Bull market pointers

I also noted that technology and small-cap stocks were sending strong signals to investors by leading the charge, highlighting much improved risk appetite. They still are. In the US, the tech laden NASDAQ 100 index has surged 22 per cent in the past 12 weeks, outpacing the 8.2 per cent gain on the S&P 500 index. Both are making new all-time highs. The FTSE Aim All-Share, the index I trawl for under researched small-cap gems, has outperformed the FTSE 350 index by 16 per cent since early June, too, and is back in positive territory for the year.

These trends should not be surprising given that the primary aim of QE is to drive long-term bond yields lower, force investors up the risk curve in search of higher returns, relative to bonds, and create a positive wealth effect by boosting asset prices. In a zero-interest rate policy (Zirp) environment, equities are a major beneficiary, as was the case when the world’s central banks embarked on their money printing programmes following the Global Financial Crisis in 2008.

Underestimate the economic recovery at your peril

The difference this time round is that this is far more than a liquidity-driven process as cheap money is being recycled directly back into the real economy.

In the UK, Chancellor Rishi Sunak should take a lot of credit for the financial support offered to both employees and companies – £52bn of government backed loans made to 1.2m businesses since March, and £35bn of furlough payments to end July – thus avoiding the mistakes made in 2008/9 when credit became tighter despite record low interest rates due to the unwillingness of high street banks to lend. Government support has also kept a lid on unemployment levels as the UK economy emerges from the deepest recession in history after GDP plunged by a fifth in the second quarter.

Admittedly, 2.5m people could still be unemployed by the year-end as the government furlough scheme ends, according to the latest Bank of England (BoE) Monetary Policy Report. That’s equates to 7.5 per cent of the workforce, well ahead of the 3.9 per cent unemployment level prior to the Covid-19 pandemic. However, it’s much lower than previous BoE estimates and layoffs are far more acute in specific industry sectors, retail, leisure and hospitality being hardest hit as highlighted by hefty job losses reported by airline carriers, holiday operators, and non-food retailers. Unfortunately, that's more of an issue for lower paid workers and those living in rented accommodation – hence the government’s temporary suspension of court eviction orders – who have the lowest savings rates.

However, what’s not being reported in the media is that millions of the 28m private sector workers, 5m government employees and 12.5m UK retirees have never had it so good. Denied the opportunity to spend during lockdown, savings rates have soared and household debt has plunged, so much so that the BoE’s economists highlight that the “accumulation of savings by higher income households is likely to pose an upside risk to UK consumer spending”.

The BoE also notes that the economic recovery has been stronger than it predicted in May. For instance, indicators from payments data suggest that consumer spending in July was, in aggregate, no more than 10 per cent below its level than at the start of the year, after falling by around 30 to 40 per cent during the lockdown. Barclays recovery tracker, an index heavily weighted to consumer spending activity, has hit 98 per cent of normal levels, a strong indication that pent up consumer demand is being unleashed and not just by those taking advantage of the government’s hugely popular half price restaurant meal giveaway.

That’s important given that the UK consumer accounts for more than two-thirds of the domestic economy. It has positive implications for the housing market, too, which in certain areas is on a tear as millions of people in stable employment take advantage of the stamp duty holiday and record low interest rates.

Playing the housing market mini-boom

Fortunately, I have exposure to the residential property market through Inland Homes (INL:55p), a south-east England-focused housebuilder and brownfield land developer, and a constituent of my 2019 Bargain Shares Portfolio.

Since I covered the interim results (‘On the hunt for recovery buys’, 6 July 2020), the company has announced a raft of deals including: the sale of Phase 1a at its huge Cheshunt Lakeside, Hertfordshire joint venture project to a local housing association for £15m alongside entering into a £34.5m construction contract to build all 195 apartments in that phase; the unconditional forward sale of 24 apartments at its Chapel Riverside development in Southampton to a housing association for £4.5m; and the sale of a development site in Staines for £6.6m.

