Stock market performance has improved in recent weeks, but a lot of people are understandably still hunkering down. Are we at or near the point where investors should be thinking this is a great opportunity?
If you go back and look at the S&P 500 since the index was conceived, there’s only been six years when it’s lost 15 per cent of its value in the first six months of the year. The seventh was 2022. Not in a single one of those years has it actually lost money in the second half of the year.
I mention Wall Street because it leads all global markets. What UK investors may wish to note is that next year is the third year of the US presidential cycle, and it’s impossible to lose money in the third year of the US presidential cycle. Research from Yardeni Research, which is pretty similar to research I did in my first big Trading Secrets book, 15 years ago, looks back over the S&P 500 over the last 100 years, and if you look at the last 20 cycles to 1943, the average return is 16 per cent in the third year. The lowest return is -0.7 per cent. History is on our side for 2023 to be a far better year than 2022.
The question is why would it be: rather than backing this historic trend, you’ve got to have reason to think what is going to change next year that could make the bottom we’ve seen this year the bottom of the bear market.
That all boils down to inflation expectations, interest rates and the depth of the recession. My view is that the Bank of England will not increase interest rates to market expectations of 5 per cent. The effect on the economy will just be too devastating.
We’re probably already in recession now, and we’ve had monetary tightening in the mortgage market beyond anything we really expected. If enough damage has been done to sentiment and people actually start reining in spending – remember in the UK 60 per cent of GDP is based on the consumer – then those inflation expectations for next year come down pretty sharply. We could be thinking in 12 months’ time about cutting interest rates rather than actually pushing them up to 5 per cent.
If the market was expecting inflation to be sticky next year, the bond market would be pricing in base rates sticking around 4-5 per cent, but it’s not. Going in to December, two-year gilt yields are below 3 per cent. That’s quite a strong message. We’ve had a sea change of sentiment in the last five weeks, of people actually buying the market, but the economics looking forward have moved as well. The dial has moved.
It’s not just in the UK, you can look at the US as well. The rhetoric coming out of the Fed is yes, they have to push up rates, and they may go to 5 per cent there, but the scale of the increases will be diminishing.
I don’t know what’s going to happen in Ukraine, I don’t know what’s going to happen with the Russian gas crisis, but what I do know is there’s a chance that Europe will get through this winter unscathed, which we weren’t thinking about three months ago. In 12 months’ time who knows, but the risks that are facing the European economy are perhaps lower now than they were a few months before.
Nonetheless, do investors need to be more careful nowadays in terms of the way they look at companies, the metrics they look at – be that debt loads, borrowing costs, refinancing positions?
I’ve always looked at them, but I’m looking at them far more carefully for the obvious reason they could be red flags in the current environment that you could possibly get away with with rates at zero.
The things that I look specifically for are companies with stable operating cash flows, and high free cash flow conversions. I’m keeping a close eye on debtor days, receivables balances, I look to the notes to the accounts to double check how many companies are not actually collecting invoices within 90 days. I’m looking at the liquid ratio on the balance sheet – that’s current assets over current liabilities, the ability of a company to fund their working capital and short-term financial liabilities. I’m looking at credit counterparty risk – that’s the concentration of customers, I’m specifically looking at companies with more than 5 per cent of sales to one company.
There’s going to be a recession next year – I don’t think it’s going to be as bad as the 2 per cent negative growth the Office for Budget Responsibility predicts, but what I do know is companies will go bust, and get into difficulties, and I don’t want the companies I recommend to be exposed to a large company or client that isn’t going to pay their bills.
I’m obviously looking at debt maturity profiles. You’ve got a rollover risk on credit lines, whereby bankers will say ‘yes, we’ll lend you another credit line, but you’ll have to tap shareholders first to actually reduce your debt because of the interest covenants, because of the higher interest costs’. So I’m questioning finance directors when I interview companies on debt maturities, and the discussions they’re having with their lenders in terms of pricing of credit in the future.
As I’ve always done I’ve looked at ratios like net debt/Ebitda, interest cover covenants, and Ebit over interest payments. I’d say I’m keeping a closer eye now than ever before.
But even in a bear market – remember the Aim All-Share fell between 41 per cent between early September last year and October this year – you can still generate positive returns [as can be seen in the performance of the 2022 Bargain Shares and IC Alpha Reports], it’s just that the leg work you’ve got to do is greater.
Are there parts of the market you find too difficult to analyse at the moment, given all the competing headwinds in the mix?
I wouldn’t say too difficult, but I’ve got to take a long time to ascertain a reasonable judgement on the worth of those companies. It doesn’t matter about the quality, because it is the sectors they’re in.
