Weekly Commentary 06/12/21: Wealth vs investment

The FTSE 100 was resilient, recovering to 7,157 on Friday up +1.6% for the week. The S&P500 and Nasdaq100 were both down less than 0.5%. Interestingly though bond yields have reacted more cautiously to reports of the new variant, with US treasuries now yielding 1.43% a 24bp point fall versus the last week of November before South Africa announced that they had detected Omicron. UK bond yields have fallen even more steeply from 39bp from 1.20% in October when markets were expecting the BoE to begin raising rates to 81bp currently. The WHO has said that it will take at least a couple of weeks to understand how effective vaccines are against the new variant, so the different reaction of equities versus bonds likely suggests the inherent psychology of market participants (Govt bond markets more risk aversion, equity markets attempting to balance risk vs reward.)

One market that isn’t signalling any caution is UK house prices. The Nationwide HPI showed even after the stamp duty holiday ended that momentum continues with growth accelerating to +10% per annum. House prices are now up almost +15% from the level in March last year when the pandemic hit. The number of mortgages approved for house purchases (a lead indicator) was still running above the 2019 monthly average.

Last week ULS Technology, the online conveyancing platform reported H1 results with revenue +48% to £10m, a gross margin of 40% but an underlying loss of £1.5m. I’m not too concerned by that loss because having sold a business last year they have half the market cap of £46m in cash on their balance sheet. In their outlook statement they say that housing sales this year are likely to exceed the 2007 peak of 1.5m transactions. They also point to an Office of Budget Responsibility report saying that housing transactions should be above pre-pandemic levels for the next few years.

Whenever I think that I know something about the banking system or finance, I always remind myself of the perpetual wealth creation machine that I really don’t understand: the UK housing market. I’m not alone, one of my bank analyst colleagues at CSFB sold his London house in the late 1990s, thinking it was a bubble back then. Fortunately for him, he invested some of the money in Amazon shares, calling the bottom just as the tech boom ended.

Wealth vs Investment I’m slowly going through a 196 page McKinsey report called The Rise and Rise of the Global Balance Sheet. Rather than look at GDP, they try to measure wealth by looking at the balance sheets of 10 countries*, representing more than 60% of global wealth. The largest number in the report is $1,540 trillion, which is their figure for the global balance sheet, taken by extrapolating from the 10 countries to the rest of the world.

Of that $1,540 trillion, a third ($500 trillion) is tangible assets like offices, machinery but the majority residential property, a third is financial assets like equity and debt held by households, corporates, governments matched by the same amount held in the financial sector (banks, insurance companies, asset managers). Balance sheets (both assets and liabilities) have grown much faster than GDP, and trebled from 20 years ago. McKinsey calculate that their global balance sheet is now 18x Global GDP.

The strategy consultants point out in their report that financial assets have grown much faster than investment. For every $1 invested, balance sheets have grown by $4. This is unlikely to be sustainable, or even desirable. It could be Central Banks that end the party, by reducing bond buying QE or raising interest rates. But even if they don’t it is mathematically impossible for debt to outpace productive investment indefinitely.

Sandy Nairn, a grandee of the Edinburgh investment scene, has a new book out called The End of Everything Bubble, which starts with a quote from Lord Macpherson, former Permanent Secretary to HM Treasury:

“The scale of monetary and fiscal expansion in recent years has been staggering, and has been much more successful at creating a boom in asset prices than growth in the real economy. Sandy Nairn’s rigorous analysis of asset markets is compelling, and his conclusion that asset prices are set for a hard landing is persuasive.”

Cash in the portfolio One way to protect your wealth from such a hard landing is to keep some cash aside to invest when it becomes more obvious where the opportunities of the future years will be. Warren Buffett is currently sitting on $149bn of cash.

An alternative way to position your portfolio more defensively is by investing in companies that are net cash. I’ve used SharePad to do a quick filter of AIM stocks with >15% ROIC, Cash/Market Cap, and a 2-year PER of less than 30x. I’ve used SharePad “Edit Criteria” to generate Cash/Market Cap, rather than just the absolute £m figure of cash, and sorted by this column.

Below I look at Arcontech which is top of that list, following a steep sell-off last week after it disappointed with a trading update. I like to use screens to filter down suggestions for further research. So for instance readers need to consider whether last week’s profit warning signals a fundamental deterioration in ARC’s business. I’d also be careful because some cyclical, acquisitive “people businesses” with large earn-out liabilities (K3 Capital and Alpha Financial Markets spring to mind) report net cash on the balance sheet, but don’t include their future obligations to employees within that cash figure. Similarly, RBGP, the litigation finance company, reports net debt of £10m but excludes earn-outs from this figure.

The screen contains a couple of other stocks I own Sylvania, Argentex, plus further down the list BOTB, Somero, Cake Box and Spectra Systems which I don’t own but have written about in the past. In this kind of market I prefer “net cash, and profitable but struggling to grow” than “growing fast and hidden risks.”