Inland has also agreed to acquire one of the largest brownfield sites in London, the Cavalry Barracks in Hounslow, West London. The site comprises over 37 acres of land, 14 Grade II listed buildings and 19 locally listed buildings together with over 439 existing residential accommodation units. Within the next six months, Inland expects to make a planning application for a mixed use scheme of over 1,000 homes with a gross development value of £600m and aims to complete the purchase in August 2021.

The point is that the value embedded in the company – proforma European Public Real Estate Association (EPRA) net asset value of £234.5m (103p a share) post the half year-end placing – is almost double its market capitalisation even though profitable land sales are deleveraging Inland’s balance sheet and it's well placed to ride the mini-boom. The shares are trading just below the entry point in last year's portfolio and the investment case remains very positive.

Of course, naysayers will say that the rise in UK unemployment will put the housing market under pressure, but that ignores the segmentation of the job losses as I have highlighted. Also, only 3.6m workers are still on furlough, or 10.5 per cent of the total UK workforce, and almost three quarters of them are having their furlough payments topped up by their employer, suggesting that they will be retained when the scheme ends next month. In turn, this adds weight to the BoE’s improved year-end unemployment forecast which is good news for consumer spending, and the economic recovery.

Small-cap outperformance

In the circumstances, it’s hardly surprising that small-cap stocks have been outpacing mid and large-caps, the lower end of the market being dominated by growth stocks offering higher earnings growth potential for investors to latch onto. In a Zirp environment, the future cash flow from these companies becomes more valuable, too, a reflection of the lower discount rate embedded into analysts’ discounted cash flow models to calculate the net present value.

From my own perspective, I have tried to capture the outperformance of small-caps by seeking out companies where earnings risk over the next 12 months reporting period is skewed to the upside, and by taking a thematic approach to hunting down new opportunities in sectors that are likely beneficiaries of the new ‘normal’. It also pays to maintain exposure to the winners from previous QE programmes, the commodity complex being an obvious one.

Profit from dollar weakness during the economic recovery

One consequence of the US Federal Reserve’s QE programme is to drive strong capital flows overseas – which can be seen in rising foreign exchange reserves – and create US dollar weakness. However, to prevent excessive currency appreciation, emerging market authorities print domestic currency to buy US dollars which raises deposits at banks, inducing a lending boom, which is commodities intense. The theme is playing out to a tee as the US dollar index has lost 10 per cent of its value since late-March when the Federal Reserve announced its QE infinity balance sheet expansion.

The weak dollar trade is likely to continue to play out, too, after US Federal Reserve chairman Jay Powell announced at Friday’s Jackson Hole Symposium that the US central bank will adopt a much more lenient approach to inflation — an average 2 per cent target that will allow some overshooting. The implication being that lower interest rates and QE programmes are likely to be with us for far longer, both of which are negative for the US dollar.

There have been some stand-out performers in the commodity complex, copper being one. Buoyed by US dollar weakness and acting as a play on the global economic recovery, the copper price has surged by more than half since mid-March. My exposure here is through 2020 Bargain Share Portfolio top performer Metal Tiger (MTR:26p), an Aim-traded investment company that has significant exposure to copper exploration and development projects in Botswana (‘Targeting undervalued small-caps’, 24 August 2020).

I have also maintained exposure to Sylvania Platinum (SLP:60p), a cash-rich, fast-growing, low-cost South African producer and developer of platinum, palladium and rhodium. Stricter emission targets imposed by governments looking to reduce pollution levels has been driving demand from the automotive industry. That’s because rhodium is two to three times more effective than platinum in an auto-catalyst, hence its appeal to car makers. 

Sylvania’s shares have more than quadrupled in price since I included them, at 14.5p, in my market-beating 2018 Bargain Shares portfolio, and are up more than 40 per cent since I highlighted the pricing anomaly at the start of the year (‘Exploiting market anomalies’, 10 February 2020). Expect the share price to make new all-time highs if annual results on Monday, 7 September are well received. They should be as the company is still only valued on 2.2 times cash profits to enterprise value even though Sylvania’s platinum group metal basket price is more than a fifth higher than the average for the 2019/20 financial year.

