Private Investor's Diary: It's time for value and strong balance sheets

The reopening of the Chinese economy further bolstered optimism about global growth. As a result, the 10-year US Treasury yield dropped to 3.5 per cent, a significant decrease from its peak of 4.3 per cent in October. The UK also saw similar gains, as the 10-Year Gilt yield fell to 3.4 per cent, down from 4.5 per cent following the Truss/Kwarteng mini-Budget in the autumn. Overall, the positive momentum of the beginning of 2023 is largely attributed to the expectation of falling inflation and the end of central bank tightening.

In broad terms, the riskier the asset, the better; bitcoin, for example, was up 39 per cent. Of the major equity markets, Italy led the way, with the FTSE MIB gaining 11.6 per cent. Other continental European markets followed close behind, with the CAC 40 up 9.4 per cent and the DAX up 8.7 per cent. In the US, the Nasdaq composite gained 10.7 per cent, with the broader S&P 500 Index up 6.2 per cent. In Far East markets, the Hang Seng was up 10.4 per cent and the Nikkei 225 up 4.7 per cent.

In the UK, the FTSE All-Share (TR) Index was up 4.5 per cent, exceeded marginally by the FTSE 250, up 5.3 per cent. The FTSE Small Cap increased by 4.2 per cent and FTSE Aim by 4.4 per cent.

Commodities responded to increased optimism regarding 2023 growth, with zinc up 14 per cent, copper 10.3 per cent and Aluminium 9.4 per cent. Oil was flat, with Brent crude ending the month at $85.5 a barrel. Nickel and platinum were down 2.4 per cent and 4.0 per cent, respectively.

Performance

If the market set off like a hare, the JIC Portfolio has been more tortoise-like. The portfolio was up 1.1 per cent in December, behind the FTSE All-Share (TR) Index's gain of 4.5 per cent. It leaves the JIC Portfolio up 334.6 per cent since inception in January 2012, translating to annualised growth of 14.2 per cent. By contrast, the FTSE All-Share (Total Return) Index achieved a 120.9 per cent increase, with annualised growth of 7.4 per cent. The FTSE All-World GBP (Total Return) Index returned 4.6 per cent in January. Since January 2012, the All-World has gained 259.5 per cent or 12.2 per cent annualised.

The JIC Funds Portfolio fared better than the JIC Portfolio in January. It was up 3.8 per cent compared with 4.6 per cent for the FTSE All-World (GBP, TR) Index. Since this portfolio's inception in June 2020, it is up 33.0 per cent compared with 30.6 per cent for the All-World.

There were some strong moves in the JIC Portfolio, but only eight of my 21 holdings recorded returns above that of the All-Share. Of those eight, three were new positions added during the month. My high exposure to UK oil and gas stocks did not help. Kistos (KIST) was down 13.5 per cent and Serica Energy (SQZ) fell 11.2 per cent. Worst of all was IOG (IOG), which posted a profit warning due to disappointing results from the Southwark field. I should have cut on the bounce following its previous profit warning in October. Luckily, I didn't add to my position in the autumn, so when I cut on 18 January, it was my smallest position. Nevertheless, it still knocked around 1 percentage point off the total portfolio performance in January. It becomes my single most significant monetary loss in the JIC Portfolio’s 11-year history.

Serica Energy cost almost as much as IOG in terms of total portfolio performance over the month due to its prominent position. Falling gas prices don't help sentiment, but the primary debate was over its acquisition of Tailwind Energy. Investors fell into two camps; those who thought it was a poor deal done purely to increase the size of the company and those who accepted that the acquisition improved the quality of earnings due to a more balanced mix between oil and gas production, with more significant development potential.

Those in the first camp are correct that, in the short term, it could have increased value by, for instance, buying back shares. However, the maths clearly shows that it substantially enhances the net asset value (NAV) per share. Modelling the combined business’s cash flow suggests that in 2023 the deal will be dilutive for shareholders, but from 2024 it will be highly accretive.

The Tailwind Energy acquisition was approved on 27 January and should complete in the spring. Mitch Flegg, chief executive of Serica, said: “The proposed Tailwind transaction represents a rare opportunity to acquire a successful company with an outstanding portfolio of assets that are complementary to the existing Serica portfolio. The significant increase in production, reserves and short-cycle growth opportunities will establish Serica as an operating company of increased scale and technical diversity while maintaining financial strength, retaining a net cash position at completion and with strong ongoing cashflows thereafter. This financial strength will allow Serica to continue its programme of returns to shareholders whilst supporting an ongoing campaign of M&A and organic investments.”

We will have to wait until June for the final dividend announcement, but the company has room to be generous, given the combined entity’s cash flow and net cash position. It looks like excellent value to me, but this is not a popular sector now. At least the dividend is paying me to be patient.  

The main positives were Lucara Diamond (CA:LUC), up 26 per cent, SDI Group (SDI), up 21 per cent, Polar Capital (POLR), up 8.6 per cent, BlackRock World Mining (BRWM), up 8.0 per cent and Niox (NIOX), up 6.9 per cent. I don't know why Lucara Diamond performed so well except that it looks very cheap. Buoyant markets helped Polar Capital. High commodity prices boosted BlackRock World Mining, and Niox posted a positive update.

The JIC Funds’ Portfolio

The Portfolio benefited from its high exposure to commodities and value. Global X Copper Miners ETF (COPX) gained 12.2 per cent, L&G Gold Mining ETF (AUCO) 9.1 per cent, BlackRock Energy & Resources Income (BERI) 9.0 per cent and BlackRock World Mining Trust (BRWM) 8.0 per cent. With its high exposure to UK value stocks, Temple Bar IT (TMPL) gained 8.0 per cent. VT Argonaut Absolute Return (GB00B79NKW03) was the only one of my 14 holdings to really let the side down, falling 10.4 per cent. (More details at www.jicuk.com.)

