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Overview
2018 was a year most investors would like to forget. The exuberance of 2017 was followed by sober conditions early in the year as the market adjusted to the prospect of rising interest rates and the winding down of quantitative easing. Conditions steadied in mid-year but prices began a sharp slide in October 2018. This was mainly due to concerns that the US Federal Reserve under new chairman Jerome Powell was steering by its model of the world rather than actual conditions. Some degree of cold turkey was always likely, given the Federal Reserve’s $50 billion monthly reduction in bond holdings. Under quantitative easing it increased its gross assets from under $1 trillion to nearly $4.5 trillion. Even reducing at $600 billion per year, it would take until December 2023 to return to its pre-crisis size. These are uncharted waters for investors and the authorities alike. In early January the Federal Reserve began signalling it will take a more pragmatic view. As the Financial Times put it: better late than never.
Commentary
Future has been our star performer, rising +12% and contributing +0.82%. The company delivered consistent upgrades. For instance the consensus earnings per share forecast for the year to September 2019 rose from 20p to 27p during 2018. The company made a string of acquisitions and carried out a rights issue. The management has established a powerful track record in buying declining magazine titles, transferring their content online and using this to generate sales commission from e-commerce. We are always wary of acquisition sprees but believe Future is genuinely adding value, not merely exploiting its higher rating to generate earnings growth.
We bought JTC when it floated in March 2018 at 290p. The shares closed the year at 383p. There are similarities to Future in that it buys other businesses, in this case fund administrators, and slots them into its highly cost-efficient platform. Outsourcing from banks also continues to be a good source of growth, so the business can grow without acquisitions. Market risk is only indirect for JTC and the business essentially trades on its scale efficiencies rather than simply from operating through tax havens. In August 2018 it paid €16 million for Van Doorn of Holland, on an enterprise value/earnings before interest, taxes and amortisation multiple of 9. In September 2018 it bought Jersey-based Minerva Holdings for £28 million, with a fully paid multiple of 7.5. We will monitor these deals for evidence of operational gains.
Liontrust Asset Management rose +22% and contributed +0.40%. The business has had great success attracting inflows for its sustainable funds. In November 2018 it reported a +21% rise in adjusted profits before tax for the half year to September 2018, helped by net inflows of £723 million, up from £178 million in the first half of 2017. Liontrust has been adept at exploiting the demand for virtuous investments without overly compromising on performance.
AFH Financial rose nearly +24% and contributed +0.37%. The company had another busy year buying independent financial advisers. During the year the company raised £15 million to fund acquisitions. Funds under management reached £5 billion, up from £2 billion in 2016. The company is capitalising on the shortage of advice from financial planners where demand is outstripping supply. AFH sees the available pipeline for acquisitions lasting at least another decade. As the expanded business matures, investors will place more emphasis on operational gains. For instance revenue per adviser is forecast to rise from £161k in the year to October 2018 to £225k in the current year and £327k in financial year 2020.
TV producer Entertainment One gained +9% and contributed +0.35%. Management confirmed that prospects remain bright and that trading in the first half underpins the full year outlook. The company is well positioned leveraging the global growth in original content being fuelled by the likes of Netflix. Reflecting this, the independent library valuation increased to $2 billion (2017: $1.7 billion). Family & Brands, which includes Peppa Pig and PJ Masks, continues to perform strongly, driven by ongoing consumer product roll-outs across a growing number of licensing contracts and streaming video on demand deals. There is a robust pipeline of new TV series. Film continues to transition to higher-quality production.
Taptica International contributed -0.35%. We sold the shares at just over 300p as we had become concerned about competitive pressures in the ad tech market generally. To be fair, the Taptica’s Chief Executive Officer gave us a frank appraisal of industry dynamics and made the decision straightforward. The shares closed the year at 160p, vindicating the decision.
Codemasters, which develops video racing games, floated in June 2018 at a £280 million valuation and closed the year 20% lower. It contributed -0.38%. This poor performance was due to the failure of new game Onrush, which was launched to little fanfare in the summer. Despite excellent graphics the game was badly received because it was modelled on arcade games where there is no clear start or finish. The latest version of the company’s flagship Formula 1 game has sold well since its launch in August 2018. The next important news will be the launch of Dirt Rally 2 in February 2018. We liked the fact that management moved swiftly to redeploy staff from Onrush to other projects. But of course it would have been better not to have launched a game with such an unfamiliar structure. On a price/earnings ratio of 13 at year end, the shares are far from expensive.
