[Commentary] Slater Recovery Fund – Interim Report for the six months to 31st May 2019

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For a PDF of the Full Report, please click here.

Overview

The half year saw a remarkable turn for the better in global markets. This was triggered by the abrupt reversal of narrative by the US Federal Reserve. During the Autumn the Fed was unwavering in its plans to raise rates. Markets wilted and the growth in money supply was snuffed out. But in December the lights came on again and equities rebounded.

The improvement in sentiment helped UK equities as well, leading to a +5.16% return from the Benchmark. But the Fund handsomely outperformed, generating +12.12% and illustrating the power of active stock selection over index chasing.

Commentary

Media company Future was the standout performer, delivering a +4.74% contribution driven by a 94% rise in the share price. Last year’s acquisition of Purch in the US has been a tremendous success, with UK-developed technology being applied to US operations. This helped drive a 92% rise in adjusted earnings in the six months to March. The Chief Executive Officer (CEO) has stated a target of doubling Future’s size every two years. Chest-beating of this kind often ends badly but in Future’s case we think it is achievable. Revenue per user in the US trails the UK by 40% but the CEO believes this gap can be reduced to 15% within three years. Running the numbers along those lines suggests there is still plenty of upside in the shares. The performance has been helped by buying from US investors and in anticipation of the company’s entry in the FTSE 250 index in June.

Serviced office business IWG leapt 45% and contributed +0.82%. We were delighted when IWG announced the £320 million sale of its 130 centres in Japan to franchisee TKP Corporation. The news lifted the shares sharply and we see further upside as other territories are sold.

Entertainment One, best known as the maker of Peppa Pig, rose 19% and contributed +0.62%. It reported March 2019 interims which showed adjusted earnings grew 30%, much as expected. In April 2019, the company paid £178 million to buy Audio Networks, a UK business which supplies atmospheric music for TV and film. The Fund took part in the £130 million placing which accompanied the deal. Entertainment One’s shares are volatile but they closed the half year on a forward multiple of 17 and a price earnings to growth ratio of 0.6, coming well within our investment parameters.

Ergomed, the clinical services business, contributed +0.57% and its shares rose 59%. This pleasing rally brought its shares back to their level in June 2018 before the company encountered some growing pains. Some problems were self-inflicted, with unsuccessful management changes. The company also encountered issues in timing the growth of its capacity in pharmacovigilance to meet rising demand. The company has also stopped signing deals where it sacrifices margins in clinical services in exchange for a share of the potential upside from drug programmes. It will also not use its own funds to develop the Haemostatix product. Founder Miroslav Reljanovic has retaken the reins and the company is showing much clearer purpose. An update in May 2019 reported trading is substantially ahead of forecast. Ergomed is focusing its clinical services on orphan diseases, which makes sense as these involve small but complex trials often involving many hospitals. This type of work is less attractive to larger competitors. The pharmacovigilance business enjoys multiple tailwinds, though realistically it future may lie within a larger business.

Safecharge International contributed +0.56%. Its shares gained 59% after receiving an agreed $889 million cash bid from Nuvei, a Canadian fintech business. At our last meeting with the company the CEO made it clear he needed to build scale to compete, either acquire or be acquired. Payment services are rapidly consolidating and we see this as a very pleasing outcome.
We bought veterinary chain CVS in February 2019 and it rewarded us with a +0.52% contribution. A trading update in January 2019 had triggered a sharp fall in the share price. We met the management after the interim results, showing earnings down 14%, and took the view that some of the headwinds were starting to ease. Staff shortages and rising pay have been the worst of these. Retention now seems to be improving. The company is looking at opening branches itself rather than chasing private equity rivals in bidding for existing practices. The shares closed half year on 14.6 times forecast earnings. Not yet a high conviction position but interesting.

Dotdigital rose 21%, returning to the levels before the Autumn tumble, and contributed +0.48%. In March 2019 the company reported December 2018 interims. These showed 15% organic revenue growth, driven by a 43% rise in sales to customers of Dotdigital’s strategic partners. These partners provide the platforms for online retailing and are fertile ground for digital marketing. One concern has been the heavy dependence on Magento, a retail platform which was acquired by Adobe last year. This anxiety is starting to recede as volumes have been rising sharply on Salesforce, Shopify and Microsoft Dynamics. The shares are not cheap by Slater standards but remain attractive given the growth rate.

Only four stocks detracted by more than -0.20%. Mears continued its disappointing performance, delivering -0.21% and falling 24%. On 31 May 2019, the board narrowly fought off at attempt by some shareholders to appoint two independent directors. This followed heavy dissatisfaction with the company’s venturing into homebuilding and its unsuccessful foray into providing home care. Normalised earnings for 2018 were reported to have risen 4%, but writedowns on housing are likely to overshadow other progress. The company had reduced success last year in bidding for maintenance contracts, its bread and butter. It said the bidding process for the large asylum housing contracts had diverted its management. Not a satisfactory situation but reflected in the share price, now on 7.7 times and yielding over 5%.

Aggregated Micro Power contributed -0.26% with a 31% price fall. We bought the stock on the prospect of a lucrative generation joint venture with Drax, the power station group. Aggregated had bought Drax’s woodchip distribution business and the two sides were close. In the event no deal transpired and nor did one with another power company. Meantime the warm summer of 2018 and the recent mild winter cut into demand for wood chips for boilers. In April 2019, Aggregated warned it would make a ‘statutory earnings before interest, tax, depreciation and amortisation loss’ of £1.3 million. After meeting the company we drew some assurance that the woodchip business is becoming better managed. Meantime Incubex, the emissions trading platform 29% owned by Aggregated Micro Power, reported €12 million revenues in 2018, well ahead of expectations. Aggregated Micro Power is over-complex in structure and the company has heard loud and clear that it must address this issue.

CML Microsystems fell 35% and contributed -0.44%. On 1 February 2019 it warned that weaker demand in China meant its full year sales would fall 12%. A later update reduced this to 11% and said profits will be ‘close to £3 million’ with net cash of £12.8 million at 31 March 2019. This is obviously very unsatisfactory but if we strip out the cash and freehold properties, the business itself is not on a demanding valuation and the yield is 3%.

Hutchison China MediTech fell 16% in the half year, contributing -0.95%. The shares fell sharply in December in reaction to the news in November 2019 that 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 as the company had found a more cost-effective route to establishing Savolitinib as a monotherapy. These setbacks should be seen in the context of a broad clinical pipeline. The company reported a $74.8 million net loss for 2018, up from $26.7 million, but well covered by a cash resource of $420 million. In April 2019, Hutchison China MediTech announced plans for a large global offering via the Hong Kong market. Interestingly, 60.2% holder CK Hutchison Holdings has indicated it will let its holding be diluted below 50%. This will help the liquidity of the share and make it more suitable for inclusion in important market indices.

Outlook

The carnage of 2018 has reversed in part, as shown in the market’s recovery this year and the Fund’s own performance. But ratings are generally much more attractive than a year ago and we enjoy more choice in stock selection. The political and economic headwinds are well known. We continue to look for companies that can make their own weather, at least in the medium and long term.

Purchases and sales

During the period we bought shares in Bonhill, CVS, Diversified Gas & Oil, Instem and The Simplybiz Group. We added to positions in Applegreen, Charles Taylor, Clinigen Group, Entertainment One, Franchise Brands, IWG, JPJ, Randall & Quilter and Restore. We sold Hotel Chocolat, Matomy Media, Quiz and XLMedia. We reduced the holdings in First Derivatives, Future Group and Lok’n Store Group.