volumes – more than 100,000 retail clients use its ShareDeal-Active and X-O low-cost online share trading services – and there has been minimal disruption to the business as the company’s sophisticated screen based technology has enabled almost all staff to work from home. He also points out that the cut in Bank of England base rate will have a minimal impact on interest income. I would add that Jarvis’ corporate division, which provides outsourced and partnered financial administration services to pension funds and wealth managers, should benefit from even more institutional clients targeting cost savings at a time when the business is enjoying improved pricing as some rivals exit the market.
House broker WH Ireland is maintaining its upgraded EPS forecast of 37.8p to support a 2020 dividend of 27.8p (the second quarterly dividend will be paid on 11 June as Mr Grant noted in his letter), implying the shares are rated on a forward price/earnings (PE) ratio of 11 and offer a prospective dividend yield of 6.6 per cent. The fair value of the shares is around 550p. Buy.
SRT funded to make waves
Aim-traded SRT Marine Systems (SRT:25.5p), a global leader in AIS, an advanced identification communications technology used to track and monitor maritime vessels, has created a prudent cash buffer ahead of the implementation of a number of substantial highly profitable contracts.
The company raised £1.8m through a placing and retail offer which was backed by chief executive Simon Tucker who purchased £100,000 of shares. In addition, SRT raised £1m by issuing senior loan notes under an existing £10m facility, and a £2.5m low cost loan facility with its main bankers under the government’s Coronavirus Business Interruption Loan Scheme. On this basis, the company now has gross cash of £5.9m and borrowings of £8.5m, implying net debt of £2.6m equating to 16 per cent of proforma equity shareholder funds. Importantly, borrowings can be paid down quickly from milestone payments when work recommences on contracts that have been temporarily delayed due to Covid-19 lockdowns.
In the Middle East, two new national vessel tracking systems awards and a smaller system upgrade contract with an existing customer were due to commence in March, but have been delayed due to Covid-19 lockdowns. SRT is in discussions with the clients to enable project implementation to start during the existing lockdown period. Prudently, SRT has allowed for a nine-month delay even though the clients only expect the start date to be pushed back by one to three months. The contracts are worth £70m in revenue.
In the Philippines, SRT’s game-changing government contract, worth £31.8m, to deliver a vessel management system for fisheries monitoring is also temporarily paused due to the Covid-19 lockdown. Installation had already started and SRT still expects to earn £17m in milestone payments in the coming year. Cash payments due in April will now be made in June upon recommencement of Philippine government activities.
In the meantime, SRT’s monthly cash overheads of £600,000 are comfortably covered by its cash pile. Although analysts have withdrawn forecasts given the uncertainty over the exact timing of when work on the four contracts will recommence, I estimate that they should still contribute upwards of annual revenues of £50m on operating profit north of £10m. Add to that SRT’s transceiver business, which generated £8.1m of revenue in the 12 months to 31 March 2020, and SRT’s profit generation from both existing contracts and a bumper £550m validated sales pipeline, is being materially undervalued in its £44m market capitalisation.
The shares hit my 55p target price in January after I highlighted the company’s potential (Alpha Report: Set sail for a profitable voyage, 16 August 2019). Offering 100 per cent-plus upside to my fair value calculation, this is a new buying opportunity.
Please note that this article was published at 12pm on 16 April 2020 and subsequently republished to incorporate the announcement of SRT Marine Systems' successful application for a Coronavirus Business Interruption Loan.
■ 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].
Special offer: 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.
