Weekly Commentary 13/12/21: Epicycles and shared illusion

The FTSE 100 was up +2.7% to 7,321, recovering last week as early news out of South Africa suggested that fewer patients with the new variant were on ventilators. Both the Nasdaq100 and S&P500 were up +2.8%. The US 10y Govt bond yield rose from 1.35% to 1.52% (ie Government bonds sold off as financial markets became more “risk on”.) The pound continued to sink against the dollar, from over 1.38 at the end of October to 1.32, as forex traders worried that the UK Government’s “Plan B” would delay the Bank of England’s rate rises.

Cathie Wood’s ARKK Innovation ETF fell back below $100 and is now down -22% this year.

There’s a fun Drew Dickson (Albert Bridge Capital) quote from early in the year:

Cults of personality do not last forever in the stock market. Narratives break. Eventually, everyone figured out that Galileo was right. Eventually, everyone will figure out that Cathie Wood isn’t. And it won’t take as long either.

I find this analogy interesting because Galileo was questioning authority and dogma, and it was the religious traditionalists who fought a losing battle against new knowledge. Whereas Cathie Wood has suggested she founded Ark as a calling from God to allocate capital, Bitcoiners like her claim to be the new faith-based thinking that is upending the traditional financial system. The authorities who don’t like Bitcoin are skeptical thinkers like Charlie Munger, Nassim N Taleb and Nouriel Roubini who wouldn’t feel out of place at an Enlightenment dinner party.

The second reason to ponder the quote is that Galileo wasn’t the first to posit the heliocentric worldview nor was it Copernicus. Instead it was Aristarchus of Samos, born c. 310 BC who suggested that the Earth and the rest of the planets circled the sun. The view was rejected for 2000 years, despite having a simple explanation and seeming obvious to us now. Majority opinion followed Ptolemy and Aristotle (and later the Church) who had a more convoluted explanation (the intricate phenomenon of epicycles) but a more comforting conclusion: the universe was built around us at the centre. Galileo and Aristarchus wanted to do their own thinking, rather than share a comforting illusion.

Gravity vs moonshots ARK ETF narrative of innovation and “moonshot” bets has been very successful at attracting inflows to their funds: peaking at $63bn (though now down to $34bn with the flagship ARKK ETF down to $17bn). A $17bn fund, by its nature, is too large to take concentrated positions in small stocks (where growth and innovation is more likely to occur) particularly when the fund is seeing outflows.

Marc Rubinstein wrote about this in Zuckerman’s Curse, arguing fund managers are incentivised to attract money, not maximise returns:

There are two types of business: those that suffer from diminishing returns to scale, and those that benefit from increasing returns to scale. The first group comprises most companies—they reach certain limitations as they grow, and eventually reach a predictable equilibrium in market share. The second group uses technology to extract increasing returns to scale, often because of the network effects they possess. Investment managers may load up their portfolios with the companies in the second group, but they themselves sit in the first. Limited investment opportunities and potential negative price impacts from trading in large size erode fund performance when funds grow large.

So ARKK might invest in exciting sounding stories like Cloud Computing, Digital Media, E-commerce and Gene Therapy, but just 2% of Cathie’s fund is invested in companies smaller than $2bn market cap, and none is invested in microcap stocks.

Yet the sub $300m microcap universe is where higher future returns are likely to come from. I have a Credit Suisse report* looking at long-term returns back to 1955 in the UK stock market which shows that £1 invested in UK large caps delivered £1,225 (or +12.2% nominal per year). But the same £1 invested in UK Micro Caps would have outperformed over the same time period, delivering +18.3% CAGR or £33,011. That is the magic of compounding which means a 6.1% uplift in Compound Annual Growth Rate (CAGR) over 62 years translates to a 27x increase in absolute GBP amounts. The regulator would probably like me to point out that past performance is not a guarantee of future returns. But there are solid theoretical reasons for expecting smaller companies to generate higher growth in returns than larger companies (smaller companies are likely to grow bigger, the largest companies are more likely to shrink).

It is a similar story for US stock market returns, where Credit Suisse have the data going all the way back to the 1920s. The recent FAANGS decade where the Nasdaq100 has outperformed the broader Nasdaq index is an anomaly, not the norm.

So if investors are really seeking growth and innovation, it’s best to avoid stories designed to attract large amounts of capital inflows, but instead focus on the smaller, less popular, part of the market. Buffett agrees: Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.