Wynnstay (WYN) – a 2021 Bargain Share – has had five earnings upgrades in 2022. If you look at 2022 numbers, it’s trading on eight times earnings because it’s had so many upgrades. That’s fantastic, but there’s no way it’s going to be able to replicate that performance last year because of the one-off drivers it’s had – a spike in ammonia prices has fed through to fertilisers and various other positives. You look next year and it says 14 times earnings, so you’re going to have a fairly substantial drop in earnings. The question for investors is whether or not there’s enough left for multiple expansion. I thought a lot about this, and my advice was sell two-thirds of your holding – you’ll get all the capital back that you invested at the start of 2021 – ride the rest for free, and target the all-time highs from a few years back: another 10-12 per cent upside. And there’s quite a few of those, where things have gone really well, that I’ve pondered. You’re tempted to be greedy sometimes, thinking ‘this can continue’, but there’s always a time to take a profit.
The other one that’s difficult is property companies, because we’re guaranteed a downwards shift in valuations due to the move in government bond prices. That shift has yet to be reflected in the accounting valuations of all the listed property companies. Take Palace Capital (PCA). The share price has come back a long, long way, because people are scared about what’s going to happen to property prices. This is the equation I do that readers may wish to do as well: I look at the total value of the properties a company is holding, I look at the debt the company has borrowed, and you can then roughly work out net assets making a few other adjustments. Then you factor in a 5, 10, 15, even 25 per cent fall in property prices, and work out when the share price discount to NAV will be wiped out. With Palace Capital, the answer is a 27 per cent fall in commercial property prices. The valuers wrote down the portfolio by 6.5 per cent in the latest account for the six months to the end of September. You’re going to take a fairly grim view of where commercial property is going if you think prices are going to fall another 25-30 per cent having already been downgraded 6.5 per cent. So I actually think the risk/reward is skewed to the upside because it’s pricing in an armageddon scenario that just isn’t going to happen.
The yield you want from commercial property has to be at a premium to risk-free government bond yields. A 30 per cent downward move in valuations for some of these companies would imply a net initial yield of 7-9 per cent. If five-year gilt yields are 3 per cent, I’d say six percentage points above that is a heck of a margin, and I don’t think you’re going to get it.
My point is we've seen a shift in share prices ahead of the shift in revaluations from commercial surveyors.
I also see value in specialist funds. I’ve been following Augmentum Fintech (AUGM), the LSE’s first listed fintech fund. I included this in my 2019 Bargain Shares at just over £1, and it rallied to 170p. I should have said take profits; I didn’t. But the net asset value at the time was 155p-156p, so it was a small premium, and the track record of the manager Tim Levene is fantastic.
The stock price has come back to 88p, the net assets are 155p. It’s sitting on 30p per share of cash, so if you strip that out you’re effectively getting all their fintech fund for less than half its book value. And it’s not as if these are very speculative investments: this is the company that backed Interactive Investor at an early stage before Abrdn (ABDN) acquired it. Augumentum made a money multiple return of about 11 times on its capital on that deal, hence why it has cash on the balance sheet.
I just think if I can buy assets effectively at half their book value, and some of those assets are very profitable businesses, valued at sensible multiples, then the risk/reward is in my favour. But, again, it takes time to go through the research to get to that point, and you’ve got to look at the underlying investments to try to ascertain whether the fund manager’s valuation that comes from its investment committee, is an accurate valuation. But it’s worth doing.
These kind of sum-of-the-parts valuations are a big part of your process. Are they particularly helpful at the moment to help you spot value traps?
They also help me also spot incredibly undervalued special situations. At the start of the year I wrote about a semiconductor manufacturer in Essex called CML Microsystems (CML). It was completely below the radar, had a £65mn market cap, £20mn cash, they sold a business for bumper profits and returned cash to shareholders. They’ve got land, for which they’ve got planning applications going through that will be heard early next year. They’ve got buyers lined up to take the premises that will be developed on that land. When I did my research, I thought ‘I’m buying a tech business for less than 10 times earnings, effectively, and it’s exposed to structural growth drivers, through the internet of things, 5G, data centres’. I thought it was a cracking buy. Since then they’ve had two upgrades.
Now we’ve got a sum-of-the-parts valuation that supports the share price completely, and the underlying business is operationally geared, feeding in to growth markets. Ultimately, value will out in the end, it always does.
How should investors be thinking of growth stocks at a time of high interest rates?