A third approach to weather uncertainty is investing in companies with strong brands with pricing power (able to raise prices) or investing in companies improving productivity (able to reduce costs and share the benefit with customers and shareholders). This is the Nick Sleep approach which seems to work through most cycles. This week I look at AG Barr, which I’d suggest is the former, and Wise is the latter.

AG Barr FY trading statement

This branded soft drinks maker (IRN-BRU, Rubicon and Funkin) with a January year end, put out a trading statement saying that they expect FY Jan 2022F results to be ahead of expectations. Assuming market conditions remain unchanged, they expect revenue to be in the order of £264m and profit before tax to be around £41m. That equates to +16% revenue y-o-y growth and +58% PBT y-o-y growth. But it’s worth remembering the FY Jan 2021 was not a typical year, and versus FY Jan 2020 revenue would be up +4% and PBT +10%. Still creditable, but a reminder that AG Barr is struggling to grow the top line.

Peak revenue was £279m in FY Jan 2019, and the FY 2022F figure is barely above the £261m reported in FY Jan 2015. But this is a Nick Train / Lord Lee stock, and it strikes me that in times of uncertainty this is the sort of company that is relatively defensive, owning durable brands with pricing power that has struggled to expand outside its core market. 97% of revenues come from the UK.

History 10 years ago AG Barr tried to merge with Britvic, despite the IRN BRU maker being the smaller soft drinks company. The larger target company’s shareholders originally accepted the deal in November 2012, but then the Office of Fair Trading ordered the Competition Commission to examine the deal, so the offer lapsed. Meanwhile Britvic’s shares rallied +35% to over 500p, which meant that AG Barr’s renewed offer didn’t look so attractive (it would have given Britvic shareholders 65% of the company, versus a then market cap ratio of 67 / 33%). The deal did eventually receive regulatory approval in July 2013, but the terms of the deal were not attractive enough for Britvic’s board to recommend it.

AG Barr then bought Funkin for £21m in 2015. Similar to FeverTree, the Funkin brand was founded in the late 1990s to make high-quality fruit mixers for drinkers of expensive spirits. Funkin now and plays an increasingly important role in revenue generation: with £19m of sales it delivered 14 per cent of total group revenues, up from 7 per cent last year.

There was a profit warning in July 2019, with the shares falling -28% blamed on the weather and sugar tax, which increased prices and forced a change in recipes. Peak to trough the shares fell -62% from 980p to 370p in September last year.

Financials The company’s balance sheet is bulletproof, with £66m of net cash at the end of July this year. Shareholders’ equity was £330m, or £241m ex intangible assets. Their H1 to end of July 2021 showed operating cashflows before working capital of £30m, or £17m after large working capital movements (which I think are understandable given that the UK was emerging from lockdown last summer). RoCE, Capital turnover and EBIT margin have all been trending down in recent years, however I think that’s the impact of the sugar tax, plus the termination of their Rockstar Energy Drinks agreement, when the drinks maker was acquired by Pepsi Inc. They received a £7.6m one off payment (recorded as an exceptional item) in November last year, but the termination hit revenue. The pandemic has also been a negative. As volumes are now increasing, the financials should begin to look more attractive and so a reversion towards 20% RoCE seems credible.

Supply chain At the H1 results they mentioned challenges with their UK road haulage fleet (ie lack of lorry drivers), impacting customer deliveries and inbound materials. They say that the situation is still challenging, but they’ve been able to continue production to support growth in volumes.

Ownership Lindsell Train owns 13%, and W Robin G Barr from the original family and non-Exec owns 6.7%. He joined the company in 1960 and was Executive Chairman from 1978 to 2009. I’m slightly surprised that there aren’t more institutions on the list.

Valuation Revenue growth is forecast to be low single digits, so 17x PER Jan 2024F might seem demanding. But it’s a very durable business, that has been around over 100 years and has the potential to expand RoCE.

Opinion I like it, as you can tell. I do wonder if it’s worth waiting a few weeks to see how the impact of the variant develops. Of course, this will eventually be priced in, but AG Barr’s FY Jan 2022F guidance was caveated with “no significant change in market conditions” which clearly they might not.

Wise H1 results

This fast growing, highly rated FinTech payments company announced H1 results to 30th September, with revenues growing +33% to £256m. They launched “Assets” for UK customers, who can now transfer balances to an index fund, while still being able to spend or transfer money overseas as though the balance were still held in cash.

Profits fell -6% to £18.8m, as “other administrative costs” more than doubled to £58m. They say this was caused by costs of becoming a public company (one off), but also additional IT and marketing spend (not one-offs). I find it rather annoying that in the management commentary they talk about reducing operating costs and passing the savings on to customers. But they haven’t split out the exceptional listing costs, versus ongoing costs associated with growth. I’m sure that profits were held back by the costs of direct listing, but the lack of transparency does suggest that administrative expenses are currently outpacing revenues. Strategically that may be the correct choice, but I disagree with the disclosure choice (to try to hide this) that management have made.