Threats on the horizon

Of course, the V-shaped stock market recovery could be derailed by shocks to the economy. You don’t have far to look. A no deal Brexit or a second wave of the Covid-19 pandemic in the autumn could create a negative feedback loop whereby both businesses and consumers become more cautious. But this has always been a risk, and perhaps ones that investors are more comfortable with.

In fact, having seen the economy shrink by a fifth in the second quarter, the perceived negative impact of a no deal Brexit pales into insignificance by comparison. Moreover, the UK government is now far better prepared to deal with a secondary spike in infections without having to lockdown the whole economy.

A third potential risk is the Democratic Party derailing the pro-business Trump administration at the US Presidential Elections on Tuesday, 3 November. The polls certainly point that way, but the US stock market is betting otherwise. It may not be widely known, but in every US election since 1984 the incumbent party has won if the US stock market rises in the preceding three months. If the market has fallen, the incumbent party has lost. The rule has worked for 20 of the past 23 elections, going all the way back to 1928. That’s worth noting because the S&P 500 has just posted a 7 per cent gain during August, the strongest rise during the month since 1986.

The back drop for stock picking in my Aim hunting ground remains favourable.

Profiting from 5G

BATM Advanced Communications (BVC:135p), a provider of medical laboratory systems, diagnostic kits, cyber security and network solutions, has made an incredibly important announcement since I covered the interim results (‘In search of value opportunities’, 17 August 2020). It’s one that has prompted me to upgrade my run profits stance on the shares to an outright buy recommendation.

That’s because the company has signed up its first tier 1 customer for the group’s NFVTime virtual networking solution. The cutting-edge technology enables network carriers to remotely deploy their own virtualised software-based networks and operates on both Arm-based and Intel-based architectures.

The customer is a leading Asian telecommunications provider that serves enterprise and wholesale customers in more than 160 countries and 3,000 cities across the Americas, Asia, Europe, Middle East and Africa. It has licenced BATM’s NFVTime operating system for a minimum of three years. Analysts at house broker Shore Capital estimate that the market for virtualisation services “stretches into tens of billions of dollars” and revenue from the new tier 1 customer has “potential to scale into a multi-million dollar, recurring base over the next five years.”

It’s incredibly high margin, too, with gross margin “building up from the 80 per cent range”. That’s a significantly higher margin than BATM makes on its traditional carrier Ethernet products. Moreover, expect further contract wins to be announced as other large tier 1 customers adopt the technology, given that NFV is a critical element in leveraging the benefits offered by 5G and Internet of Things. This highlights the potential for BATM’s revenue and cash flow to scale up rapidly.

Not surprisingly, investors have reacted positively to the news. BATM’s share price rallied 15 per cent following the contract win taking the total return on the holding to 650 per cent since I included the shares in my 2017 Bargain Shares portfolio. I now feel that the earnings upgrade cycle I previously highlighted is poised to accelerate. I also feel that BATM is a US$1bn market capitalisation company in the making, implying a new target price of 171p. A cash profit multiple of 50 times to enterprise valuation may not seem a bargain, but given the high margin nature of BATM’s revenue streams, and the way it is monetising its patent protected IP, that multiple could drop like a stone if further NFV contracts are secured.

From a technical perspective, a chart break-out above the 19-year high of 150p would confirm the next up-leg in the share price is underway. On a bid-offer spread of 134.5p to 135p, I rate BATM’s shares a buy.

Chenavari plans delisting

Chenavari Capital Solutions (CCSL), a Guernsey-registered closed-end investment company that is in the process of winding itself up, has announced plans to delist its shares from trading on the London Stock Exchange on 30 September 2020.

Since announcing its change in investment policy in December 2017, Chenavari has undertaken 11 compulsory redemptions of its shares to return capital to shareholders and now has a market capitalisation of £7m, well below the company’s latest net asset value (NAV) of £12.4m. There are only two assets still to sell and some residual holdbacks, too, so the directors believe that it is in the best interest of shareholders to minimise operating costs during the remaining run down period where possible. I agree with them and still believe that if you followed my advice to buy the shares, at 61.4p, in my 2020 Bargain Shares Portfolio, you will have a profitable outcome on this holding.

