Pick your own Buffett style small caps
This month Richard Gill, CFA, takes a look at a couple of small cap companies which might fit the bill for the Sage of Omaha.
In last month’s Master Investor Magazine article I commented on the moribund state of the small cap IPO market. While new issues continue to be slow, October saw the highest monthly total of new companies joining AIM so far this year, with four new additions. These included Calnex Solutions (LON:CLX), a provider of test and measurement solutions for the global telecommunications sector; Fonix Mobile (LON:FNX), a mobile payments and messaging business; and Sourcebio International (LON:SBI), a laboratory services provider which raised a decent £35 million on admission.
However, an overall degree of caution remains amongst small cap investors. This has been highlighted by the recent IPO cancellations of several trusts looking to invest in smaller British businesses. The Tellworth British Recovery and Growth Trust pulled its listing last month after failing to generate enough interest, while Sanford DeLand’s UK Buffettology Smaller Companies Trust did the same after it was unable to raise its minimum target of £100 million. Hopes remain that the Schroders British Opportunities Trust, which is looking to invest in high-quality, small and mid-sized UK companies with sustainable business models, will manage to raise its own target of £250 million.
For those disappointed that the Buffettology trust won’t be trading, this month I’m taking a look at a couple of companies which might have been potential investments for Sanford DeLand. In line with Warren Buffett’s investment philosophy, the trust’s prospectus set out various criteria for its constituents. Like any value investor, the trust was looking to buy shares at a fair price in relation to the estimated intrinsic worth of the business, with UK listed or traded companies in the £20 million to £500 million market cap range being considered.
Other Buffettesque features being looked for included the following: pricing power and an economic moat; consistent operational performance with a proven business model; high returns on capital employed; strong free cash flow; a strong balance sheet; and management focused on delivering shareholder value. Of course, investments were intended to be bought with a long-term time horizon in mind, meaning 5-10 years at the very least, with an ideal holding period of forever.
PAYPOINT
This first stock meets many of the investment criteria set by Buffett, especially in terms of the historic financials. However, it is currently unloved by the markets due to a couple of caveats, discussed in more detail below. PayPoint (LON:PAY) is a payment and retail services business which operates via a network of over 27,000 outlets in the UK, typically newsagents or local supermarket chains. Via three divisions the company provides a number of offerings which help retailers to offer more services and increase footfall to their stores, while helping consumers to conveniently pay their bills and collect parcels.
In its Bill Payments division, making up around 37% of revenues last year, retailers are paid a commission for hosting a physical terminal or till software capable of receiving payments. PayPoint then manages the transfer of payments to suppliers in exchange for a transaction fee. Meanwhile, the similarly sized Top-ups and eMoneysegment makes commission revenue from top-ups for mobile phones, eVouchers, pre-paid debit cards and lottery tickets. Finally, the smallest division, but perhaps having the widest offering, is Retail Services. Core product PayPoint One is an EPoS (electronic point of sale) platform currently installed in over 16,500 retailers, while parcel collection service Collect+ is in almost 10,000 stores, with the company’s ATMs in c.3,600 stores.
PayPoint also currently operates a similar business in Romania but recently agreed to sell it for c.£47 million and use the proceeds to invest in its core UK markets. The division contributed pre-tax profits of £6.8 million in the last financial year, around 12% of the total, and will still contribute for the rest of the current year as, subject to competition and regulatory approvals, it is expected to complete at the end of next March.
Financials on point
The term “economic moat”, often mooted by Warren Buffett, refers to things that help a company maintain its competitive advantage and increase earnings visibility long into the future, things such as brands, intellectual property, high switching costs for customers and so on. PayPoint’s moat comes from its large and established UK retail network which covers pretty much all of the country – 99.5% of the urban population live within one mile of a PayPoint retailer partner. What’s more, partner numbers are growing and existing retailers tend to be “sticky” to PayPoint’s services, with only 5.8% customer churn last year.
