When Deep Value Surfaces: OPG Power Ventures

My weekly Friday evening ritual of manually entering into a spreadsheet the current values for each investment held (to force me to keep everything under review) has become progressively less appetising as 2018 has worn on: a significant decline across virtually all sectors and geographies held, particularly acute in the UK small cap and emerging market investments in which I’ve been overweight for a while.

Yet not all is negative, and the one recent bright spot, besides reassuring me that I’ve not lost all my stock-picking ability, is an opportunity to reflect on wider investment lessons.

The most recent investment I’ve made is on the face of it one of the least likely and most questionable. 
OPG Power Ventures is an Indian power generating company listed on the AIM market in London. That one sentence alone would be enough to deter most investors.

However, value investing, particularly of the ultra-contrarian deep value variety, requires the ability to explore what appears profoundly unattractive.

OPG appeared on a very rough and ready Web FG list of AIM companies ranged from high to low dividend yield earlier in 2018 and had been on my watch-list since then. Further investigation revealed a share price that had fallen unrelentingly since the heights of over one pound in 2015 to 17p mid-year.

The perfect storm of rising coal prices – the major input to its energy generation – high debt, poor management and performance of a power plant in Gujarat culminated in a set of final results for year end to March 2018 greeted by the shares falling to just over 10p, with a loss of £101m on annual revenue of £140m, the one pence dividend being paid in scrip form rather than cash. Uninvestable, surely?

Yet the results contained perhaps the beginnings of a recovery path. The company henceforth was to focus on its profitable Chennai plant, repay debt, deconsolidate the Gujarat misadventure and continue the development of solar energy production.

Signs of progress, but not enough to persuade me to invest.

Then, rather more rapidly than expected on Tuesday November 27^th, interim results to 30^th September 2018 gave substance to the turn-round story: profit before tax of £7.3m, earnings per share of 1.67p for the half year; underpinned by an increase in electricity tariffs for 2018/9 and reducing coal input prices.

The shares began a rapid ascent from 11p to 17p on the day, and have continued since to close on Friday 21^st December at 26p.

Unfortunately, away from my computer for a few hours on the day of the announcement, I was only able to initiate and then top up a position at an average entry price of 17p.

I do not regard OPG as a strong conviction long-term hold, particularly in the light of the management’s questionable track record from 2015-2018, but given the turn-round underway there is, in my view, still some latent value here.

Price to book is still well under 1.0; and so long as the coal price does not rebound the implied forward PE is firmly in single-digit territory.  The latest research note from Cenkos is estimating full-year earnings to March 2019 of 3.6p and then 6p for the following year as further debt repayment aids free cash flow. In a December interview the OPG finance chief suggested next year’s dividend would be honoured in cash.

Wider investment lessons

1. Stay alert at 7 a.m. each weekday morning for Stock Exchange RNS announcements, particularly from smaller companies, as these tend not to be flagged in advance and produce sharp movements in these relatively illiquid, under-researched opportunities.

2. Earning maximum returns requires decisive action at the point of maximum aversion. For OPG investing just after the September results was the turning point.

3. Waiting for complete confirmation of a deep value recovery story may limit returns. When deep value begins to surface, you have to plunge in to reap the fullest rewards.

4. Value investing, like all investing, depends on judgement in the face of incomplete information.

As Seth Klarman put it in a late 2000s question and answer session marking 75 years on from the publication of Graham and Dodd's classic text Security Analysis:

“[Value investing…]  necessitates dealing with imperfect information — knowing you will never know everything and that that must not prevent you from acting.

It requires a precarious balance between conviction, steadfastness in the face of adversity, and doubt — keeping in mind the possibility that you could be wrong. Ultimately, Graham and Dodd teach us not only about investing, but also thinking about investing. At the core of its wisdom are not mechanical rules to be blindly adhered to, but a way of thinking that allows us never to be blinded by rapidly changing facts or conditions. Mechanical rules are dangerous — requiring the world to be more constant and predictable and analyzable than it can be. "

From Outstanding Investor Digest, 17th March 2009

Revisiting the Investment Confessional

As a lapsed Catholic the word ‘confessional’ conjures vivid memories of childhood visits to a gruff-voiced priest faintly discernible behind a metal grille who absolved my minor transgressions with a blessing and a few prayers. I suppose posts like these are the digital equivalent of ‘penance’ in the investment universe.

In my last entry I mentioned Duke Royalty. What I’ve so far neglected to account for is the sale that partly funded its entry into my portfolio.

XL Media was one of several high-yielding smaller companies I invested in with high hopes in 2015/2016. For quite some time all went well and it doubled to over £2.00. From early 2018 the share price began to fall, culminating in a profit warning in June, and a collapse from £1.70 to just over £1. This resulted in a decision to sell at in effect break-even. XL Media shares continued to fall until October, although they are just (as of November 6^th) back over £1.

I’ve taken several lessons from the case:

1. Don’t invest in what you don’t understand. 

Every investment needs to pass at least two tests:

Firstly, the ‘Just a Minute’ Test: can you explain the investment case in 60 seconds without hesitation, deviation or repetition? In XL Media’s case being brutally honest I doubt I would have got to thirty seconds. Its revenue stream was something to do with ‘push-marketing’, getting people to click onto web sites of ‘variable’ quality. I’d under-estimated its vulnerability to regulatory threats and the fickleness of online consumers navigating from site to site with little loyalty.

Secondly, the Damodaran Test: drawing on the framework in Professor Damodaran’s 2014 text, Narrative and Numbers: is the investment story of a business possible, plausible and probable?

