Weekly Market Commentary | 03/01/2024 | AVAP | What’s in store for 2024?

Bruce reviews 2023 performance and the outlook for this year. Plus a detailed write-up of aircraft leasing business AVAP.  

Last year the Nasdaq 100 was the best-performing major index, up +54%, followed by Japan’s Nikkei. Not something that many people would have predicted. The S&P500 also did well +24% last year, followed by the B and I of the “BRICs” acronym: Brazil and India.

The worst performer was China though, down -17% despite the ending of its Covid Zero policies.

The FTSE 100 was up +4%, which although better than AIM still failed to beat inflation. Despite the German economy shrinking into recession at the beginning of the year, the DAX was the best-performing major European Index, up +20%.

Aside from the FTSE China 50 and Hong Kong’s Hang Seng, AIM was the third worst performer of any major index, down -8%. It’s been a very difficult 2 years for investing in UK small-cap companies, but it does look like the index troughed below 700 at the end of October and has now bounced +14% in the last two months of the year.

My own performance was down -4%, which was better than AIM but still disappointing. My three best performers were Burford +81%, Bank of Georgia +53% and mortgage conveyancing company Smoove, which was bid for by Pexa halfway through the year, +49%. Pleasingly I averaged down in Smoove, so I did make a small gain on my investment, despite the share price falling to 30p before the recommended cash offer of 54p.

My worst performers were very poor: Superdry and Frontier Developments, which were down -73% and -86% from the start of the year. I didn’t buy on the 1st of January but nevertheless was down roughly -70% on both stocks. I would have done better to pay more attention to the downward trending charts, rather than assume they looked “cheap” on fundamental ratios. I also should have cut my losses quickly when it became apparent the turnaround at Superdry was not going to plan with wholesale buyers of the clothing brand avoiding their new season’s fashions.

Last year I crowd-sourced ideas for 2023. Mark Simpson suggested Capital Drilling, which I also own, up +4%. They ought to benefit from the rising price of gold up +15% last year in dollar terms to $2,077 per ounce. The shares are trading on just 6x Dec 2024F PER, so at some stage I am hoping the investment case comes good. I note CAPD shares bounced +14%, over the last couple of months.

Gordon, known as Glasshalfull on Twitter suggested FX and payments company Equals, which was up +36%, considerably better than Argentex -29% which I own. The Chief Exec of AGFX left the company with immediate effect and was not thanked in October, followed swiftly by the CFO who resigned. Gordon also mentioned Spectra +37% and Mears +50%. Zoo, the translation services company for streaming companies fared much worse down -63%.

Carcosa, who I met up with in Kuala Lumpur in November, also liked Equals and Games Workshop +15%. He mentioned a few ideas that he then rejected. For instance: IBPO, which he suggested had potential upside but was likely beyond most readers’ risk tolerance. IBPO was de-listed by the majority shareholder, Anil Aggarwal, so that proved a good call. Other companies mentioned, but rejected, were Jersey Oil & Gas, Ferrexpo and Anexo, which is as well because they’ve all performed poorly. Ricardo was his pick for 2023, which did rise +29% in the first 6 months of the year but gave back most of the gains in H2.

So readers’ suggestions haven’t done too badly in what was a very difficult year for investing. I haven’t asked people for ideas for 2024. If you do want to share your ideas in the Sharepad chat, I can have a look and possibly write them up.

AIM’s median (ie the middle value of 785 AIM stocks) average performance was -19%. Just one-third of AIM shares recorded a gain in 2023, so if you did badly last year, I would encourage you not to lose heart. As Lord Lee said at the Mello Investment conference in May: “You make most of your money in bear markets, you just don’t know it until three years later.”

Speaking of Mello, the next online events are on Monday 15th and the 22nd of January. David has already published the dates for the next in-person event: Mello 2024, which is the 22nd and 23rd of May.

As far as 2024 goes, there seems a consensus that interest rates have peaked and that this should prove positive for markets. FT Alphaville has done a fun round-up of investment banks and asset managers’ investment outlook reports. After a quick skim, my conclusion is that it is better to use Sharepad to analyse specific companies and invest where you can develop an edge, rather than give your money to other people to manage.

Turnaround ideas that I own for 2024 include Creightons, The Mission, Gulf Keystone, Capital Drilling, SDI and CML (the latter has not really disappointed versus expectations, but the share price did fall -35% from its peak last year). By their nature, turnarounds are speculative, so I wouldn’t expect all of them to be successful. Hopefully, the gainers should make up for the losers. My largest position is Games Workshop, followed by Bank of Georgia. I still own FDEV and SDRY, but neither of these can be high-conviction ideas.

A Closer Look at Avation

I wrote about meeting Carcosa for a gin & tonic in Kuala Lumpur and that I would write up Avation, the aircraft leasing business. As of November 2023, AVAP owned a fleet of 35 aircraft leased to 15 airlines in 13 countries. The average age of the fleet was 6.7 years, and the average remaining lease term was 4.9 years. My conclusion is that: I think he could be on to something; however, it’s complicated!