Buffett should also be attracted by PayPoint’s attractive long-term financial record and profitable operations. In the last financial year, to March 2020, net revenues were £120.7 million, up from £76.4 million ten years earlier. This is a highly profitable business, with operating margins running at 47.2% and pre-tax profits growing from £32.6 million in 2010 to £56.8 million in 2020.
PayPoint also has a pretty exceptional return on capital employed ratio (ROCE), favoured by Buffett, which measures how efficiently a company is using its capital to generate profits. With a level of 20% usually considered to be pretty good, PayPoint excels with a ratio of 145% last year. Cash flow is also excellent, with the net inflow from operations last year being £51.5 million. This has enabled the company to pay substantial dividends to shareholders over the years, including many “additional” or special distributions alongside the ordinary payment.
Payment probe
A trading update for the three months to June 2020, reported on a challenging time for the company, as many of its partner sites were forced to shut during the pandemic lockdown, but a resilient performance nonetheless. Net revenues for the period were down by 6.6% to £26.8 million, with £1.1 million of this a result of a lost contract with British Gas. Volumes were down across most services in the quarter, with UK bill payments net revenue down by 28.2% to £8.2 million as a result of consumers making larger payments less frequently during the Covid-19 lockdown. Since the low point in April however, there has been a recovery in activity as restrictions have eased and sites have reopened. While no guidance on profits was given, net debt at the period end was said to be £7.3 million, down from £12 million three months previously.
As well as the effects of the pandemic the second main thing weighing on investors’ minds is news, released in September, that regulator Ofgem is investigating the company for a possible breach of competition law. The allegations are that from at least April 2009 to October 2018 PayPoint included exclusivity clauses in most of its contracts with energy suppliers and retailers relating to over-the-counter payment services for pre-payment energy customers. This practice limited customers’ ability to use rival services and thus excluded its competitors from the market.
At this stage the findings are provisional and Ofgem states that no conclusion should be drawn that there has been an infringement at this stage. If an infringement is found, PayPoint expects this could impact its ability to enter into such exclusive arrangements with energy suppliers and rely on the exclusivity provisions in existing agreements. Also, Ofgem may impose a financial penalty of up to 10% of PayPoint’s annual worldwide group turnover, which would be just over £12 million based on last year’s numbers.
Pay Day
Shares in PayPoint have had a bad year, falling from just under £11 at the beginning of 2020 to currently trade at 505p. They more than halved following the Q1 pandemic inspired sell off before recovering to almost £8 and then slipping to their current level. The price earnings multiple is now just 7.5 times based on last year’s numbers.
Management have not given any specific guidance on the numbers for the full year, instead having modelled for a “broad range of potential profit outcomes” given the uncertainty. Market analysts however are looking for earnings of around 47p per share in 2021, meaning the earnings multiple rises to 10.7 times – still attractive given the strength of the business.
Last year’s ordinary dividend of 47.2p per share amounts to a yield of 9.34% at the current price, which rises to an almost unheard of 16.6% if we include the 36.8p additional dividend. I think it’s highly unlikely that such level will be repeated this year, with management guiding towards a target dividend cover range of between 1.2 and 1.5 times earnings. Assuming forecasts are met then that equates to a payment of 31.33p at the lower coverage rate, resulting in a still decent yield of 6.2%.
Last year’s ordinary dividend of 47.2p per share amounts to a yield of 9.34% at the current price, which rises to an almost unheard of 16.6% if we include the 36.8p additional dividend. I think it’s highly unlikely that such level will be repeated this year, with management guiding towards a target dividend cover range of between 1.2 and 1.5 times earnings. Assuming forecasts are met then that equates to a payment of 31.33p at the lower coverage rate, resulting in a still decent yield of 6.2%.
Overall, PayPoint looks highly attractive despite the risks here. Of course, we have the ongoing pandemic weighing on the business as well as uncertainty over the impact of any decision from Ofgem. However, I believe that the business should continue to trade resiliently during the current lockdown as its services are mainly situated within small to medium sized food stores which will be essential for consumers. Analysts at Canaccord Genuity see value here, revising their target price in late October to 825p, implying upside of 63%.
