Small Cap Value Report (Fri 5 Aug 2022) - Base Rates & Inflation. RNO, BEG, CARR

5th Aug '22 by Paul Scott

72 comments 7728 reads

Good morning, it's Friday, so just Paul here today, and a more leisurely pace.

This week's podcast is here (just put the URL into your podcast service, and it will update automatically). Lots of topics covered, as usual!

Agenda -

Paul's Section:

I have a ponder on the 0.5% increase in base rates announced yesterday. NB I'm not an economist, so this is just the musings of an investor, not an expert.

Renold (LON:RNO) (no section below) - I like this share (not currently holding personally, but it's on my possible buys list), and the big acquisition announced yesterday looks interesting. I've spoken to the CEO before, who explains the company well, so have invited him to an audio interview with me (no fee, it's completely independent, I'm just doing it for general interest). Here is my audio interview with CEO Robert Purcell, recorded this afternoon.

Begbies Traynor (LON:BEG) (no section below) - Red Flag Report - is here. Just in case you found last night's TV news too cheerful, here's another helping of doom, No surprises to hear that bars & restaurants, and retailer sectors are struggling - we've been expecting this to worsen, due to the ending of the rent moratorium (which made paying rent optional during the pandemic). So a cull of zombie companies is coming - leaving more business for the companies that survive of course ( Next (LON:NXT) mentioned earlier this week about good weather, and less competition, as being a surprise upside on the performance of its retail stores). Begbies also mentions construction as another problem sector, which I'm surprised at, as the listed construction companies have been putting out fairly upbeat trading updates recently. Do readers have any thoughts on that? This is an unusual comment on inflation from BEG - "Businesses continue to be impacted by rising inflation in the 'real economy' which is far exceeding the official rate of more than 9%.". There's a big rise in CCJs. No surprises here, but it's worth a reminder -

"We are now in a very high inflationary environment that's piling pressure on businesses that were already weakened by the shock of the pandemic.

"Sectors most exposed to discretionary consumer spending - bars and restaurants and general retailers - are feeling the pain most. Hit by staff shortages due to the latest…

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FREng

5th Aug '22

Unless prices continue to rise at current rates or more, month after month, inflation will fall as it's an arithmetic comparison between the current prices of specific goods and services and those prices 12 months previously.

Prices are some product of commodity input costs, energy costs, wage costs, taxes and profit (unless I have overlooked a further big component - which is possible - other input costs are themselves made up of the same five factors, complicated by different policies internationally).

IMO, commodity and energy prices are very unlikely to keep rising this steeply. So the policy problem for central banks and governments is how to prevent the current inflation from permanently increasing wage costs leading to a feedback loop of ever-increasing inflation and wage catch-up.

The usual solution is unemployment, forming a pool of labour willing to work for less than current wage rates plus inflation. Before Brexit, imported labour provided a significant part of this pool. Without imported labour, increasing unemployment requires UK job losses for long enough for the inflation arithmetic to have eliminated the imported inflation from increased energy prices, post-COVID recovery and any weaker currency.

It's a tough problem to solve, but the UK Government say they are committed to helping poorer people through the crisis and that they are willing to borrow to pay for it. If that's the case, then eliminating VAT on basic goods and domestic energy consumption would immediately cut inflation (arithmetically) especially the inflation experienced by the poorest.

planetx

If it is 70% dont forget that includes all investors and I believe the stats are something very different when timescales are added (historic )

0-1. Year - 70% lose money

0- 5 year. - 30 % lose mo et

0-10 year - 10%

I’m sure the stats are thus wildly different for investors with differing timescales

Eg my dad invested consistently the 1960s / 1970s / 1980s and is not in the 70%.

The stats regarding long term consistent investing are much better than leaving cash in the bank , I think that is beyond doubt .

It is simply too easy to trade in and out in the modern climate , I’m sure we are all guilty of this and of course this adds to the wild swings and manic depressive bevaviour followed by the rushing euphoria of “Mr Market”.

Buffet talks a lot about his belief in the American economy, It underpins his investing that ultimately he believes in the American economy ,

If you don’t believe in the British economy and British companies then that’s the strongest reason not to invest and your hard earned cash needs to be deployed somewhere / somehow (property ? Bonds ? Under the mattress ? Flash cars ? Forestry ? )

No easy answer and the smartest strategy is to divide your wealth into “pots” and set a plan you can live with knowing you’ve made the decision and analysis .

Eg mine is a mix spread across

Cash long term don’t touch

Cash short term spend it and enjoy life

Propery

Forestry

Shares AIM

Direct investments in third party businesses

Direct investment into future business of my own

So long as I don’t whack it all into one category and take big risks I’ve found it is all sort of balancing out .