Remember too that +18.3% CAGR above is the average micro cap performance. By using SharePad to avoid the lower quality or wildly overpriced companies, I’d like to do better than that – though probably not +50% per annum that the Sage thinks he could do!

Mello Christmas Special This evening (13th Dec) there’s an interview with Sir Martin Sorrell formerly of WPP. He is an interesting example of my point: he has already grown one small company (WPP) from a £1 million cash shell in 1985 into the world’s largest advertising and marketing services company. He’s now trying to do the same again with S4 Capital, which I write about in detail below. Other companies I look at this week are SDI, Games Workshop and Somero.

S4 Capital

Although they didn’t report results last week, I’ve been meaning to write about S4 Capital for some time. It’s interesting to see if a successful entrepreneur can repeat his success, particularly if the new venture is attempting to disrupt the old business that the entrepreneur had previously built up. Aside from that, SFOR is operating in a fast-changing sector, there are management teams with a good story to tell but it’s not easy to verify which companies will capture the value.

Cookies and competition Facebook and Google/Alphabet make a lot of money from online advertising, the latter will remove third-party cookies from Chrome by 2022, which SFOR says is both a challenge and an opportunity (they focus on first-party data). Apple has allowed users to opt out of tracking.

Similarly platforms like Tremor, The Trade Desk and Digital Turbine (demand side/ supply side) up +202%, +601% and +2660% in the last 3 years have been strong performers in this space. But smaller advertising agencies (System1 and The Mission Group) are trying to take advantage of the shift to digital marketing, while WPP is trying to restructure for the digital age. SFOR say that their biggest competitor is none of those names, instead it’s the management consulting firm Accenture. So I think it’s an area that is worth trying to understand, even if you’re put off by SFOR’s high valuation or acquisition-driven growth. The table below shows the sector sorted by 3-year forecast PER.

History Sorrell founded S4 in May 2018, shortly after he left WPP, then reversed the new company into Derriston Capital a “cash shell” already listed on the LSE raising £51m in cash. SFOR is a standard listing with less disclosure requirements than a premium listing. One criticism mentioned in this FT article is that SFOR makes multiple acquisitions by issuing shares, often with a very long gap between the deal announcement and the share count update.

Acquisition-led growth Early institutional backers were the hedge funds Tosca and Lansdowne, plus Rathbones and TT International (another hedge fund with an emerging markets/macro bias). S4 Capital then bought MediaMonks, in July the same year a digital advertising agency headquartered in the Netherlands for €300m, funded with debt and a further placing of €143m and issuing €63m of shares as a subscription. The next deal was MightyHive, headquartered in San Francisco, a programmatic advertising company (ie buying through algorithms) for $150m – to buy the company they issued £70m in shares at 110p. At the time of the acquisition MightyHive was Google’s largest Google Marketing Platform Manager and also had a close relationship with Netflix. S4 then went on to make more than 25 further acquisitions at a cost of £942m as of June 2021, but unlike WPP integrating the businesses so that there is still one p&l for the entire company.

Balance sheet As of H1 June 2020 there were £880m of intangible assets on the balance sheet vs net assets of £735m, so tangible equity is negative £145m. There’s a €375 million senior secured term loan and £100 million revolving credit facility negotiated just after the H1 in July, so the balance sheet is weak if there is an advertising downturn. In Q3 cash payments for earn-outs on past deals were £56m (ie paying 2/3 of the £83m of contingent consideration shown on the balance sheet at H1 end of June). Management have said there’s further capacity to do deals worth over £400 million, assuming that they pay half in shares and half in cash, before reaching the maximum limit of debt 2x EBITDA.

Contingent consideration I note that contingent consideration this is clearly set out on the face of the balance sheet, recorded at fair value rather than lumped in with trade payables (RBGP) or in the notes of the account (K3 Capital). Recording amounts at fair value does mean that if they have a bumper year, like H1 2021 when advertising migrated online, then the cost of that will be expensed through the p&l. Cash generated from operating activities was a positive £12.7m in H1, but they reported a statutory loss before tax of £19m in H1, partly due to a couple of non-cash charges related to acquisitions: 1) a goodwill amortisation charge of £17.5m 2) a separate revaluation of prior year contingent consideration of £19.7m.