Let’s begin with a quick explanation of how leasing works and why aircraft are more often leased than owned outright:

Airlines prefer to operate a “capital light” business model, renting aircraft for a period of time, rather than buying directly from Airbus and Boeing. They pay monthly rental fees, typically for 10-12 years for a first lease on a new aircraft. If one of AVAP’s customers goes bust (and airlines do fail fairly frequently) there’s no argument about who owns the plane or waiting to be paid out with other creditors, which can take months. For instance, Avation has recently repossessed and sold one of their planes (a 12-year-old ATR 72-500) from an airline in India which was in default under the lease agreement. So the leasing company simply takes back its own plane and looks for other customers to lease it out to, or sell the plane. Marc Rubinstein has written this up for his Net Interest blog.

The average lifespan of a plane is 25 years (give or take) by which stage the value ought to be depreciated off AVAP’s balance sheet. This means shareholders need to have faith in management’s depreciation and impairment policies because the risk is that shareholders will be oblivious to over-optimistic assumptions about residual values. Below is a copy of AVAP’s depreciation policies, which I have taken from Note 3 of their Annual Report. They look reasonable.

Unlike the financial crisis, when (say) Irish commercial property didn’t recover in value, the airline industry can bounce back quickly and planes can be written back up in value. Carcosa (who is a retired pilot and industry veteran) has spotted that AVAP management has taken around $60m of cumulative provisions on its $300m Turboprop aircraft fleet, and so we could (I emphasize could) see writebacks. I reproduce his graphic from his blog below.

For context, AVAP has a market cap of £90m ($115m), and total assets of just under £1bn ($1.2bn). A write-back of a previous provision could be very material.

So that is the bull case. It’s worth looking at a couple of cross-checks though.

First AVAP is using short-term financing (albeit hedged with interest rate derivatives) to finance long-term assets – maturity mismatches can result in failure, even when the underlying assets have no credit risk, as the failure of SVB last year shows. Below is AVAP’s loan maturity chart, showing a big refinancing is due FY Jun 2027.

The second risk revolves around accounting and the fair value of assets. Just under ¾ of AVAP’s balance sheet is aircraft held in Property, Plant and Equipment (ie valued using held to maturity, historic cost accounting). That represents $845m versus total assets of $1.18bn. The Available For Sale portfolio (where accounting standards allow management to use fair value accounting) is just $8m, down from $113m the previous year. That $105m reduction is because FY Jun 2023 management sold two turboprop aircraft (ATR 72-600) and a Boeing 737-800 from the AFS portfolio, worth $41m. They recognised a loss of $1m on $41m of those two turboprop disposals. However, management also transferred two jet aircraft worth $78m out of the AFS portfolio back into the $845m Property Plant and Equipment (i.e. hold to maturity accounting bucket).

It seems likely that if AVAP management cancelled the sale then the two jet aircraft might not be worth what AVAP thought that they should be worth on the open market. During the financial crisis, banks reclassified fair value assets in their AFS portfolios as held to maturity, meaning that they didn’t need to recognise losses on their CDOs, CDS and other derivatives that they didn’t like the market prices of.

Turboprop represents around a quarter of balance sheet PPE and the harder-to-sell jet aircraft $620m or three-quarters of PPE.

It seems likely that if we marked to market the entire $845m PPE of aircraft on the face of the balance sheet, we’d probably see the company have to take marked-to-market losses. You can make the case that it doesn’t matter, AVAP is not Silicon Valley Bank, they’re not a forced seller having to liquidate the balance sheet at a price that’s unfavourable. Their refinancing is still a couple of years out.

The reason I’ve spent so long on this is that there are similarities with both litigation finance, where the leased assets are legal disputes and banks where the assets are loans but also trading assets. Any business which has a balance sheet that is a combination of fair value and historic cost accounting, that is funding long-term assets with short-term debt, is fiendishly difficult to invest in with conviction. Famously Enron management cracked open the champagne when regulators allowed them to use Fair Value accounting. If you own a large position in UK bank shares, you might want to check your understanding of their balance sheet, rather than assume you understand their business model because you’re a customer with a current account and occasionally visit a bank branch on the high street.

Opinion: I do enjoy disappearing into the weeds of companies’ reports & accounts, however, it is possible to become lost in the details. A simpler analysis for AVAP might be: do we think air travel will continue to recover into 2024? Does AVAP have the right mix of aircraft on its books? If so, then AVAP might be a leveraged way to play this theme. This does look like an interesting investment case. As ever, this discussion is supposed to be a trigger for using Sharepad and reading through the Annual Report to investigate further and understand the risk/reward.


Bruce Packard |  Twitter: @bruce_packard

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.