If we enter Armageddon / depression then for sure everything is heading south and there will be no thing but pain for a good while .

Anyway , best enjoy the weekend is a good short term strategy that works well

TheFloatingInvestor

Planetx agree with what your saying in terms of divesting your interests, its very important to 'spread' your bets.

For me I will happily sit on a share for 10 years, enjoying the benefits of dividends etc etc for it to reach my target, providing it does not breach my stop loss.

However holding a sub stop loss individual losing share for 5 to 10 years on the chance it (albeit perhaps increasingly) will rebound based on a multitude of local, macro, or global economic possibilities, oh and of course not forgetting the whims of Mr Market, makes no sense IMO. Am just not that good a picking them, or reading the future.

If that's the approach am thinking stick it in a tracker and at least, as you say, 'spread' your bets, and yes 7 years later you are going to start making money, even if you invested at the height just before any of the previous crashes.

I suppose the important thing is to have a system (ideally winning) and stick to it through thick and thin.

Its good to write down and read other comments in such times as these, and appreciate your thoughts!

cockroft

It’s baffled me for a long time that you can buy small companies for relatively low EVs compared to say housing ,especially when the costs of owning houses has been going up and will go up for a long time .Maybe a profitable business with some inflationary pricing power on a low p/e will end up on high p/e in inflationary times,especially if they have manageable debt (better than cash in this environment )?

Cuddlesticks

UK Inflation and electricity prices

In light of the BOE's inflation outlook, the role played by electricity in driving up prices and the high proportion of electricity that can be generated from local sources, I'm surprised the UK Government hasn't copied Spain and Portugal and changed the price setting mechanism such that the price of electricity is not set by international spot gas prices.

As illustrated below, the price we pay is currently set at what’s known as the ‘marginal cost of production’.

Under this method, bids are accepted from suppliers starting with the lowest cost until sufficient supply has been contracted to meet demand. The bid from the supplier that provides the final volume of electricity to meet anticipated demand is known as the marginal cost provider and the price they bid is the price every bidder gets paid - even if other suppliers offered electricity at a lower price.

This was to encourage investment in green energy, however, since the Ukraine war, electricity generated from gas sourced at international gas spot market prices has become the marginal cost provider. This means, for example, providers of electricity from nuclear sources get paid 20p a unit whilst producing and offering to supply at 2p.

I understand from a source at EDF that business secretary Kwasi Kwarteng is reviewing this pricing mechanism. Spain and Portugal have already replaced the marginal cost provider model with a price cap model.

https://ec.europa.eu/commission/presscorner/detail/en/ip_22_3550

Naturally, a similar policy change here would help UK competitiveness. In Spain, Atalaya Mining Atalaya Mining (LON:ATYM), has been vocal on the impact of the marginal cost provider structure (see page 8 below).

https://atalayamining.com/wp-c...

Whilst the UK doesn't have as much green energy as Spain I think a similar policy change here, even if only temporary, would be a big help to UK companies.

davidallen77

i hold Bank of Georgia (LON:BGEO) just think it is so cheap and fste tracker funds are buying in for dividend only 48million shares in issue.

Boon

Yes - defaults are definitely a concern. Reading through their last few results, they've not flagged up any concerns yet, and I believe that energy bills will be the last to be unpaid (before a business goes into liquidation) as its critical for the running of the business, so risk exposure might be just 1-2 months.

Competitive pricing - well, they've been winning new customers, so I am making an assumption here. The switching market will grow, so there are more in-market customers to chase. Also, Gazprom used to be the biggest business energy supplier in the UK; they still exist, but probably lost a lot of share of the new market, given their tarnished reputation now.

Today's fall - no idea, its fallen on quite low volumes. Might just be low liquidity, which is a problem with Yu (LON:YU.) and one or two forced sellers can push down the price rapidly. I've taken the opportunity today to top-up my holdings.

My investment thesis in Yu can be summed up in four bullets:

I think we've yet to see the real growth in business energy switching; and so they will beat the market expectations over the next two quarters. We're now getting closer to the time where high winter energy prices are more or less certain, unless there is a massive shock (sanctions withdrawn against Russia, big economic recession sapping demand)
They're currently firing on all cylinders, based on my convos with industry pros and publicly available data.
Competition is lower; many SOLRs (Yu took some of them) and Gazprom is in no position to compete effectively in the UK energy market for the switchers.
Decent balance sheet. Good amount of forward visibility of revenues.

But the current model encourages the expansion and construction of the cheapest energy source.

