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Small Cap Value Report (13 Oct 2016) – RNO, ACL, VNET

Thursday, October 13, 2016 8:23
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Good morning!


My Twitter feed is buzzing this morning with news of a row between Tesco amp; Unilever, over price rises, which has resulted in marmite supplies running out. An Australian chipped in that “Vegemite is better anyway”, and my favourite quip came from @joeheenan who suggested a solution;

Don’t panic about the impending marmite shortage.  Simply make your own by mixing a rotting fox carcass with some tar.

This is of course the tip of the iceberg in terms of inflation. The huge drop in sterling means that prices will have to rise considerably in the shops. Retailers amp; consumers will resist these price rises of course, but there’s no avoiding the reality that imported goods will have to rise in price. A lot, if sterling remains this depressed, or goes even lower.

This article in the Guardian (yes, I know, I know) says that Unilever has pushed Tesco for 10% price rises. In my view that’s not unreasonable, given that sterling has fallen by a good bit more than 10%. The interesting thing is how much UK manufacturers will be able to benefit by replacing imported products with UK-manufactured ones? That is likely to be an ongoing trend. 

Although of course imported raw materials will go up in price, so for UK manufacturers it’s only the UK-based costs such as property, wages, admin, etc, that have actually fallen relative to overseas competitors. Still, this situation creates lots of opportunities for UK companies to replace imported goods, if they can.

I was doing some research last night to see what the breakdown of costs is for car manufacturing. I only found one source, and don’t know how reliable it is, but this suggested that raw materials make up almost half of the total cost of making a car. This suggests that UK car manufacturers could benefit by about half of the move in sterling – making them a lot more competitive, even when higher imported parts costs are factored in.

Going back to marmitegate, the fall in sterling is going to make life really tough for importers – it’s bound to squeeze margins, because retailers will be forced to absorb some cost increases into lower margins. Plus sales volumes will drop – it’s going to get really ugly on the High Street next year I reckon. These are certainly the worst conditions for retailers since 2008.

One of my roles is as a NED for a UK garment importer, and we’re scratching our heads over costings from the Far East (priced in US dollars) for next year’s ranges. We’ve got no choice – prices will have to rise substantially. Customers may then force us to discount, so our margins are definitely going to be lower next year. If we try to maintain margins, then sales could dry up. Very tricky.

I’m sure we’ll soon start thinking that our hands have grown – they won’t, it’s just that product sizes will get smaller. That’s a classic sign of rising inflation. Estimates I’ve seen suggest that inflation may rise to 3-4% next year. I wouldn’t be surprised if it’s more than that – maybe 5%-ish? What happens next? Surely interest rates will need to rise? That’s going to potentially hurt a lot of heavily indebted households with big mortgages.

If interest rates do rise though, and it’s difficult to imagine how they won’t, then that could be good for companies with pension deficits. The liabilities are calculated with reference to bond yields, so higher yields mean that the scheme liabilities will shrink. Although rising inflation assumptions would act the other way, and increase future payments to pensioners. There are lots of moving parts.

Could this be a good time to short UK bonds? Quite possibly, but who knows – we are not in normal times. The traditional economic rules amp; relationships have gone out of the window due to extreme actions from central banks all over the world.

I think it’s also becoming increasingly obvious that the UK Government doesn’t really know what it’s doing, and is just making strategy up on the fly – then back-pedalling if there’s an outcry, or markets punish it. I suspect that Mrs May’s reputation for competence is likely to be short-lived.

Overall then, I’m braced for years of semi-chaos, with intervals of complete chaos. Having said that, as long as I largely avoid importers, and stick to shares with a good geographic spread of activites, and plenty of overseas earnings, then there’s actually still money to be made.

The nice thing is, we don’t have to own the whole market. We can pick amp; choose the likely winners from the Brexit process, and sterling devaluation. This is why this topic is of such vital importance at the moment – ignore it at your peril. Bottom-up stock picking which ignores macro factors is quite dangerous at times like this. We have to consider both company specific, and macro factors, to get it right.

It depends on your timeframes though. In the long run, things have a habit of sorting themselves out. Panics ebb amp; flow, but decent companies adapt amp; do well in the long run. Although I think the chances of a recession in 2017 are rising fast.

I’m off to an investing seminar this afternoon, so have to be quick today.

Renold (LON:RNO) – today’s trading update covers H1 to 30 Sep 2016. I’ve had to read it 3 times to get my head around it, as there are some positives, and some negatives.

There’s additional detail given, but this is the key paragraph overall;

The level of underlying sales activity and adjusted(3) operating profit in the Period has been in line with expectations and broadly similar to the second half of the previous year.

However the impact of weaker sterling will boost reported results in the first half of the current year by approximately 10 per cent which will flow into the full year results.

At this stage, it is too early to say the extent to which the beneficial currency impact will continue into the second half of the year.

Our markets remain uncertain following the referendum vote and we do not have sufficient clarity on the final quarter of the year, traditionally the strongest, to be other than cautious about the longer term outlook.

Pension – I’ve mentioned the pension deficit at this company in my reports before.

For anyone not aware, a new feature has recently been added to StockReports, which flags up if there’s a pension deficit. It’s easy to miss, but is on the lower right-hand side of the StockReport. Here is the one for Renold;

(sorry, had to delete screenshot, as it messed up the whole article)

The gearing ratios now show gearing including pension deficit (which is a kind of debt). I’ve highlighted the relevant numbers. In this case, since the net gearing is much higher when including the pension deficit, this tells us that there’s a significant pension deficit, which requires further investigation.

My opinion – I had a small long position in this a while ago, but decided to ditch it, as I wasn’t fully on top of the issues or figures here. The uncertain-sounding outlook today doesn’t incentivise me to buy back in. Although it’s good to see that weaker sterling is helping the company’s figures considerably.

Acal (LON:ACL) – a fairly upbeat H1 update today. This electronics supplier also says that it’s benefiting from weaker sterling:

Given the international nature of the Group’s business, we are benefitting from the translation effect of Sterling’s decline in value since the end of June1 partly offset by the impact of higher US Dollar purchases.

This echoes what I was saying above – that higher raw materials prices are blunting the currency gains somewhat, so both effects need to be taken into account.

Restructuring is going to incur a hefty £8m exceptional cost, but that will generate £4m higher profits in future years.

The outlook for this year “remains unchanged”.

My opinion – looking at the valuation metrics, it looks priced about right to me. It’s not a company I’ve ever looked at in any great detail though.

Vianet (LON:VNET) – a sound update today, also for the 6m to 30 Sep 2016.My view - The dividends are the main attraction here.

It’s a better proposition now the petrol forecourts business has been sold.

This share’s a bit of a plodder, I don’t think there’s enough upside potential to entice me back in at the current valuation.

Research Tree – subscription price has just been dropped from £40 pm to £25pm.

disclosure: I had a recent lunch with the MD, but we split the bill 50:50. Also, I am not receiving any kind of reward or commission for mentioning this. I genuinely feel it is a terrific service for private investors, which is why I’m mentioning it now the price has come down to a level that’s actually quite modest compared with paying £50 commission on each trade from a full service broker in order to access research notes that way. They do a free trial anyway, so you can judge for yourself.

Wouldn’t it be great to have Research Tree broker notes integrated into Stockopedia – so that a button appeared on each StockReport if there was any broker research available to download?

Not much else of interest today, so I’ll sign off now. See you tomorrow!

Regards, Paul.

(usual disclaimers apply)



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