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Riding earnings upgrade cycles

Our small-cap stockpicking expert highlights two companies benefiting from an earnings upgrade cycle and multiple expansion
March 12, 2021

There are many drivers of share prices, but by far the most important is earnings momentum. Investors like a good news story and no more so than when a company upgrades forward guidance as is the case with cyber security software provider Kape Technologies (‘Tap into an eye-catching earnings cycle’, 8 March 2021).

Of course, some directors can be overly cautious when giving guidance to analysts, which skews the odds of overdelivering, as well as mitigating the risk of missing guidance. That’s no bad thing as it means that you are basing your investment decision on what is achievable as the bare minimum, rather than on unrealistic expectations.

The greatest share price gains will be made by identifying companies in earnings upgrade cycles at an early stage, and then riding off their coattails. That’s because the earnings momentum will attract more investors along the way who are willing to pay higher earnings multiples for a slice of the action. The twin tailwind of rising earnings per share (EPS) and price/earnings (PE) ratios can drive eye-catching gains.

These dynamics are working a treat for financial services company Jarvis Securities and asset manager Gresham House. Beauty brands company Brand Architekts looks primed to deliver strong earnings growth in the coming years, too.

 

Jarvis’s profit surge highlights re-rating potential

  • 2020 pre-tax profits ahead of upgraded forecasts.
  • No sign of organic growth slowing.

Full-year results from Jarvis Securities (JIM:260p), a financial services outsourcer and retail client stockbroker, highlight why I suggested buying the shares at 115p (‘Jarvis offers medium-term value’, 15 August 2018).

Annual pre-tax profit and EPS surged 43 per cent to £6.9m and 12.7p, respectively, on 27 per cent higher revenue of £13.3m, the key drivers being: higher trading volumes from 100,000-plus retail clients who use Jarvis’s ShareDeal-Active and X-O low-cost online share trading services; and ongoing demand from pension funds and wealth managers looking to make cost savings by outsourcing their financial administration services to the company’s corporate division. The result was slightly ahead of WH Ireland’s forecasts, and that’s after the house broker pushed through multiple upgrades in the past 12 months.

Jarvis asset-light business model generated an eye-watering post-tax return on equity of 128 per cent and is hugely cash generative, so a high percentage of net profits are paid out as dividends. Adjusting for the 3.75p a share special dividend in 2019, the ordinary dividend per share increased 69 per cent to 11.1p in 2020 to take the total to 27.75p since I initiated coverage in 2018.

Even after upgrading 2021 profit estimates by 8 per cent ahead of the results, WH Ireland views its revenue, pre-tax profit and EPS forecasts of £13.8m, £7.4m and 13.7p as conservative. I concur. Trading volumes started 2021 from a higher run rate than a year ago, and Jarvis has a “healthy pipeline” of new opportunities on the corporate side. A 50 per cent operating margin looks sustainable with both revenue and profits skewed to the upside.

The shares are up 30 per cent since my last update (‘Six small-cap value picks’, 16 November 2020), and trade on a forward price/earnings (PE) ratio of 19 and offer 4.6 per cent prospective dividend yield. I am raising my fair value to 300p. Buy.

 

Gresham House’s ESG credentials attract strong fund flows.

  • 2020 pre-tax profits exceed forecasts.
  • Organic fund flows driven by investment performance and demand for ESG assets.

Gresham House (GHE:820p), a fund manager specialising in renewable energy generation, solar power, wind, forestry, infrastructure funds and public and private equity investment strategies, has delivered eye-catching organic growth in assets under management (AUM). The company also delivered better-than-expected pre-tax profit of £12.1m (up 17 per cent year on year) on 29 per cent higher income of £40.3m, and 33 per cent dividend hike to 6p a share.

Strip out the contribution from acquisitions, and organic growth accounted for £1bn of the increase in AUM from £2.8bn to £4bn, buoyed by strong investment performance and a raft of capital raises for funds including: Gresham House Energy Storage Fund (GRID), the largest listed specialist fund in UK energy storage systems (£150m raise); Gresham House Forest Fund I LP (£108m); British Strategic Investment Fund (£100m); and Baronsmead VCTs (£57m).

The directors look well placed to achieve their 2025 targets: increase AUM to £6bn; earn a return on invested capital of 15 per cent; and generate an operating margin of 40 per cent. Gresham House has strong ESG credentials, deriving more than 50 per cent of revenue from environmental solutions. The company has also been awarded the coveted London Stock Exchange Green Economy Mark, which can only raise its profile at a time when 88 per cent of institutional investors in the European pension industry are looking to integrate ESG into their investment policy (source: Mercer), and 40 per cent are aiming to increase allocations to alternative assets (source: CoreData).

Simon Thompson's Bargain Shares Portfolios Performance (2016-2021)
PortfolioPortfolio total return to dateFTSE All-Share total return to dateFTSE Aim All-Share total return to date
201687.5%43.1%84.0%
2017121.2%14.3%40.6%
201892.9%4.6%16.0%
201961.8%8.2%34.3%
202039.9%-4.9%24.0%
20219.8%3.9%-0.7%
Source: London Stock Exchange, FTSE International, Bargain Shares Portfolio total return calculated on offer-to-bid basis with dividends un-invested. Prices correct at 12.15pm on 11.03.21

Fund launches for 2021 include Gresham House's Residential Secure Income LP fund (shared ownership housing with first close in the second quarter), new energy and renewable funds, and a follow-on BSIF fund. Post results, analysts at Jefferies doubled their 2021 AUM growth forecast to £700m. Panmure Gordon have taken note, too, pencilling in EPS of 34.7p and 40.5p for 2021 and 2022 following mid-teens upgrades. Gresham House retains cash and liquid resources of £45.1m (141p a share), so is well funded for both organic and further acquisitive growth.

I included the shares, at 312p, in my 2016 Bargain Shares Portfolio, and my target of 950p is based on a cash-adjusted 2022 PE ratio of 20. 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].

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