Like share-based compensation of £6m at H1 2020, the £19.7m increase in contingent consideration is a non-cash item (assuming consideration was paid in SFOR shares, rather than cash) so added back to the “cash from operating activities”. But it is included within “acquisition set up and related expense” which presumably analysts will be encouraged to consider a “one off”, not an ongoing item. So readers should be aware that the goodwill on the asset side and contingent consideration figure on the liability side of the balance sheet likely understate the true cost that will eventually be recognised, if acquisitions perform better than expected. Conversely, when advertising budgets were cut earlier in the pandemic in H1 2020, this resulted in a £8.2m non-cash benefit to the p&l, as the fair value of earn-outs was revised downwards.

B share and incentives There is a single B share structure, which Sir Martin holds, which allows him to block any resolution proposed by other shareholders on acquisitions, disposals and executive appointments. The B share rights are negative (ie they give him a veto) and the prospectus mentions a risk that a disagreement over strategy could result in a deadlock situation. There’s also a separate “incentive share” scheme, which awards Sir Martin and other executives up to 15% of the company if the growth rate of invested capital compounds at +6% or more. Invested capital takes into account the date and price at which shares are issued. This pays out from July 2023 (the fifth anniversary of the MediaMonks acquisition) and if the condition isn’t satisfied by July 2025 the incentive shares must be sold back to the company at the original price.

Valuation Trading on 76x historic earnings, the high growth means that ratio falls to 25x forecast Dec 2023F. That is an impressive tech stock valuation growth multiple, despite the company being founded by someone in his 70’s. Recently the shares have been weak, down -28% in the last 3 months.

Opinion I don’t have a high conviction about SFOR. Sir Martin Sorrell is clearly very capable, driven and I suspect knows the future of advertising and how to be positioned to make money from it. I am looking forward to hearing the Mello presentation, and hopefully having the opportunity to ask questions and verify some of the information coming from other companies like Tremor and System1.

SDI H1 to 31 Oct

SDI shares sold off sharply, down -9% on the day before the results and then fell a further -3% following their H1 results. That’s probably a reflection of high expectations for this scientific and digital imaging products company because these H1 results (including outlook statement) are in line with management guidance on 4th November.

Revenue was up +75% to £25m, helped by a couple of acquisitions and their Atik Cameras business, which has enjoyed a one time benefit from Covid because their precision cameras are used in PCR test instruments to amplify DNA. They say that orders in this division are likely to be fulfilled by January next year, and they have no further visibility. Previous guidance was “substantially reduce in H2”.

Ex acquisitions and Atik cameras revenue growth drops to a still creditable +22% y-o-y. Gross margins were down 2.2% to 64.4%, partly due to change in product mix (including the acquisition of Monmouth Scientific) and partly due to increase labour and materials costs, which they have tried to pass on to customers. The commentary says there’s been a “general acceptance” of this, Solid State who also reported last week made similar comments. Statutory PBT was +115% to £5.1m and net cash was £1.1m (no deferred consideration outstanding). They’ve renewed their £20m loan facility with HSBC with a further £10m according option at the discretion of the bank. Note that acquisitions have benefitted RoCE.

Outlook They say that they are trading in line with expectations (FY Apr 2022F £45m revenue, Adj PBT “modestly above” £9.2m) in the Nov trading statement. That implies that H2 revenue to April 2022F vs H2 last year will be flat to slightly down.

FinnCap, their broker, have left EPS forecasts unchanged (6.6p FY Apr 2022F dropping to 5.3p the following year as Atik Camera orders fall back). That gives a PER of 37x in Apr 2023F. FinnCap do say that they expect more acquisitions, so if that does happen then EPS in FY April 2023F should receive a boost.

Opinion Looks good. I think this has sold off due to valuation and expectations getting ahead of themselves. I’m happy to continue holding. I can see why people are reluctant to pay the full price, but relative to Judges Scientific (forecast PER, Price/turnover, EV/EBITDA and price to FCF), SDI doesn’t look too expensive.

Games Workshop Trading update H1 to Nov

Similar to SDI, Games Workshop the Warhammer miniatures company announced an “in-line” H1 trading update, which was taken as disappointing as the shares fell -6% on the morning of the RNS. H1 sales to end of November are expected to be £190m (+2% vs last year) and PBT down -6% to £86m. Less than a quarter of sales come from the UK, while costs are mainly in GBP, so the relative strength of sterling (until October) this year versus 2020 means that constant currency results were better than the statutory figure with revenue growing +6%.