I personally steer clear of any company trading well above 20 times earnings. History is littered with companies trading on 50 times earnings that just failed to deliver on growth expectations. And because expectations are so high in the first place, any profit miss sees the share price get absolutely hammered. I prefer to target niche growth plays in sectors offering structural growth drivers, which I’ve been doing all this year.
For example, Ashtead Technology (AT.) is exposed to mechanical engineering for sub-sea work on wind farms and the oil and gas sector, and it’s a leading player in it, so it’s got a moat around the business because it has a dominant market position. I looked at Crestchic (LOAD) last autumn – the old Northbridge Industrial Services. It provides loadbanks – so transformers effectively – that back up data centres. The data centre market has gone ballistic, and will continue to do so, because we are data hungry. Their factories are operating almost at maximum capacity, they’re in an earnings upgrade cycle, and they’ve got a structural growth driver. But, despite that, the stock is only trading at 12 times earnings [on 8 December the Crestchic board agreed a recommended cash offer from Aggreko, at a 44 per cent premium to the pre-approach share price].
Another feature of Crestchic and Ashtead is free cash flow. I’m looking for high free cash flow yields, 6-8 per cent if I can, which then underpins a progressive dividend policy, but also enables the company then to recycle the cash flow back into the business so it creates a virtuous circle. But it’s important for those companies then to have a high return on capital, ideally of 15 per cent or more.
All of these things basically protect profits. That’s a key thing. We do not want earnings expectations to be missed. If I’m paying 12-13 times earnings, but I’m skewing the risk in my favour that a company is going to deliver on earnings, the higher the multiple I can actually pay. It’s when you’re paying 50 times earnings for not the best quality company that’s exposed to a huge number of risks, you’re opening yourself up to a not very nice experience.
Looking at Aim as a whole, are there sectors as well as individual companies that are still under-recognised?
I think because some people have been burnt in the past by the oil exploration companies, the more speculative ones, they’ve steered clear of them and it’s created pockets of value. Even more so now, given what’s happened in Ukraine and Russia with energy security being a huge issue for Europe and the West, ultimately the politicians will have no choice but to seek alternative energy sources, and that’s what I’ve been targeting. I’ve maintained exposure to players like Chariot (CHAR), which is Moroccan gas that can be exported through the Maghreb pipeline back into Europe if that project gets off the ground. You’ve got a North Sea oil and gas play called Jersey Oil & Gas (JOG), which is effectively being run by the former team at Ithaca Energy (ITH), who’ve proved incredibly successful there. I’ve focused on Nigeria as well, San Leon Energy (SLE), which is doing a huge deal over there. I know the oil price has come down throughout November because of concerns about China, Covid, and potentially Opec actually ramping up supply rather than cutting, but ultimately the long-term outlook for oil and gas is still incredibly positive. If you can actually buy into companies that have an operating breakeven of $30-$35 a barrel, and Brent is trading at $90, there’s a huge margin there.
The other area that is less understood than it should be, but will become understood, is battery metals. Trident Royalties (TRR) has a royalty over the Thacker Pass project in the Nevada desert in the states. What I don’t think investors have realised is that energy security in the US is such that all the production there will go to the US. It is very protective of its industry. So you’ve basically got a guaranteed market for these battery metals when that scheme is up and running next year.
Copper as well – sure the copper price has come down, that’s indicative of global recession. But if you’re going to get renewable energy projects off the ground, and take up the slack from fossil fuels in a meaningful way, we need vast amounts of copper produced. That’s why I’ve maintained exposure to the likes of Metal Tiger (MTR).
All these companies are very undervalued at the moment because people are too risk averse. They’re not actually aligning the long-term fundamentals of the end markets these companies are targeting and will actually fulfil with the current price.
How do you guard against the risk of blow-ups in the commodities sectors?
The first thing to say is if you can’t live with the volatility in a share price, just walk away. You’ve got to be able to go to bed at night and sleep. Take it as given that in the oil & gas exploration sector you’ll see down moves of 25 per cent. Even in large caps, Shell and BP, just look at long-term graphs there, it’s painful. But equally the long-term rewards can be huge if it pays off.
But I take a good look at the deposits they’re actually targeting and whether or not commercially they stack up, and whether or not from a government point of view it’s actually going to happen. Because you’ll see across many parts of the world, companies with a great idea, but ultimately theses projects never get off the ground, all they do is burn cash, then they’ve just got a big hole in the ground.
Management is incredibly important – as with Jersey Oil & Gas. But ultimately, you’re getting excess returns because you’re taking greater risk. And as long as you understand that, and are happy with it, then I can see from the companies I’ve mentioned some quite substantial long-term gains to be made.