QaaUP? Wise direct listed (rather than a formal IPO process) in July at 800p, valuing the company at £8bn. There’s no doubt that it’s a quality business with a gross margin 65-67% and taking market share from the banking sector. They have a Net Promoter Score (how likely you are to recommend to a friend) of 75. For contrast Lloyds uses NPS, and if they achieve a score of 68 is achieved, executive remuneration pays out the maximum for that measure.

However I’d put WISE in the Quality at an UNreasonable Price filter. In the outlook statement they say that they expect FY Mar 2022F revenue growth to be mid-to-high 20s percent. That implies around £534m of revenue, versus a market cap of £7.3bn. So the shares are trading on 13.6x Mar 2022F revenue.

Share issuance There were 94m (worth £780m at today’s share price) of vested and unvested options outstanding in July when the company came to market. The Employee Share Trust already held 49m shares, but they will issue a further 30m shares (worth £249m at today’s price). That does create some selling pressure. In October the company announced that Taavet Hinrikus (co-founder and Chairman of Wise) would sell 11m shares, and enter a loan agreement with Goldman Sachs where up to 49.6m shares would be pledged as security. There’s a dual share structure with the founders holding B shares which have 9x more votes than the A shares, and lets them keep control if they decide to cash out their A shares.

Ownership Baillie Gifford owns 24%. Then some venture capital firms: IA Ventures 12%, Valar Ventures 10% and Andreessen Horowitz 9% – I do wonder how long these VCs will hold. So that’s another source of potential shares coming on to the market.

Opinion I’m a fan of the company, and think that they’re a great innovation for customers, and employees with share options. However, I’m sceptical that shareholders should be paying over 10x revenue for the story. SharePad shows a RoCE of 14%. I’m hoping it will be possible to buy some shares at below 10x revenue, which would imply an entry price below 520p.

Arcontech profit warning

This financial markets data processing company with a December year end announced that it would disappoint market expectations, due to one customer reducing spend and another customer not renewing. The shares fell -19% in response and have halved in value since the start of the year. This is one I got wrong: I own the shares, and had been hoping that as people returned to the office it would be easier for Arcontech’s salesmen to make face to face contact, demonstrate the product and close sales. My thinking was that 2021 technology budgets may not have been spent, and in November / December Arcontech’s new hire salesmen might be able to benefit from banks deciding to invest in their data systems. I can now reject that hypothesis.

Broker forecasts FinnCap, their broker, lowered FY 2022F and FY 2023F revenue by 6% and 11% respectively. This is a company with a high gross margin and operational gearing, so eps falls -17% and -30% for FY 2022F and FY 2023F. FinnCap now forecast 6p EPS for both 2022F and 2023F meaning the shares are on 16x.

The company is still profitable, and has £5.4m of net cash. The profit warning tries to sound upbeat, pointing to a healthy sales pipeline, but they don’t give any figures to support that. SharePad’s “Forecast Growth” line is a sea of red.

Clouds on the horizon? It’s not clear how unique Arcontech’s software and relationships really are. Here’s a link to a recent CNBC article about a Goldman Sachs collaboration with Amazon Web Services, where they store financial data on the cloud, and give hedge funds access to tools to back test trading strategies. This recognises that a lot of time is spent “wrangling” data from different data sources that don’t quite match up (ie missing data, treatment of bank holidays in international financial markets, or different opening hours between currency, OTC and equities markets). I’ve played around with some of this stuff in an amateurish way and can confirm that a lot of time is spent “wrangling” rather than analysing and back testing.

I also found the story interesting for another reason. Apparently, Amazon taught Goldman to “work backwards.” This is an Amazon technique where they envision a successful outcome, and write a press release and FAQ before starting the project. My first job was in management consulting, straight out of university, I was tasked with building a marketing database for the firm. The trouble was no one quite agreed on the purpose of the marketing database, what data it should contain or even who the users were and how it would be used. I had no technical background, apart from a degree in Theology, but the most difficult part of building the database was not the technical skills. Instead it was the lack of clear specifications about what was required.

Too late, a seasoned IT professional schooled me in the pub, that IT projects were like building projects: you have to get people to agree what they want beforehand, and every time they change their mind, take a deep breath, suck in your teeth and say “ffffff, I can change that but it will take time and be expensive.”

Opinion I am normally happy to invest in profitable companies with net cash and operational gearing that are struggling to grow revenue. When the revenue does come through, the economics look even more attractive. However, ARC is a low conviction hold for me, because I worry that Arcontech’s data services don’t have much of a “moat”.

Management are reluctant to present to retail investors at Mello, PI World or InvestorMeetsCompany, so it’s hard to make a qualitative judgement on how sustainable the business is. For now it’s a weak hold, I’m still hoping that management can back up their optimistic talk with growing revenue.

Bruce Packard


*Countries covered by the McKinsey report: Australia, Canada, China, France, Germany, Japan, Mexico, Sweden, the UK and the USA.

The author owns shares in ULS Technology and Arcontech, plus Somero, Argentex and Sylvania

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