Royalties £19m (or 22%) of PBT has come from licensing deals with computer game companies. There’s very little cost attached to this, although the company has to be careful that they don’t damage their Intellectual Property by working with low quality partners. The timing of the royalty deals is also likely to be lumpy. In one sense this is good, but it also suggests the pre-royalties core PBT would have been down c. -20% on a statutory basis. Using SharePad to look back at the long-term p&l it’s possible to see that this is a business where revenue and profits tend not to rise in a straight line. For the 3 years before the financial crisis, sales and PBT fell each year. In retrospect that was a buying opportunity, because it was possible to buy the shares at £1.20, so as a core holding I’m not too worried about declining PBT for a year or two.

Valuation The shares are trading on 24x May 2023F, which for a 73% RoCE business seems reasonable. GAW had an exceptionally good lockdown last year, with FY revenues rising +31% and PBT +70%. I don’t think that the company has gone ex growth, the lockdowns merely brought forward some demand from this year and so flattered last year’s strong results.

Opinion Unlike other Covid winners turned re-opening losers (BOTB, G4M, FDEV, WINE) I don’t think that there’s much that is fundamentally going wrong at GAW. The shares are down -21% from their peak, as investors looked at the other companies who reported strong results during lockdown then disappointed and sold GAW shares as a “read-across”. In the short term that was the right interpretation, but to then sell the shares a second time following a -21% fall when results are “in line” is punishing the stock twice.

Somero Trading Update FY Dec

There was brief trading update from the US-headquartered concrete screed company raised revenue expectations by $10m to $130m, implying +47% y-o-y revenue growth, and year end cash rising to $39m. The shares were up +12% last week and are now up +42% since the start of the year.

FinnCap, their broker raised FY 2022F to EPS to 61c (46p) implying a PER ratio of 12x. I saw that Somero was the most searched for company on the SharePad database two days running last week so I thought I’d highlight a couple of risks with buying a cyclical company forecast to make 48% RoE FY 2021F but trading on 12x earnings and a dividend yield of 7%.

Lessons from Lloyds 20 years ago Lloyds was trading on a similar 12x P/E, reporting 35% RoE and an even higher dividend yield of 8.5%. However the problem with cyclical companies is that profitability can fall steeply (as it did with LLOY in 2002 and 2003). Investors feared that they’d cut the dividend and the bank traded on a yield of 13% in March 2003 before recovering. This episode was burnt into my memory, because I had a “buy” recommendation on the stock – my investment case was correct, they didn’t cut the dividend, but the share price still fell by 2/3rds.

Through the Cycle So I thought it was worth mentioning a couple of ways of thinking about how to adjust for cyclicality in valuation. The first is to look at “Through the Cycle” RoE, which is the way banks analyst account for the volatility in bank profits. SOM RoE has averaged 21% since 2006, implying that current profits are double the long run average and investors are paying closer to 20x PER average earnings. Another similar approach is to look at price to revenues which have averaged 2.8x over the last 4 years, which would imply if revenues disappoint and fall back to $120m (£90m) in a couple of years’ time, the market cap would be £250m or c. 20% below the current price.

Opinion I’m a holder and am happy with how things are progressing at SOM – but I’ll suggest the “buy SOM because it’s on 45% RoE, but only 12x earnings” could be flawed reasoning. It’s often better to buy companies when bad news is in the price, as the example of loss-making SOM a decade ago at 10p per share shows.

I know this, but it’s easier said than done. I’m kicking myself for missing out on Equals, which also reported last week and has recovered from loss-making in 2019 and 2020. It was possible to pick the shares up at 27p this time last year. I should have listened to Glasshalfull on Twitter, who highlighted it back then.

The same goes for Warpaint (W7L), the cosmetic company that reported 4 years of declining profitability and a loss in 2020; now since recovered with the share price up almost 5x is another good example.

Investing is easy with hindsight!

Bruce Packard


The author owns shares in SDI, Somero and Games Workshop

* Credit Suisse Global Investment Returns Yearbook 2018: Summary Edition – I do have the same report for 2021, but annoyingly they have not updated the large cap vs small cap analysis for the US and UK markets.

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