In this case, if nuclear is only 2p cost and 20p revenue, then those who know how to build nuclear plants will be falling over themselves to build more. Obviously this is a bad example, as there's so much red tape and politics in nuclear that the decision is not solely on economic rationale.

But if you take something else, say battery arrays. If they only cost 10p and they can then sell their energy at the marginal cost of 20p, then we should see huge amounts of battery arrays mushrooming within the next year, which is exactly the sort of long-term investment we need. This, is the investment thesis for Gore Street Energy Storage Fund (LON:GSF)

Bingo. A company that has high debt currently, but has pricing power and able to protect both margins AND volumes (so a defensive product, or one with such a strong monopoly). Would be a winner in persistent high inflation times.

Water companies spring to mind.

But hard to find, amongst non-utilities industries.

Dave787

The real problem was with the last government ever getting involved in setting energy prices in a previously at up free market. On the one hand lots of energy providers go bust and on the other the public get overcharged and the companies make lots of money and in all cases the government gets blamed

I think the problem lies with the governor of the Bank of England who over the last 12 months has said things like, I can't do anything about rising inflation; inflation will be transitory; inflation will peek at 7% then 9% now 13%; and now to top it of says we're going into a deep recession that will last more than 12 months. All of which have the effect of reducing the value of the pound contributing to high inflation, the majority of which has been caused by high energy prices which, guess what are priced in dollars. He then says he hasn't caused the recession well he's done as much as anyone in causing a recession. He has two KPI s in his job keep inflation at 2% and assist in maintaining growth in GDP. Clearly failing on both. I thought his last news conference spelled out every reason why he should resign.

Deegee Eff

Evraz (LON:EVR) First of all I do not see why Evraz was suspended from trading. The FCA claim that it was to prevent a disorderly market, however it has achieved an orderly market only by destroying all value for current owners . It may not have followed its own rules, in order to harm a Russian company, whilst UK individual shareholders look like collateral damage. The FCA may have lent on by government in order to achieve a political result.

Thus, should you leave your shares registered with your UK broker in order to retain ISA tax benefits or move them to the Russian Evraz ?

That depends on who you trust more to look after your interests. If at some future time you find there is a market Evraz shares somewhere will your broker contact Evraz on your behalf ?

Sorry to reply here, but there seems to be very little information or discussion anywhere else.

Tommy H

Dear All

Whilst I have to be very cautious as these are personal feelings rather than company statements.

I work for a "Tier 2" UK Contractor within the construction trade, so we work for the likes of Balfour Beatty (LON:BBY) Kier (LON:KIE) Costain (LON:COST) MACE etcetera doing the actual work, their model is primarily that of what I would describe as a "management contractor" putting a few staff onto the job and then engaging a massive and long supply chain and endeavouring to seek prices lower than they have committed to the client, claim changes from the client and fight changes from the supply chain..

The last few months have felt very challenging, all the projects bid last year are now "in pain" as these are typically lump sum / fixed price and programme from 6-18 months in duration from award/commencement. So the Client (Tier 1 and sometimes direct) has a committed price and programme to complete and now we are having to pay staff (pretty much all folks are on our books which is normally a big advantage), agency labour, materials (not hedged) and particularly diesel!!!! at market rates, not what we priced last autumn or even in Q1. We cannot bulk buy materials, say ready mix concrete, we pay by the load on the day, we cannot say to ready mix we want 100,000 cubic metres over the next 12 months give us a fixed price, we are just one of many many customers.

To note previously construction plant used red diesel, similar to say farming, so tax free, this has now been removed, so is a massive cost to be absorbed. Historically the driver was the highest cost, now it is the machine (and fuel). Hopefully this will continue the drive to more efficient vehicles and better practice, like not sitting in the machine engine idling all day (personal rant).

So inflation is typically in as an annual event on a construction contract, so on anniversary your costs can be increased by a fixed amount - typically CPI, short contracts you do not have this. Most clients (Tier 1 contractors) state that inflation is your risk outside the annual event, they have little concern if Tier 2, 3, 4 or 5 companies go to the wall, there is always someone picking up the scraps (opportunities) or buying the company for pennies in the pound.

I would add also that clients are asking for lots of bids which has costs which are not recoverable for your estimating and management team, but are delaying awards, or not awarding, or that someone is desperate for the work so bids at a loss to keep the bank away from the door. So the new work is not coming in at the normal rate, as surprise the prices you are getting now are higher than the model produced 12 months ago that got board approval to proceed.

