Weekly Commentary 22/11/21: Indexing Regret

The FTSE 100 fell in the second half of last week, but at 7,202 still remains around the top of its previous May-Oct trading range. The Nasdaq was up +1.75% and the S&P +0.5%. Brent Crude fell back below $80 per barrel, suggesting that tensions between the EU and Belorussia are not having a wider impact on energy markets.

This week I’ve been using SharePad to compare the international stock market indices over 10 years. I’m aware that most readers are (like me) UK-focused but it’s worth keeping an eye on international markets’ performance. So I downloaded the data from SharePad’s Major Indices (in “Other Lists”) to a CSV file using the “Sharing” button.

When I joined CSFB in 2000, I noticed that the investment bank’s own defined contribution pension scheme default selection was to a low-cost index tracker. That was despite CSFB having a top-rated equity research franchise earning huge revenues from active fund managers (including pension funds) advising which companies to buy and sell. So following what stockbrokers did with their own pensions, not what they advised other people to do, I’ve invested some of my pension in low-cost index trackers ever since.

However it had not occurred to me that it makes a huge difference which country’s stockmarket you choose to track with an index. Up until a few years ago, I had been making the naïve assumption that developed world stock markets were highly correlated, and long term returns between stock markets in the US, Germany, France, Japan and the UK would not differ over the long run.

Big mistake, as the chart I made from the downloaded SharePad data shows.

Around half my pension is still in a FTSE All Share index tracker, which is up a disappointing +44% in the last 10 years, despite the tail wind of a weak pound. The FTSE 100 index +33% in the last 10 years has done even worse, a long way behind the best performing index, the Nasdaq 100 +585%. The S&P500 with less concentrated exposure to world beating tech stocks and no (until recently) Tesla is still up +272%.

There’s been some debate about whether the FTSE’s poor performance has been caused by BREXIT or merely the fact that there’s a heavy weighting of banks, oil and mining companies (some of which are from the former Soviet Union, with decidedly poor corporate governance) and lack of large UK tech stocks. Rather than delivering returns from faster growing economies, very often the likes of Bumi, ENRC, Kazakhmys, Polyus Gold, Evraz and NMC Health have been a way for unscrupulous owners to debase the currency of a London listing.

Given that the FTSE Techmark Index is up +242%, I think it should be obvious that the index constituents play a far more important role than BREXIT considerations. The table below shows the top 10 performers in the FTSE Techmark Index. Flutter is the only share that has a market cap greater than £20bn, so it’s certainly true that there’s no UK equivalent of the FAANGs + Tesla and Microsoft.

I was also rather surprised by the strong performance of both the Nikkei +247% and the German DAX +171% (despite the inclusion of not just Deutsche Bank and Volkswagen, but also Wirecard!)

Institutions influence index returns Similarly three of the BRICs countries (Brazil +85%, Russia +18% and China +10%) feature in the bottom five performing markets (the other two being London’s FTSE 100 +33% and Hong Kong’s bank heavy Hang Seng Index +31%). That performance doesn’t fit the narrative of higher growth emerging markets delivering higher returns for shareholders. China’s bottom of the table returns are without (yet) experiencing an “economic hard landing”. I would suggest poor performance is due to the weak institutions that don’t seem to protect investors.

For instance former Fidelity star fund manager Anthony Bolton launched (with much media fanfare) his China Special Situation Fund a decade ago. He attracted over half a billion pounds, but later, after his fund lost a third of its value, he complained about the level of fraud in China and he left in 2014. While there are plenty of high returning companies in emerging markets, I think the lack of institutions means index trackers are not the suitable investment vehicle to take advantage of the opportunity.

I’d also suggest that weak institutions in London (not just the banks and commodities exposure per se) has meant that the FTSE All Share performance has become more similar to an emerging market. This has worked well in the case of the least risky bank on the FTSE (Bank of Georgia), because of the high corporate governance standards and ownership structure at the bank – but in many cases London has been a way for wealthy oligarchs to cash out their gains at the expense of UK savers. That seems to be a good reason for using SharePad to screen for quality companies, and not just buying the UK index through a low-cost tracker.

Stocks this week

This week I look at a couple of winners Gear4Music, which has warned on supply chain issues and Naked Wines which has warned about rising customer acquisition costs in its wine subscription business. Plus Georgia Capital, the Tbilisi portfolio of companies that’s trading at a c. 50% discount to NAV, and which reported Q3 results last week.