Breedon, which operates quarries, fell -31% and contributed -0.41%. Forecasts ended the year little changed from their opening levels, so this was a case of de-rating rather than downgrades. The key event of the year was the £455 million cash purchase of Belfast-based Lagan Group. This was funded by a £170 million placing. At 10x earnings before interest, tax and amortisation this was not the sort of low-rated acquisition which had made Breedon so popular with investors, though it did give the company access to the much more buoyant market in the Irish Republic. At year end the shares stood at a price/earnings ratio of 11.5 and a price/earnings to growth ratio of below 1.
Online Bingo and casino business JPJ had a frustratingly mixed year. The business performed impressively but the shares suffered along with the whole sector as investors became alarmed by tightened regulations and rising levies. The shares were bought at around 800p, quickly rose +25% but then began to slide, closing the year at 637p. The contribution was -0.41%. In the UK the Remote Gaming Duty was increased from +15% to +21% as from April 2019. An increase to 20% has been expected after the government’s crackdown on fixed odds betting machines, which created a shortfall of tax revenues. JPJ is expanding rapidly on the continent and in Germany in particular. By the end of this year we expect the UK to fall below 50% of total income. At year end the price/earnings ratio was 5.6 and the enterprise value/earnings before interest, taxes and amortisation of 7.8. The company will start paying dividends from mid-year as cashflow reduces net debt.
Cyber-technology specialist NCC Group contributed -0.44% after falling -25%. This was despite giving a positive trading update in September 2018. The company reiterated that trading is in line with full-year expectations for adjusted operating profit. It remains on track for double-digit revenue growth at its Assurance division, which comprises cybersecurity consulting, and, accounts for over 80% of revenues. The company is part way through its strategic transformation and there is room for margin improvement. A core technology holding.
Price comparison website Gocompare.com was bought during the year at around 125p. Profit forecasts remained broadly stable but the shares fell sharply, closing the year at 69p with a contribution of -0.45%. Motor premiums have been falling and the company decided to protect margins by reducing its marketing spend. Its strategic focus has been to develop savings-as-a-service offerings. In October 2018 it began a soft launch of the first of these, called weflip, which automatically switches power suppliers. We await early feedback from this and guidance on marketing spend. Meantime the shares closed the year at an undemanding price/earnings ratio of 7.6 and a 3% yield.
Online travel agency On the Beach took a roasting during the heatwave, but we remain massively impressed by the agility of its management. The shares fell 28% to close at 336p. The contribution was -0.49%. In August 2018 On the Beach paid £20 million for package holiday business Classic Collection. This gave the company an offering in long haul beach holidays. It also provided access to the segment of customers who still prefer to buy packages from their local agents. We suspect the experience gained here will be important when On the Beach eventually makes a serious move into Continental markets. At 336p the price/earnings ratio was 12.7 and the price/earnings to growth ratio below 0.5.
ITV contributed -0.53% after falling -24%. The share took a downward lurch in November 2018, when the company guided toward a soft fourth quarter for broadcast advertising, leaving full year like for like forecasts at around 0. Erosion from digital competition has combined with consumer fatigue to make life particularly hard at the moment. Broadcasting has fixed cost and variable revenues. Towards the year end the company agreed new terms with Virgin which should be accretive to profit and we await a similar deal with Sky. The shares trade on a very modest 9x price/earnings ratio, generate plenty of cash and yield 6.5%.
Marketing automation provider Dotdigital contributed -0.70% despite a good set of final results in which the company delivered adjusted earnings per share of 3.12p compared with broker consensus forecasts of 2.98p. Key operational metrics were positive including average revenue per user (ARPU) up +18% to £845 per month. The partnership with e-commerce platform provider Magento is delivering particularly strong growth. Following the acquisition of Comapi the company has accelerated its transition towards becoming an AI-driven, omni-channel platform, positioning itself extremely well to capitalise on the large global market for marketing automation technology. This is reflected in sales based on the ‘volume of emails sent’ now accounting for less than 50% of group turnover. The company is one of only a small handful of quoted ‘Software as a Service’ based technology companies in the UK delivering predominantly organic growth and high quality recurring revenues.
Quiz, the fast-fashion retailer, was particularly disappointing. It contributed -0.76% and the shares fell 79%. The damage was done with an update in October 2018 which reported that sales via the Next website had suddenly stopped growing. This had been the biggest driver of online sales growth in the year to March 2018, so the abrupt change was disconcerting and the explanation for it was unclear. Quiz is ramping up its marketing spend to boost sales via its own website. The shares were duly punished, closing the year on a price/earnings ratio of 6, a 5% yield and with net cash. Nonetheless, we have reduced the holding and are accelerating our exit strategy.
