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

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 spike in Covid rates, their customers are now reining in spending on anything that's not necessary, ahead of the expected hike in the energy price cap, and we are seeing clear signs of this in this Red Flag data."  

"I am also particularly concerned for those SMEs who operate in energy-intensive sectors, such as manufacturing, as some could simply become unviable. Without the benefit of an energy price cap, business energy tariffs have at least trebled, and for many it will be much worse."...

..."Additionally, the anticipated double-digit rise in business rates next April will heap more pressure on to vulnerable businesses, despite some benefiting from the recent revaluation.

Carr's (LON:CARR) - an in line with expectations trading update. CARR is successfully passing on inflationary pressures to its customers, a key plus right now. I draw out wider points from its update today. Looks quite a nice value share, with a decent yield too. More below.

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Explanatory notes -

A quick reminder that we don’t recommend any stocks. We aim to review trading updates & results of the day and offer our opinions on them as possible candidates for further research if they interest you. Our opinions will sometimes turn out to be right, and sometimes wrong, because it's anybody's guess what direction market sentiment will take & nobody can predict the future with certainty. We are analysing the company fundamentals, not trying to predict market sentiment.

We stick to companies that have issued news on the day, with market caps up to about £700m. We avoid the smallest, and most speculative companies, and also avoid a few specialist sectors (e.g. natural resources, pharma/biotech).

A key assumption is that readers DYOR (do your own research), and make your own investment decisions. Reader comments are welcomed - please be civil, rational, and include the company name/ticker, otherwise people won't necessarily know what company you are referring to.

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Paul’s Section:

The Bank of England (BoE) raised base rates by 0.5% yesterday, but the new rate is only 1.75%, which is incredibly low compared with historic levels. Especially when you consider that inflation is now forecast (by the BoE) to peak at 13%, which would mean real (as in, inflation adjusted) interest rates would be negative, at (11.25%). Further increases seem likely, but not by that much. I doubt we'll see rates anything like the levels in the early 1990s bout of inflation, over 10%, for example. That's unthinkable now.

Therefore the losers from negative real interest rates will be people holding cash, or on fixed incomes, since inflation will erode their savings and incomes by almost 1% per month. I had a chat last night with Mum, about cashing in her Premium Bonds, and putting it into defensive, cheap, medium-high yielding shares instead.

The winners from inflation will probably be any individual or company that has high, but manageable debt, which will likely remain historically cheap to service, but will be substantially eroded by inflation over time.

We're likely to see an autumn/winter of discontent, as workers struggle to get pay rises, with strikes likely in unionised sectors.

The BoE report out yesterday is excellent, worth a look. It’s written in almost too simple language, but I like that - all information should be communicated in simple terms, no matter how complex the underlying subject, that anyone over the age of about 15 can understand, in my opinion. I detest technical, complex language, and long sentences with obscure words in them. Writing is about communicating ideas, so it should always be accessible to anyone.

This graph above, in particular, strikingly shows the situation we are in re inflation. This indicates that we have higher inflation in goods & services (excl. energy) of about 6% - bad, but not horrendous by any means.

However, the current energy crisis is the cause of inflation likely to peak at about 13%, as you can see from the top line of the above graph.

Therefore it seems obvious that directly targeted action is necessary by the Govt to lower energy costs, a lot, and fast. Otherwise we’ll have excessive inflation, which then has a knock-on impact on everything else, and would probably cost more than inaction, because public sector wages & pensions/benefits payments would shoot up more when they are index-linked. Once that’s embedded, it’s difficult to eradicate without deliberately triggering a deep recession to snuff out demand. Why would they do that, when demand is already falling due to squeezed household incomes, and company profits coming under pressure? Policy mistakes are likely, and could make things worse - that's what usually happens!

Inflation looks like a spike, albeit a big one, that is now set to go on for a while, and cause a recession for 5 quarters, according to the BoE. Hence we need to be seeing weak broker forecasts for 2023 in many sectors. If not, then profit warnings are likely, where brokers have not factored in a drop in profits - which could be large, due to operational gearing.

This is a much bleaker macro outlook than previously, so it’s bound to cloud our view of individual shares.

Could this snuff out the recent rally? I’d be quite surprised if it didn’t really, but you never can tell. The market is meant to be forward-looking, so it might have already factored in this bad news, who knows?