Gear4Music H1 Sept

This retailer of online musical instruments released H1 results with revenue of £65m (down -8% vs H1 last year, but still up +31% versus H1 two years ago). G4M was a “Covid winner” with many buying musical instruments to annoy their neighbours – I mean spend their free time constructively – over the lockdowns last year. Statutory PBT was £1.9m, down -66% versus H1 last year and net cash was £3.6m at the end of September.

G4M had already announced a month ago that revenue figure of £65m, and gross profit would be £18.1m – so these numbers were inline. Nonetheless the shares fell -14% on the morning of the RNS

Outlook The damage seems to have been done by comments about current trading in their H2. Having raised guidance in June this year, management are now warning of “Brexit related supply chain challenges”, meaning that FY Mar 2022 are likely to be below consensus expectations (which they think are revenue of £157m and EBITDA of £14m). The cause of the disappointment has been sales into Europe (down -16% in H1) from UK warehouses.

Transitory? Supply chain issues should be temporary, in which case the sell-off looks overdone. But management was confident of achieving FY numbers as recently as a month ago, saying that they deliberately increased on-hand stock to £30m at 30 Sept in preparation for disruption. The risk is that lockdowns merely brought forward demand from this year, and we’re now seeing that effect reverse and are in for a disappointing Christmas. In the past I have also worried that Amazon might be a competitive threat to G4M too.

TUNE Results As luck would have it, Focusrite (TUNE) the music and audio products group announced strong FY results to August with revenue +28% organically on the same day. Their outlook statement said that “demand for the vast majority of our Group products has remained strong, and those sectors negatively impacted by COVID-19 are showing ongoing signs of recovery.” They did however dilute that with a “cautiously optimistic about the prospects for modest revenue growth in the current year.” TUNE shares were up +8% on the morning of their RNS. TUNE (professional musicians) and G4M (amateurs) operate in different markets, but I’d expect similar supply chain issues to affect both companies.

Financials Pre Covid, G4M reported RoCE averaging 5.5% for the three years up to FY March 2020. Revenue was growing at more than +40% per year, but at the expense of margins and profitability. Then with lockdowns we saw +31% revenue growth and 32% RoCE, helped by an increase in EBIT margin and capital turnover.

Management have just announced the acquisition of AV Distribution (an online retailer of Home Cinema and HiFi equipment) earlier this year, due to complete in December 2021 which they believe will increase their addressable market. They think that they have identified a significant growth opportunity, but if this disappoints then RoCE (and the earnings multiple) is likely to suffer.

Forecasts Progressive, the company’s paid for research house, says that the solution to supply chain issues is going to be new hubs on the continent (Ireland and Spain). However they think these won’t be scaled up until FY Mar 2023, hence have cut revenue forecasts by 4-5% for the next 3 years, resulting in a cut to EPS of -26%. That suggests 37.5p in FY Mar 2024F, putting the shares on 17x that year’s earnings.

Opinion It is not unknown for retailers to blame disappointing sales on temporary factors beyond their control (the weather being the classic example) when in fact there’s something more fundamental going wrong. So there’s a risk that “supply chain” becomes the equivalent of “weather” for online retailers with lacklustre sales. Readers can judge for themselves how credible they think the explanation is with management’s most recent investormeetcompany presentation. Even if investors are tempted to believe the problems are temporary, it may still be worth waiting until after Christmas before they try picking G4M shares as a bargain?

Naked Wines H1 to end Sept

This direct-to-consumer company hoping to disrupt the wine industry was a “Covid winner” with the shares +196% in 2020, but the share price has fallen -5% this year. They announced H1 results with total sales +6% on a constant currency basis (or +1% ex adjustments) to £159m, around half of revenue comes from customers in the USA, 40% from the UK and the rest from Australia. They reported an improving gross profit margin of 42% (+240bp versus 39% margin H1 last year) and finished their financial half with £57m of cash, down from £85m at the FY, as they increased inventory to £127m (vs £76m end of March). Having the available cash to be able to do that seems like a resilient way of dealing with supply chain problems.

Naked Wines have a subscription business model (although they refer to their 947K subscribers/repeat customers as “Angels”.) Angel subscriptions are £20 a month in the UK and $40 a month in the US and Australia. They can then place orders as often as they like, using the balance on their account and any additional spend is paid by card. The company says Angels/customers save between 25-45% vs buying the same quality of wine from a retail supplier (do they mean supermarket or specialist off licence?)

I find it rather grating when companies corrupt the English language like this, substituting “customers” for “Angels” – so I’ll refer to subscriber numbers (rather than Divine spiritual intermediaries) which are up +25% versus H1 last year, but only +7% versus the FY March year end. So growth has clearly slowed since lockdowns ended, but it’s an impressive result that they’ve been able to continue to grow unlike G4M and BOTB. Repeat customer sales were +16% H1 and represent 91% of total sales.