In its interims digital marketing specialist XLMedia (-0.77% contribution) said that it had been negatively impacted by regulatory changes and suffered the loss of revenue from some of its websites as a result of malicious activity by hackers. The company also reported a 31% year-on-year revenue decline at its Media division partially offset by growth in Publishing. In December 2018 it announced a $10 million buyback programme. This helped the shares to stabilise and close the year at 75p, but still down -62%. As with Taptica, we see online advertising as a very challenging market. We sold the shares steadily from mid-year and, at the time of writing, have a tiny position remaining.
Life insurance giant Prudential fell -26% and contributed -1.01%. This poor performance came in spite of its plan to demerge the M&G business, long seen as a laggard compared to the faster-growing Asian operations. For five years until late 2017, Prudential moved in lock-step with the share price of AIA, its Hongkong-listed peer. Both of them trebled in sterling terms. The sharp underperformance of Prudential since then looks an interesting opportunity, while not forgetting that quantitative tightening makes a difficult environment for life funds generally.
CVS, which operates a network of veterinary practices, fell nearly -37% and contributed -1.06%. In 2018 the earnings multiple contracted sharply. The company seems to be getting a grip of staff turnover problems, though at the cost of higher pay for vets and nurses. On 12.5 times earnings at year end, the rating is hardly dizzy. We expect to see further consolidation of the market.
Restore made a -1.71% contribution after falling -45%. It reported interims in September 2018 which showed sales up +9% and adjusted earnings per share up +10%. The integration of the TNT document storage business was held up by the competition authorities but is now proceeding. This was the last sizable document storage acquisition possible in the UK that moves the dial although there are still new sales opportunities in the un-vended public sector. The core business of box storage still accounts for 70% of group profit. Looking forward, the scaling up of the scanning and shredding businesses and cross-selling look like being the big drivers in terms of top line growth, the challenge being to raise scanning and shredding margins closer to that of box storage. As with CVS, this has been a painful de-rating but it seems to have run its course. The shares closed the year on a 10.9 price/earnings, a rating which gives no credit for promising cross-selling opportunities. We sold the shares at higher levels during the first half.
Despite delivering a good set of interim results to the end of August 2018 with adjusted pre-tax profits up +15%, shares in database specialist First Derivatives (-1.71% contribution) fell precipitously after it was de-rated by the market on the back of short sellers targeting the company. With its unique proprietary database offering the company is starting to open up sizable new opportunities in substantial verticals outside finance. These include industrial applications, the Internet of Things, pharma, retail, telcos and utilities. The company, however, does not appear to have put sufficient effort into developing and scaling up its partner channels. As a result, progress is perceived by the market as being slower than anticipated and at odds with its very high historical rating. We had been reducing the holding steadily in the last year or so, selling on rising prices, and accelerated the pace in October 2018.
Hutchison China MediTech contributed -2.55%. Disappointingly, in November 2018 its leading drug, Fruquintinib, failed in a Phase 3 trial for the further indication of non-small cell lung cancer. In addition, in December 2018 the company announced it was abandoning a Phase 3 study comparing Savolitinib with Sutent in kidney cancer. On a positive note, Hutchison China MediTech still has a profusion of clinical trials under way and as we have seen with AstraZeneca’s Imfinzi, a drug can miss the mark with one cancer and triumph against another. AstraZeneca and Hutchison China MediTech have begun a global Phase 2 study of Savolitinib and Tagrisso in non-small cell lung cancer patients whose disease has progressed after initial treatment with Tagrisso. In November 2018, Hutchison China MediTech successfully launched Fruquintinib for the treatment of colorectal cancer and the company has engineered more attractive terms with its partner Eli Lilly. During the year the Fund reduced its holding materially for risk management purposes when the shares were trading at the top of their range.
Purchases and sales
During the year we added shares in AFH Financial, Alliance Pharma, Breedon, Entertainment One, Ergomed, Future, Inspired Energy, Iomart, ITV, Liontrust Asset Management, Mears, Next Fifteeen Communications, Prudential, Quiz, Safecharge International and STV. We bought shares in Applegreen, Charles Taylor, Codemasters, Gocompare.com, IG Design, JPJ and JTC.
We reduced shares in First Derivatives, Hutchison China MediTech, Quiz, Restore and XLMedia. We sold entirely out of Matomy Media, OPG Power Ventures, Photo-Me International, Staffline and Taptica International.