CHARLES STANLEY
Warren Buffett’s ideal holding period for a stock is forever. While all firms disappear at some point or another, this next company has done well to stick around for over two centuries. Founded in 1792, during the reign of King George III, Charles Stanley (LON:CAY) is one of the oldest firms on the London Stock Exchange. Its origins lie in a banking partnership established in Sheffield which went on to prosper and then expand down south. As a listed company, it has been trading on the stock exchange since 1960 and has been a member firm of the LSE since 1852.
As of today Charles Stanley is a specialist UK based wealth management group which provides its services to private clients, charities, trusts and institutions from 26 locations around the country. The largest division is Investment Management Services where the company earns fees and commissions on a range of funds including discretionary, advisory and execution only. The smaller Financial Planning business helps clients to create a financial plan for their futures, while Charles Stanley Direct is the company’s online investment service which allows individual investors to build up their ISAs, SIPPs and investment accounts.
Wealth increase
Financial services firms such as Charles Stanley are generally cyclical, with profits being exposed to the ups and downs of the stock market and also being highly operationally geared. While the company has put in a good revenue performance over the past decade (up from £115 million in 2010 to £173 million in 2020) profits have been more erratic. In 2015 a statutory loss of £6.1 million was posted as the business saw higher administrative costs and non-cash charges. Since then however, CEO Paul Abberley (appointed at the end of 2014) has revamped the company, selling the loss making corporate finance business Charles Stanley Securities and focussing exclusively on wealth management in the UK.
An ongoing restructuring programme delivered significant results in the year to 31st March 2020, with pre-tax profits rising by 57% to £17.3 million. While revenues only increased by 11.5%, the bottom line surged following a “repricing exercise” – essentially upping fees to bring rates into line with the wider market and focussing on higher margin services. The company also benefited from a cost saving programme which is on track to deliver further expected savings of £2.6 million in 2021 and £4.5 million per annum from 2022.
On to the Buffett metrics and Charles Stanley stands out for having an incredibly strong balance sheet. Cash balances, including Treasury Bills, ended the year at £93.5 million (with no borrowings) and the capital solvency ratio was 189% – almost twice the regulatory requirement. The company’s cash flow from operations was particularly strong in 2020 at £25.8 million but mainly as its trade payables increased by £16.2 million – in other words it put off paying its bills. Meanwhile, Charles Stanley’s economic moat comes from its large base of funds and assets under management which provide predictable and ongoing commission and fee income. The ROCE ratio last year was 13.3% but if we remove the cash (which distorts the calculation) it rises to a more impressive 44.5%.
The latest trading update from the firm reported a resilient performance for the three months to September 2020 in the face of difficult market conditions. Total Funds under Management and Administration in the period increased by a modest 0.9% to £22.8 billion against the prior quarter but were up by 12.9% compared to the year end in March as stock markets recovered. While revenues for Q2 were down by 6.8% to £39.9 million, for the first half as a whole they were down by just 4.1% to £82 million as revenue margins improved.
Buy for recovery and value
Shares in Charles Stanley are looking very good value at present. At the current price of 240p they are down from c.340p just before the current crisis, capitalising the business at £126.6 million. That valuation is backed by net assets of £116.5 million as at 31st March 2020. Stripping out the cash, the operating business is effectively being valued at just £33.1 million – a multiple of just over two times last year’s net profits.
While the current financial year is likely to show a marked fall off in profits, remember that this is a cyclical stock currently trading during a trough in the stock market. Therefore, investors are buying a cheap stock here in hope of a long-term recovery. Charles Stanley’s strong cash flow also allows it to pay a modest dividend, with last year’s 9p payment covered 3 times by earnings and equating to a modest yield of 3.75%. Investors may want to take a position before the interim results are released on 19th November.
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