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A good opportunity to upgrade

John Rosier is taking a sanguine view of market gyrations, using deratings to work for, rather than against, him
November 19, 2018

October was uncomfortable for equity investors, delivering one of the worst monthly returns in a long time. Since inception of the JIC Portfolio in January 2012, the 5.2 per cent drop in the FTSE All-Share (Total Return) has only been surpassed three times before. In the midst of the Greek debt crisis the All-Share fell 6.8 per cent in May 2012 and then in June and August 2015 it was down 5.7 per cent and 5.3 per cent respectively. 

As usual, the US led the way. The 10-year US Treasury yield hit the highest level in over seven years, responding to robust economic growth, low unemployment and the fastest real wage growth in decades. Higher-risk assets such as equities suddenly looked less attractive, and nowhere more so than highly rated growth/tech companies. Stocks such as Amazon (US:AMZN) and Netflix (US:NFLX), which had led the market up in 2018, were off 20 per cent or so. In the UK, the Alternative Investment Market (Aim) was hit hardest, falling 11.2 per cent over the month. Many of the glamour growth stocks of the past two years fell back to earth with a bump. The likes of Fevertree (FEVR), down -23 per cent, Keywords Studios (KWS), down 30 per cent, Learning Technologies (LTG), down 33 per cent, Burford Capital (BUR), down 15 per cent, and Abcam (ABC), down 16 per cent, are just a few of the larger Aim stocks to see significant de-ratings.

 

Performance

In last month’s update, having worked my way back to positive territory for 2018, I said it was too early to break open the champagne. Barring a couple of strong months to finish the year, it can be safely stored away for another day. Despite a valiant effort on the last day of the month, when the portfolio was up 2.0 per cent, October saw it down by 8.6 per cent, just worse than May 2012’s drop of 8.4 per cent. The long term still looks okay, with the portfolio up 155.6 per cent (+14.7 per cent annualised) since January 2012, compared with +75.0 per cent (+8.5 per cent annualised) for the All-Share. I am wary that the annualised figures are drifting, with a down year in 2018 being unhelpful.

Fifteen of my holdings moved by more than 10.0 per cent over the month, but unfortunately only one was positive; Serica (SQZ) up 25.3 per cent. It responded well to the granting of a licence from the US Office of Foreign Assets Control, (OFAC) allowing the Rhum field to continue operating. This was a major stumbling block, which would most likely have seen the collapse of Serica’s acquisition of BP’s and Total’s interests in the Bruce, Keith and Rhum fields in the North Sea. Those transformative deals are set to complete on 30 November. My confidence that common sense would prevail was not misplaced.

Now to the villains. Superdry (SDRY) warned that warm autumn weather had hit sales and that there would be an £8m hit to profits from foreign exchange. Despite rallying 14 per cent from its low, the share price was still off 25.6 per cent over the month. Taptica (TAP) fell -20 per cent and AdEPT Technology (ADT) 13.4 per cent. Biotech Growth Trust (BIOG) gave up -16.9 per cent, reflecting the fall in Biotechnology stocks on Wall Street. Fund manager Miton Group (MGR), which fell 15.9 per cent, succumbed to profit taking after a strong performance over the summer months. Publisher Bloomsbury (BMY) released decent first-half results, including a 5.0 per cent increase in the dividend. Cash flow and cash conversion remained strong, with net cash at 31 August up to £16.9m. This was not enough for the share price to buck the market trend, down 13.5 per cent over the month. My near 10 per cent exposure to Japan through Baillie Gifford Shin Nippon (BGS) and Fidelity Japan Trust (FJV) did little to protect the portfolio. Having hit a 27-year high on 2 October, the Nikkei 225 swiftly dropped 14 per cent over the next three weeks. Baillie Gifford Shin Nippon lost -16.4 per cent and Fidelity Japan -13.1 per cent.

The rules-based experimental 'Momentum' portfolio, introduced in my September column, was down -8.6 per cent in October. I was forced out of five positions, Games Workshop (GAW), JPMorgan Japanese Smaller Companies (JPS), Mincon (MCON), TT Electronics (TTG) and fortuitously, the week before its profit warning, Warpaint (W7L). All five stocks had either closed at a six-month low or hit my 20 per cent trailing stop-loss. In a mechanical rules-based portfolio there is no room for emotion. Three stocks entered the portfolio: Telecom Plus (TEP), Entertainment One (ETO) and Polymetal (POLY), having closed at six-month highs and met my valuation criteria. The portfolio ended the month with 18 holdings and 8.5 per cent in cash.

 

Activity

October was a month to follow the advice of that old, World War II poster: Keep Calm and Carry On. As long as one is not leveraged or living off your capital, one can afford to take a more sanguine view of these market gyrations. It presents an opportunity to upgrade the quality of the portfolio and boost its overall dividend-paying potential. The trick is to get the market working for you, not against, and to try to take advantage of the huge intra-day moves in stock prices. Forced or panic selling in thin markets can lead to stocks dropping 10 per cent or more on no news. I had a busy month on the dealing front, but in nearly every case I had left a 'limit' order at a price at which I was prepared to trade. In most cases it was the prospective dividend yield that governed my price limit. Why wouldn’t I add to a stock such as Bloomsbury, with its strong balance sheet and cash flow, when on a prospective yield of over 4.0 per cent.