More details at www.jicuk.com

Activity

In January last year I added three new stocks to the JIC Portfolio. None of them were that successful, although that was primarily due to the unhelpful market conditions. I have sold two of them, Somero Enterprises (SOM) and Lloyds Banking Group (LLOY), while Niox (formerly called Circassia) remains. I sold Somero on 19 January at 443p. It is cheap, but could struggle if the US economy does not land softly. In any case, I required the cash for three new positions, which I hope will do better than last year's efforts. My cash holding was also boosted by reducing Next Solar Energy Fund (NSEF) to 2.5 per cent and cutting IOG. 

The first of the new purchases was ME Group International (MEGP) at 115.75p on 9 January. I’m attracted by the momentum in the business, with growth in its traditional Photo-Me machines augmented by new areas such as laundries and photo printing. It is a high-quality company as measured by return on capital (18.6 per cent), return on equity (21.8 per cent) and operating margins (15.9 per cent). It is highly cash generative – in 2021, earnings per share (EPS) of 5.7p translated to free cash flow per share of 6.6p. It has net cash on the balance sheet (£38.2mn on 31 October), and after investing in growing the business (on which it makes super returns), it has money left over to return to shareholders. The valuation is attractive on a forecast price/earnings (PE) ratio of 10.1 times October 2022 earnings, falling to 9.4 times for October 2023. The dividend yield forecast for October 2023 is 5.9 per cent. Over the past year, analysts have upgraded earnings forecasts. The most recent upgrade was in November following a robust trading update. The next news should be the results in March.

On 11 January, I added Shoe Zone (SHOE) at 218p. It has performed well over the past year, but has more to go. Results for the year ended 1 October 2022 demonstrated that management has got to grips with the company, turned around its fortunes, and that there is clear momentum in the business. Not only that, but the valuation also looks attractive, leaving plenty more upside. On 31 October, it had net cash of £24.4mn and, as well as resuming ordinary dividends in 2022, it is paying a special dividend of 8.2p (3.3 per cent yield alone) and is buying back shares. The total dividend in respect of the 2022 financial year amounts to 17.0p (a yield of 7.0 per cent). It benefits from a post-Covid recovery and from trading down, given the squeeze on household budgets. Management has also been proactive in maximising the estate. Poorly performing stores are being closed, and it is negotiating improved terms with landlords. In addition, it continues to convert stores to its new format, achieving a better brand mix and higher margins.

On 13 January, IG Design (IGR) joined the portfolio. IG Design is a recovery story but one where the recovery looks to be well under way. It was a stock market darling from 2013 until 2020. Covid did not help, but the company ran into problems; problems that the previous management foresaw by selling out in the summer of 2020.

I first met the management in 2019 and was impressed but was wary of the high valuation. Thank goodness it got no further than my watchlist. Over the past couple of years, there have been changes at the top. Last year it started to reap the benefits from these changes and from a post-Covid recovery. The trading update on 20 October 2022 said that both of its divisions, DG Americas and DG International, experienced strong trading. As a result, the board expected the group's sales, profits, margins and cash flow to be significantly improved compared with the same period in 2021, and ahead of the board's expectations. Results for the six months ended 30 September showed a significant increase in sales and profits. Diluted earnings per share nearly doubled to 23.1¢ per share from 12.3¢ the year before. The market currently values IG Design at about 16.5 times March 2024 earnings forecasts, which seems too cheap for a recovery story. EPS could be significantly higher, but I will probably have to wait for a year-end update in March/April to see the magnitude of upgrades.

Outlook

Last month I concluded my outlook section by asking, “where could I be wrong?” My response was: “Energy prices could come down faster and further than anticipated, boosting household income. Inflation could surprise to the downside leading to positive real wage growth. Allied with lower energy bills, favourable real wages would be a massive boost to household budgets, the government’s finances, and overall economic growth. Interest and mortgage rates could peak earlier than expected, fall quicker and lift the clouds over the housing market. If this alternative scenario plays out, it could be a good year for equity markets. My positions in commodities and stocks such as Polar Capital (POLR) should help the JIC Portfolio keep up.”

On January's showing, the markets are playing out my alternative scenario. I can't help feeling that the markets have got ahead of themselves. Inflation will fall because of simple mathematics; significant increases in energy and other components last year dropping out of the 12-month numbers. The risk is that inflation comes down more slowly and not as far as currently anticipated. Employment numbers are robust, and it will be surprising if wage inflation does not increase, feeding into overall inflation. It won't take much of a nasty surprise on the inflation front to dent the current optimism of the markets. In my November report, I referred to Charlie Bilello of compoundadvisors.com's observation that in 2022, up until 23 November, the S&P 500 was down 14.3 per cent. If, however, one had bought an S&P 500 ETF when the Vix volatility index was above 30 (ie when fear was at its highest) and sold when the VIX was below 20 (when greed was the predominant force), the return would have been 28 per cent. The Vix is currently 18.5.

As always, these things are difficult to predict, and it usually does not pay to be too pessimistic. While my portfolios are fully invested, caution in what one holds is the order of the day. There are times to buy growth stocks and times to be more value-orientated. I favour value and think currently the safest route is to hold companies with decent balance sheets (ie net cash or little debt), strong cash flow and attractive valuations. I expect 2023 to be another strong year of dividend income for the JIC Portfolio.

JOHN ROSIER’s portfolio as at 31 january 2023