At individual company level, the key questions to ask remain -

• Pricing power - can companies pass on cost increases? (in particular, do contractual terms already allow for price rises, the ideal scenario)
• Demand - how robust is it, and will higher selling prices cause customers to cut back on purchases? (elasticity of demand). Do customers need the products, or are they discretionary? How much revenue is recurring? What alternative products are there? What are competitors doing?
• Costs - what inflationary pressures are there specifically? Any hedges or forward contracts to limit price rises? When do these expire?
• High energy users - as flagged up in Begbies red flag report today, businesses don't benefit from a price cap.
• Mitigation - what actions has a company taken to become more efficient, and offset cost increases? Does it need to restructure & lower costs? How much will that cost in exceptional items? Will customer service suffer as a result of cost cuts? Can processes be automated?
• Supply chain - how is this panning out? Improving? Margins could begin to improve (e.g. Shoe Zone (LON:SHOE) recently), as freight costs come down, and cashflow could improve as companies reduce inventories. Shortages of materials could turn into gluts, which often happens over time.
• Debt - is it manageable? If profits plunge, will a company breach banking covenants? What does the going concern statement say? Are interest rates fixed, if so how long for? When is debt repayable?
• Will it need to raise more equity to survive? Is there a risk of insolvency or heavy dilution (in which case, I don’t want to be anywhere near it, generally)
• De-listing risk - small companies with a few controlling shareholders, often plunge in price when they announce an intention to de-list from the stock market.
• EDIT: I just thought of another point after reading today's trading update from Carr's (LON:CARR) - it flags (as other companies have) that higher inflation is absorbing working capital, as debtors and inventories grow due to higher prices. This has correspondingly increased bank debt, because higher working capital has to be funded somehow - hence expect more companies to come under a working capital & debt squeeze, as cash is absorbed into higher working capital - that could trigger solvency problems at companies where the bank is already jittery. Another reason to avoid highly geared companies right now. Balance sheets matter a lot more, now that interest rates are rising - banks are less accommodating when interest costs are piled on top of already problematic loans. End of edit.

I'll add to this list, if I think of anything else, that's enough to be going on with.

On the upside, all these problems could get resolved one way or another, and many shares could end up being very cheap at current levels, once you factor in earnings recovering. Inflation also means that companies figures will be much bigger in future, so long-term, being in equities should provide inflation protection to investors, if we pick the right companies to invest in.

Above all, nobody knows how this will pan out, so anyone talking with great certainty (this or that will happen, etc) is talking out of their bottom.  I have no idea what is going to happen, but it's fun to discuss, and hear other peoples' views. The best thing is to keep an open mind, and constantly check the facts & figures, and be prepared to change our minds when the facts change, in my opinion.

Owning equities isn't about earnings for 2022 or even 2023. We own part of the business, and all its earnings for the rest of time. Profits should recover from a recession, so good businesses that are now cheap, should be decent long-term investments. Shorter term, who knows? It feels like there could be plenty more pain ahead, especially for weaker companies that didn't make much money in the good times, and could come unstuck in the hard times ahead. Why buy speculative rubbish in conditions like these? I think a flight to quality makes sense. Or cashing out and watching from the sidelines, as some people have done? Is this a bear market rally, or a new bull market? I've got no idea, we'll have to wait and see.

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Carr's (LON:CARR)

130p (up 1% at 09:46)

Market cap £122m

Board Succession (i.e. changes) - the existing Chairman is becoming the new CEO. The CFO is moving on, and a specific job is mentioned (at a boutique motorway services business [I just invented that term after looking at its website!], so that adds credibility (i.e. that it’s probably not a concerning CFO departure). The CFO is staying on until Jan 2023 too.

Trading Update - the current year is FY 8/2022. Today’s update is for the 11 months to 30 July 2022 (it says 22-week period, but that’s H2).

Overall trading is in line with the Board’s expectations.

There are some interesting additional comments -

Agriculture division - cost increases have been passed on to customers - a key thing on my general list above, which reassures.

Drought in USA is impacting cattle feed, so is a shortage of beef in the pipeline I wonder?

Engineering division - strong order book, but supply chain delays for components, and higher costs on a “key project” have harmed performance - sounds like the agriculture division might have taken up the slack from this, given that overall trading is in line with exps.

Working capital - this is a key point I want to emphasise , and have added it to my list above. Higher inflation means that almost all companies that sell goods on invoice (as opposed to cash) and get paid typically 30-60 days later, are likely to see working capital suck in cashflow as debtors and inventories become more expensive (and only partially offset by higher trade creditors, typically) -

Working capital requirements have continued at higher levels as reported in April due to the inflationary impact from increased raw material costs and selling prices with the effect that debt levels continue to be higher than the prior year. Undrawn facilities at 25 June 2022 were £28.4m.

This is an additional cashflow squeeze on most companies, so liquidity & bank facilities are under even more pressure. Many have also deliberately increased inventories too, due to supply chain problems. I wonder how many companies are going to run out of cash, and need to do emergency placings, or go bust?

Just to be clear, CARR’s balance sheet looks fine, I’ve just checked the last published balance sheet, and NTAV (the way I adjust it) is about £100m, which looks ample.

My opinion - CARR looks a decent, solid company, at a fair price, paying nice divis. The strategic review is being concluded soon, but I doubt anything much will come of that, because deals have dried up, but we'll see.

Above all, it seems to have pricing power, so looks a good long-term hedge against inflation, with an income along the way.