Wine Moat? Although it’s a subscription business, it’s worth pondering whether they have a real “moat”. The company admitted last week that they’d faced some specific challenges acquiring new online customers at a cost that they would have liked over the last six months, which will impact their near-term growth. They decided to spend less on new customer acquisition costs due to unattractive payback.

Outlook To their credit the outlook statement is very clear. They have lowered their sales guidance to £340-355m (previously £355m-375m), which equates to 2% to 7% sales growth on a constant currency basis, reflecting lower investment in acquiring new customers. They also said that to prevent supply chain disruption they will continue to run the business with higher inventory balances, though they don’t think this will constrain their growth potential.

Customer acquisition costs has certainly been an issue for BOTB, which last FY reported RoCE of 225% has also had to pay more to acquire online customers over the last 6 months. Aside from scale, WINE claim to have unique data and technology which helps them predict lifetime value of new customers plus they say that their strong relationships with 235 wine suppliers. I’m not particularly convinced with this argument, because the business has been losing money for three years, and is forecast to make less than £5m of profit in FY 2024.

Forecasts Medium term they expect to grow sales at c.20% a year, and believe that as the business scales that they will report an EBIT margin of 10%. That aspiration doesn’t match forecasts which are for mid-teens growth to 2024, and an EBIT margin of below 1%. FY March 2024F EPS forecast of 5.3p implies a PER of over 100x, and a price to revenue of 0.9x.

Opinion By co-incidence I spent a couple of days this week helping out some friends who have a small wine business, so I’ve been operating a wine canning and labelling machine. It’s good to get out from behind a computer screen but I’m not convince that wine is the path to riches that others seem to believe. It’s possible that WINE will grow into a business with attractive returns on capital, but at the moment there’s not much evidence of their ability to increase margins. Not for me.

Georgia Capital Q3 Sept

This Tbilisi-based Bank of Georgia spin-off reported NAV per share +10% from June, in local currency terms. NAV in GBP is £14.24, so at 660p the shares trade at a more than 50% discount to book value. Of that NAV, 20% is Bank of Georgia (or £3.34 per share) which is publicly traded on London Stock Exchange and marked to market.

The rest of CGEO is the Bank of Georgia businesses that they acquired a collateral on defaulted loans when Russia invaded in the middle of the 2008 financial crisis. They split these into:

  1. Large Portfolio Companies: Healthcare (previously Georgian Hospitals) 21% of total portfolio value, Pharmacies 18% of total portfolio value, Water Utility 18% of total portfolio value, Insurance (both property and medical) 8% of total portfolio value. Together these businesses are 65% of CGEO and worth £11.55 per share. They announced last week that they would buy out the minority shareholders of the pharmacies business, who are the current management.
  2. Investment Stage Companies: Renewable Energy (originally hydropower but now also windfarms) 6% of total portfolio value, Education 4% of total portfolio value. Together worth £1.73 per share.
  3. Other companies (7% of total portfolio value): a property developer, second-hand cars, brewery and a vineyard. Together worth £1.27 per share.

There is also Net debt of £170m or £3.66 per share deducted from the gross value to give NAV of £14.24 versus a current share price of £309m. Net debt to market cap may look high for normal business, but over 60% (or £103m) is allocated to the water utility which is a regulated business and should have cashflows that are highly reliable.

Annoyingly the consolidated p&l begins with dividend and interest income upstreamed to the holding company, so it’s hard to get an overview of the trends. They put up this chart in their slide pack to show aggregate revenue was up +24% vs Q3 last year and 9M 2021 revenue was up +26% y-o-y or +36% vs 9M 2019 – all in local currency terms.

I wrote about the company in more detail here. The shares are trading on EV/EBITDA of 5x – but I’ve been thinking even that probably understates the valuation, because of the rise in the market value of their Bank of Georgia stake (+42% in the last 6 months) to £153m or £3.34 per CGEO share. Deducting the value of BGEO from the market cap within the EV means that the EV/EBITDA drops to 3x.

Or put another way CGEO looks set to generate around £50m of net profit for FY 2021F, so that implies 3x earnings and 0.3x revenue, which seems a very high conglomerate / frontier markets discount. Georgia Capital’s management have said that they intend to sell businesses, which should simplify the financials and hopefully provide reassurance that the group’s NAV has been valued conservatively.

I own the shares, though I must admit trying to understand all the moving parts gives me a headache.

Bruce Packard


The author owns shares in CGEO

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