Think if you had an extension designed, the architect said budget £50-55k, you got the mortgage extension approved at £70k as you know there will always be more cost as something always happens, and the contractor comes back tomorrow at £95k what is your response to them even if they give you a priced breakdown that looks reasonable...

So you need to be thinking here for Begbies Traynor (LON:BEG) report, not the big listed companies, but the masses of privately owned family companies that operate in the space below them with £10m-£500m turnover. These are the companies in real pain.

Then you have to think that if a Tier 1, such as Carillion, or Tier 2 such as ROC go to the wall, this then brings in their own massive supply chain, all those companies on 30-90 days payment terms doing work in good faith, and then finding themselves locked off the site, materials bought but impounded by the administrators, wages to pay and no cheque coming in. Right down to Sarah or John the self-employed person, who finds 3 months of back pay is now on hold...these people rarely have the bank balance to take this sort of hit!

Often we talk about high turnover, cash is king, low margin work. You are one bad job away from failure... Other than employee share schemes, where the tax advantage and sometimes the purchase price gives the incentive, I do not invest in construction ever. Yes you can make money, but I work in the industry I take the salary but that is my risk limited.

Yes there are companies that are very successful, my current employer has been around over 50 years, they will hurt A LOT this year, but I have confidence they will still be here in 10 years time, the family will find a way through, staff will be laid off, maybe the head office will be sold off, the company will shrink but they will find a way. I may be made redundant, I do not expect a bonus or pay rise, I might well be asked to take a pay cut (again).

Similar with my previous employer who had a long history, it really really hurts, all employees get a pay freeze or pay cut, the partners and family get no pay (100% bonus), but many have been there for 20+ years so know that good years come again, so hang on in and make it work.

So not an answer, but within construction as probably with a lot of industries, it is not the big players, or even the AIM players that are being hurt, it is the long and extended supply chains below them that are really really struggling.

So for us the thoughts are what are the impacts when a supplier goes bust? Or a sub-sub supplier? What happens, how is this managed? What are the cost and programme and reputation impacts from having to buy at any cost to complete the job, or miss delivery?

Tommy

55555

A really interesting and logical explanation - many thanks.

simoan

6th Aug '22

Yes, I saw a recorded interview with the Governor of the BoE on C4 news on Thursday explaining why there is a need to raise interest rates even though this will not stop the main source of inflation i.e. food and energy prices. He stated the bleeding obvious; that the poorest in society would be the worst affected, but then laid a very low blow in stating that those unions and workers asking for inflationary wage rises would be making things worse for the poor i.e. the rise in rates is somehow to indirectly save the poorest from those that can negotiate pay rises and further fuel inflation in the process. Like he really cares with his big fat paycheck! There was even an indirect jibe at Brexit, mentioning that the "labour shortage of the past few years" was a major cause of rising wages. He comes across a a total idiot to me, and I'm no economist.

For balance, C4 then spoke with Danny Blanchflower who gave several good reasons not to raise rates and declared that BoE was talking "poppycock". Even mild old Roger Bootle in the studio stated that the BoE may have to reverse direction on rates with their tail between their legs sooner than expected. It's clear they acted too late on rates and are now maybe over-reacting. What with the Tory leader vote, and not having a real government currently, it's a total bloody mess, quite frankly.

BTW Just seen that Sky News are reporting that Next (LON:NXT) are looking to buy 25% of Joules (LON:JOUL)

https://news.sky.com/story/nex...

All the best, Si

The Phoenix

Would agree with your investment time stats when it comes to a collection of funds and investment trusts I'm not so sure though on someone holding 4-10 single company stocks the logic being most people won't cut losers as they don't have the discipline.

Even the best traders only have a ratio of 1 to 1 winners against losers and as a previous poster mentioned if you don't deal with the losers quickly you will be skinned.

I've only met a handful of traders who consistently make money from markets and I don't include myself in that group despite twenty years plus investing and working in the investment industry.

I've recently started to move away from single company stocks to a collection of 10-12 investment trusts the logic being if I can't beat the managers long term returns why am I bothering spending 15-20 hours a week on research even if I enjoy it.

If your one of the few making consistent returns I salute you and if so keep sharing any nuggets of wisdom picked up on the way.

Regards Andy

eParo

Victoria (LON:VCP)

https://twitter.com/BondHack/s...

Something for the weekend.... a recent interview with Terry Smith:

https://masterinvestor.co.uk/p...

Always good value IMHO. Si

GloucesterBob

Excellent way to spend 30 minutes, look forward to part 2

Small Cap Value Report (Fri 5 Aug 2022) - Base rates & inflation. RNO, BEG, CARR

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Paul Scott

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