Valuations in the UK small and mid-cap space might look cheap, but a plethora of uncertainties means JPMorgan’s Guy Anderson is feeling cautious.
The recent de-rating of the FTSE 250 has not come from earnings downgrades, but rather from non-fundamental factors such as geo-politics. As a result, the price/earnings multiple on the index has decreased substantially.
But despite valuations approaching the low levels they were at back in the summer of 2012, Anderson, manager of the Morningstar Bronze Rated Mercantile Investment Trust (MRC) isn’t overly bullish.
“With all that’s going on in the UK now, I think it would be aggressive to be massively geared at this point in time,” he says.
“We’re taking the view that we’re going through a period of uncertainty and that we should remain fully invested but we don’t yet need to put a massive amount of leverage on the portfolio.”
That could change in six months’ time however, and Anderson points out that the trust has a history of being around 10-11% geared.
Still, he has been adding new positions to the portfolio this year. The portfolio is currently tilted more towards industrial names, which tend to be more internationally facing, and away from domestic consumption.
While data has moderated recently, it’s still a call Anderson is sticking with. Below, he tells Morningstar.co.uk about a three companies; two he’s bought this year, and one longer-term holding he continues to back.
Amigo Holdings (AMGO)
This year has been “pretty uninspiring” for initial public offerings, says Anderson, but therer, there have been a few interesting new issues, including lender Amigo. The Bournemouth-based firm floated on the main market at the end of June at 275p, valuing it at £1.3 billion.
Shares have taken a knock since then. Shares fell 11% in July, after a story in The Times newspaper accusing Amigo of “exploiting vulnerable borrowers”.
There is a perception that it is a high interest pay-day lender Wonga-type business, says Anderson. But Amigo loans, offered to consumers with poor credit histories, have a fixed rate of 49.9% APR, putting it firmly at the lower range of the mid-cost credit market, which stretches from 35% to 99.99%.
“The reality is that if you look at the interest rates that these guys charge, it’s not materially different from if you want to borrow on your Barclaycard or a store card,” counters Anderson.
And all loans are backed by a guarantor, which is a key pillar of the business model. It means its borrowers are more likely to pay back loans because they don’t want to have to rely on their guarantors.
“So you get good behaviour from a lender perspective. Having that additional backstop is beneficial to the company from a loan-losses perspective,” Anderson adds. Therefore, the company, which is run very efficiently, generates very high returns.
First-quarter results at the end of August showed revenue of £62.9 million growing almost 50% year-on-year and adjusted earnings per share up 31% to 5.5p. Meanwhile, the loan book increased 37% year-on-year to £638.2 million and the customer base is up 39% to 194,000.
Hunting (HTG)
On the theme of exposure to industrial names with international earnings, Hunting provides services to the oil and gas industries globally, but predominantly focused on North America. It has operations in the Permian Basin, on the border of Texas and New Mexico.
The £950 million firm was added to Mercantile over the summer and is a 1% position currently. After riding a wave of rising oil prices, that trend has now started to reverse, meaning sentiment has, too. At 592p today, the stock is over a third lower than its mid-May peak.
Its largest business, Hunting Titan, makes products that are used in the process of fracking wells. While the oil price strength may have rolled over recently, drilling activity continues to pick up.
Some companies engaged in oil and gas activity in the Permian have reported poor trading updates, but Anderson thinks the long-term future for Hunting is positive.
While drilled but uncompleted wells, or DUCs, in the shale basin are at record levels, Anderson says this is due to there not being a big enough pipe to get the oil out. “That is a temporary factor rather than a structural shift,” he says, noting a new pipe is going in next year and should lead to the backlog of DUCs being completed eventually.
Profits at Titan are now around the same level as they were in 2014, which some might think signals the top of the cycle. However, Anderson disagrees. “We actually think there’s good opportunities for the profitability of that business to continue to grow further.”
Hunting’s other businesses tend to be either marginally profit-making, or marginally loss-making, but Anderson also sees optionality for these to pick up and become profitable. “That would have a big impact on the aggregate valuation of the group,” he concludes.
Auto Trader (AUTO)
Mercantile has held Auto Trader since its 2015 IPO. The stock has almost doubled in those three and a half years to 428p.
The firm runs a marketplace where it facilitates the advertisement of used cars for sale. And Anderson puts the emphasis on the “used” part of that sentence.
Sentiment towards the stock has been weak through September, thanks to deteriorating data on new car registrations and regulations to limit fuel consumption and CO2 emissions from new cars.
But, again, Auto Trader’s focus is on used cars, not new cars. While the amount of new cars in the UK eventually feeds through to Auto Trader’s markets, it’s not the main driver of the business, says Anderson.
Historically, the company’s revenue growth has been driven by three factors: the number of cars advertised on its platform, its pricing model and its products mix. Generally, the latter two factors have had the biggest impact.
And Anderson thinks those two levers have a long way to run still. “Whenever they put price increases through, they don’t lose any customers. That tells you quite a lot about their pricing power,” he explains.
A big driver of the business in 2018 has been its product roll-out. One of the most exciting of which is its platform which will allow the sellers on its platform the opportunity to provide car financing to their customers.
Financing has very low penetration in used cars, especially when compared to new cars, which is heavily financed. So there’s big opportunity there for Auto Trader without taking any credit risk, says Anderson.
“We’re not invested in that business because we’re trying to play the car cycle. We’re there for the structural growth of driving over the longer term.
“And the economics of that business are fantastic… it generates about 70% operating profit, has perfect cash conversion and requires very little capital. That’s generally a pretty good formula for a business from a shareholder returns perspective.”