Early in the month I sold my position in Royal Dutch Shell (RSDA), booking a nice profit but also giving me some cash to take advantage of indiscriminate selling. Feeling its valuation looked a little rich, I sold Medica Group (MGP) for a small profit. I also reduced my position in Bioventix (BVXP) at 3,263p on 11 October, again sensing the valuation had got a little ahead of itself. Results for the year ended 30 June were good and on the back of continued strong cash flow, it announced a 55p special dividend. Total dividends for the year of 116p were up 27.5 per cent on the prior year. Following a tremendous run from early August, I reduced the position in Avation (AVAP) to 3.0 per cent on 26 October at 251.2p, to free up some cash for some of the purchases listed below.

On the first of the month, in a poorly timed trade, I increased my exposure to Japan by adding Fidelity Japan Trust to the portfolio. I subsequently added on two further occasions to take the position to 3.0 per cent. I added to Serica Energy at 89.9p on 1 October and again on 9 October, at 100.4p, on the news that it had received that OFAC licence. Opportunistic additions to existing positions included AdEPT Technology at 345p on 11 October, Iomart (IOM) at 365p on 10 October and 338p on the 11th, Bloomsbury at 194p on 23rd, Lloyds Banking Group (LLOY) at 56.3p on the 24th and Strix Group (KETL) at 142p on the 29th. The full list is on my website: www.JohnsInvestmentChronicle.com

Market volatility also gave me the opportunity to get back into an old favourite, Melrose Industries (MRO). On 26 October the share price, having already been weak, fell a further 10.0 per cent, enabling me to pounce at 150.9p. This FTSE 100 company has an enviable record of value creation with its Buy, Improve and Sell strategy. Since flotation on Aim in 2003 an investment of £1 would have given a total return of £29.15 through to December 2017. Since making its first investment in 2005 it has achieved an average annual return on equity investment of 25.0 per cent. Earlier this year, it gained control of GKN, and while it is tempting to say that you are only as good as your last deal, management has proved over and over again an ability to improve the returns of businesses it acquires. It is also very focused on selling non-core businesses and eventually, if the price is right, core businesses, thus generating substantial value for all stakeholders. It is still at an early stage with GKN, having only completed the acquisition in April. Over the next year I expect news on how it is setting about improving margins and for some disposals. At 150p, on current forecasts the shares were on a prospective 2018 dividend yield of 3.0 per cent. Consensus forecasts are for 22 per cent dividend growth in 2019 and 14 per cent the following year, taking the prospective dividend yield to 3.6 per cent and then 4.2 per cent. That seemed an attractive entry point to me.

 

Outlook

November has got off to a good start, but it’s too early to dismiss the possibility that this bounce is of the 'dead cat' variety. Hopefully October’s fall was just one of those healthy corrections that sets up the market for the next move upwards. Having said that, while it was good to see some of the excessive valuations blown off the market’s favourite growth stocks, many still look too richly valued for me. There must be a risk of a further de-rating of these companies. While I have indirect exposure to some highly rated stocks through the likes of Scottish Mortgage Trust (SMT)ROBO Global Robotics and Automation ETF (ROBG) and Syncona (SYNC), the highest rated of my individual holdings is Bioventix. It is on a prospective June 2019 PE of 26 times. I am happy to hold due to its high margins, returns on capital, cash generation, growth prospects and dividend yield. All my other positions are on prospective PEs of less than 20 times and, with the exception of Faroe Petroleum (FPM) and Serica Energy, pay attractive dividends. Hopefully that will set me up for the year ahead.

The highlight of my investing diary in November is the Mello London investment forum on 26 and 27 November, in Chiswick. The organisers have put together an excellent programme, with presentations from more than 50 companies and leading industry commentators such as Gervais Williams and Lord John Lee. If this is half as good as previous Mello events, I’m in for an early Christmas treat. More details at www.melloevents.com

 

John Rosier's portfolio (at 31Oct 2018)

NameEPICMarket cap (£m)% of portfolio
    
Bioventix PLCBVXP1476.6
Baillie Gifford Shin Nippon PLCBGS4636.1
Biotech Growth Trust (The) PLCBIOG3705.2
Scottish Mortgage Investment Trust PLCSMT70095.1
Lloyds Banking Group PLCLLOY407114.5
Iomart Group PLCIOM4164.4
Faroe Petroleum PLCFPM5534.4
Bloomsbury Publishing PLCBMY1454.3
U and I Group PLCUAI2874.3
Robo-Stox Global Robotics and Automation GO UCITS ETFROBG 3.8
Central Asia Metals PLCCAML3823.6
Diversified Gas & Oil PLCDGOC6343.6
Serica Energy PLCSQZ2873.5
Strix Group PLCKETL2833.5
Anglo Pacific Group PLCAPF2373.4
Syncona LtdSYNC17263.3
Melrose Industries PLCMRO81933.3
India Capital Growth Fund LtdIGC893.2
AdEPT Technology Group PLCADT843.2
Miton Group PLCMGR1073.0
Avation PLCAVAP1603.0
Standard Life UK Smaller Companies Trust PLCSLS4593.0
Fidelity Japanese Values PLCFJV1932.8
Taptica LtdTAP2042.6
Cash depositCD 2.3
Superdry PLCSDRY6622.0
Vietnam Enterprise Investments LtdVEIL9881.8
Geiger Counter Ltd (Subscription Shares)GCS 0.1
Fidelity Asian Values PLC (Subscription Shares)FASS20.1