That’s because the company completed a £10m compulsory repurchase of 34.73 per cent of the shares in issue at 85.72p a share in March, and returned a further £3.5m through a compulsory partial redemption of 21.9 per cent of the issued share capital at 72.94p a share in July. This means that for every 10,000 shares originally purchased at a cost of £6,140 you have recouped £2,977 and £1,042, respectively, for the two compulsory capital redemptions and retain ownership of 5,098 shares which have a break-even of 41.6p. That’s 43 per cent below Chenavari’s end July 2020 NAV of 72.59p a share.

The point is that the directors only need to complete a further compulsory capital redemption of 57 per cent of the remaining shares in issue at the current NAV of 72.59p for you to recoup 100 per cent of the capital invested back in February. When that happens, you will then have a free ride on the balance of your holdings. I certainly wouldn’t be selling out at the artificially depressed bid price of 30p in the market, the bid-offer spread having widened dramatically on the delisting news. My advice is to continue holding the shares for further capital redemptions which was the whole point of investing in the first place.

Anglo Eastern Plantations delivers tenfold profit surge

When I suggested buying Anglo-Eastern Plantations (AEP:524p) shares, at 570p, in my 2020 Bargain Shares Portfolio it was predicated on a strong profit recovery this year. The Covid-19 pandemic may have created uncertainty, but the company is clearly delivering. Importantly, Anglo’s plantations and mills have been able to operate close to normal levels, so output has not been negatively impacted.

In fact, buoyed by a 23 per cent increase in the average crude palm oil (CPO) price to US$648 per metric tonne (mt), albeit that’s below US$878 per mt at the start of the year, and 9 per cent higher production of fresh fruit bunches, Anglo’s first half revenues surged by 26 per cent to US$123m. Pre-tax profit increased tenfold to US$16.8m in the six-month trading period, only US$2.1m shy of total profit reported for the whole of 2019. The CPO price has recovered to US$700 per mt since the start of the second half, although low crude prices and higher seasonal crop production may lead to some downward pressure later this year.

However, that’s more than priced in with Anglo’s shares trading on a rolling 12-month price/earnings (PE) ratio of 10 and on a 30 per cent discount to book value. That seems overly harsh given that net cash of US$89m covers total liabilities of US$53m and property assets of $355m (£269m) are worth 27 per cent more than Anglo’s market capitalisation of £211m. On a bid-offer spread of 512p to 524p, Anglo’s earnings recovery is underrated. Buy.

Exploit CIP's 'margin of safety'

CIP Merchant Capital (CIP:50p), a Guernsey-based closed investment company that predominantly invests in listed equities by adopting a private equity style approach, has this morning announced the disposal of its stake in specialty biopharmaceutical company Circassia (CIR (32.1p) to realise £3.9m. The disposal also generates a net profit of £1.1m in the seven month holding period since CIP made its investment in January this year.

By my reckoning, CIP now has around £22.5m (41p a share) of cash in the bank, a healthy sum in relation to its market capitalisation of £27.5m, and well below its last reported NAV of £41.5m (75.4p a share). In other words, its portfolio of mainly listed investments, worth £19m, is in the price for £5m, or 74 per cent below their open market prices.

CIP’s portfolio includes valuable stakes in Orthofix Medical (US:OFIX), a $586m market capitalisation Nasdaq quoted medical devices company, and CareTech (CTH:438p), a heavily asset-backed provider of social care services and one of the largest companies listed on London’s junior market. Those two stakes alone are worth £9m, accounting for half the equity portfolio. They are easily realisable. The same is true of a £1.4m stake in vehicle management company Redde (REDD:193p). The value on offer here is obvious.

So, with the shares trading below my 57p entry point in this year's portfolio, and CIP's fund managers starting to prove their stock picking ability, the valuation anomaly is worth exploiting. On a bid-offer spread of 48p to 50p, CIP's shares rate a buy.

■ 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.