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Deep values - buying on fundamentals rather than following sentiment
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Judith MacKenzie
Partner and Head of Downing Fund Managers
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Any personal opinions expressed are the views of the Fund Manager at the time of publication and are subject to change and should not be interpreted as advice or a recommendation.
In the smaller company universe, illiquidity and a lack of natural buyers can lead to heavily depressed prices over a protracted period. This is particularly true in the current environment where markets are being predominantly driven by growth and momentum. In many cases, share prices are motivated by market sentiment rather than the underlying fundamentals or operating performance of individual companies. The resulting pricing inefficiencies can provide long-term investors with attractive entry points and occasional opportunities to average down book cost throughout the holding period.
Adept Telecom, an independent provider of voice and data telecommunications services, is an example of the impact of market sentiment. In August 2017, when the Downing Strategic Micro-Cap Investment Trust first invested in Adept, the business was trading on approximately 25x trailing earnings and around 12x forward earnings. The forward earnings included the contribution from the recent acquisition of Atomwide, a technology services provider within the education sector. We believe this was another transformational deal made at an attractive price that further demonstrates management’s M&A capability. The shares sold off over the fourth quarter of 2017 and into 2018, despite the Atomwide acquisition and the fact it was trading on a relatively low forward earnings multiple. At its lowest point, the share price reached around 260p, pushing Adept to approximately the cheapest forward earnings multiple in its recent history. We determined that the reason for the sell-off was perception and sentiment related rather than fundamentals driven, and bought more shares. Since then, Adept’s performance has exceeded our own expectations. This was reflected in a trading update issued at the beginning of April 2018 which reported both EBITDA and turnover are expected to be ahead of market consensus.
Gama Aviation, a global business aviation services provider, has also been subject to negative market sentiment. In April 2018, Air Partner, another listed business in Gama’s sector, announced accounting issues dating back to 2010/11. Gama and Air Partner’s business models are fundamentally different so we believe that this is an unwarranted overreaction to irrelevant, company specific, news. The shares have since rallied slightly following a positive update from Air Partner but we believe that Gama is still too cheap at these levels, trading on a single digit multiple of earnings with plenty of growth opportunities.
2018 will be a pivotal year for Gama as management embark on several organic and inorganic growth opportunities. We also hope to see operating margins grow further as the model matures internationally. This sets the stage for 2019 and beyond, from which we expect the business to move to a new level of profitability and cash generation as management deploy £48 million of growth capital from a fundraise in February 2018. Once the strategic initiatives are fully implemented, we expect that underlying free cash flow could double in this time.
Redhall, a niche UK engineering business, is a similar story, with an order book and pipeline that is continuing to grow. We estimate that its tangible opportunities in mid-term UK critical infrastructure projects now amount to over £100 million. While some of these projects have become delayed, the gap between what the business is worth to a long-term holder or a trade buyer, and the enterprise value, has continued to widen over our holding period. The shares are more attractively priced than when we first invested and we believe that the market continues to factor in too much risk over the long term.
As value investors, we believe that buying businesses at a significant discount to intrinsic value will outperform over time, unlike growth and momentum styles which are typically transitory. Buying deeply discounted businesses reduces the likelihood of permanent capital erosion - the largest drag on performance through time. These opportunities exist because of the inefficiencies in markets – particularly so at the micro-cap end of the spectrum – yet many investors lack the long-term view and patience to profit from them.
Within the Downing Strategic Micro-cap Investment Trust we overlay various strategic mechanisms to grow and subsequently realise the intrinsic value of portfolio holdings. These mechanisms, alongside capable and well incentivised management teams, are required to be able to deploy meaningful capital in a concentrated portfolio that has the potential to earn good returns with reduced risk.
However, these take time to deploy and typically even longer to mature, therefore our average investment horizon is five to seven years. As portfolios mature and these strategic mechanisms evolve, the investment strategy should deliver returns which are largely uncorrelated, through the cycle and regardless of prevailing market sentiment.