Whilst technically possible that XL Media could go on generating profits at a higher rate through its existing activities, a rigorous assessment of the investment case would have concluded that the changing regulatory and competitive environment made that prospect less plausible and increasingly improbable.

2. Companies with a low price-earnings ratio (XL Media’s PE was about 10 at time of purchase), favourable recent growth trajectory, and a high, growing, dividend yield (XL Media was on a yield of about 5%) are rare to find. But this appealing combination alone does not make an investment case. It is the sustainability of the business’s revenue streams relative to one’s investment horizons that determines whether it should be added to your portfolio.

So, why have I re-allocated the capital freed from XL Media to another, possibly riskier, AIM stock, Duke Royalty? 

Partly because, in my view, the higher prospective yield (just under 7% at purchase) justifies the risk, but mainly because Duke Royalty is unique in the UK context in offering a proven model capable of generating high initial income with scope for growth in both in dividends and capital.

Duke applies a royalty model well-known in North America by offering capital on a multi-decade basis to businesses in return for a stream of regular royalty payments. These royalties vary with the revenue of the businesses concerned and unlike most fixed interest loans have the potential to grow over time. A recent RNS announcement from Duke demonstrates this with a 6% uplift in royalty payments from two of the portfolio companies. From these royalties Duke pays a quarterly dividend to its shareholders, recently increased to 0.7p per quarter.

If (and it’s a big if) Duke Royalty can further diversify the current roster of royalty providers, there’s potential to replicate the success of American and Canadian counterparts such as the Diversified Royalty Corporation. 

The risks are clear: 

• to secure capital to provide to new royalty partners further placings will be needed. 
• If one or more of the royalty partners runs into difficulty the income stream to Duke shareholders will slow.  

Yet compared to XL Media there is far greater transparency on the underlying sources of income. In this case the royalty partners are long-established cash generative companies:

Temarca BV a Dutch cruise ship company; Brownhills Glass, a West Midlands based glass producer; Trimite Global Coatings, supplier of specialist coatings to aircraft and military vehicles; Lynx UK, a holding company for a portfolio of royalty partners; Interhealth Canada, a healthcare management business.

Subjecting Duke to the Damodaran test: it’s possible and plausible to see this doing well; the royalty model has worked well elsewhere and the management team has a long track record of securing such deals.

Ultimately the probability of success is best left to each investor’s judgement and taste for risk.

With an eye on the prevailing investment climate, I’m cautiously hopeful.

Just when things were going swimmingly...

Recent stock market moves in early October 2018 have provided a forceful reminder of Warren Buffett’s oft-quoted remark that when the tide goes out you see who’s been swimming naked. Whilst not completely nude, I have felt a little exposed in the last few days so now is a good time to reflect and summarise my financial and emotional responses to the recent volatility.

Firstly, although there has been virtually no hiding-place in long-only equity strategies, my tilt away from the UK to emerging and frontier markets has suffered from the combination of dollar strength and US/Asia trade concerns. Black Frontiers and Jupiter Emerging and Frontier income have fallen by more than 10% since early 2018.

I remain convinced of the virtues of an allocation to developing economies and indeed have increased my weighting to this sector in a hopefully income-generative manner by opening a small position in the recently London-floated Grit Real Estate Income Group - a real estate company invested in African commercial, retail and tourist-related properties. It’s the only Africa-focused investment I can find that promises a regular dividend.

Secondly, the recent sharp falls enabled me to re-purchase K3 Capital, a rapidly growing AIM listed company I’ve mentioned previously which I had sold in the middle of 2018 after it had doubled in just over nine months. The company’s most recent results indicated if anything an acceleration in progress and last week I was able to re-enter at a lower price than I’d exited. In retrospect I should never have sold out, but at the time wanted to move some funds into slightly higher-yielding ISA purchases, e.g. Duke Royalty, about which another time.

Thirdly, even before the recent falls I had been adjusting the portfolio at the margin. For example selling out of Numis to avoid over-concentration in investments directly related to the stock market (I retain positions in Polar Capital and Premier asset managers for the moment but with a little less conviction). I also moved out of the SGVB Lyxor ‘value’ ETF – which at the time was heavily Japan-dominated – to exploit the change in dividend policy of JP Morgan Japan Smaller Companies trust.

Fourth, notwithstanding the market sell-off, I have/am about to invest in two of several new investment trust launches: Fundsmith's Smithson investment trust in global small and mid-caps; and Asset Value Investors Japan Opportunities Trust , an activist trust seeking to exploit and correct what it sees as inefficient capital allocation in a number of Japanese small and mid-cap companies.

In short, rather than panic selling I’ve engaged in selective purchases. I have no idea if the markets have further to fall in the remainder of 2018 but taking a much longer-term view some of the valuations (briefly) on offer in the week of 8^th October looked tempting.

Beneath the headlines it may be that the first signs of a move back to ‘value’ were already discernible in September 2018 with the MSCI World Value Index outperforming the MSCI World Index during that month.

Suggested Reading

Two new books I hope to find time to purchase and read in the last few weeks of 2018 are Howard Marks’s Mastering the Market Cycle, and particularly apt in the wake of the Patisserie Valerie case, Tim Steer's case studies of how to spot fraudulent accounting The Signs Were There due in November 2018.

CAKE will eat itself?

A brief note on the Patisserie Valerie case: I have a soft spot for the company as one of its brands, Druckers, is a much-loved institution in my home city. The apparently fraudulent accounting is shocking and worrying (if we can’t trust public financial statements on what basis can we invest?) and more will doubtless be revealed about such matters as the ‘secret’overdrafts of £10m.

As the case came to light I had the audacity to initiate an E-mail exchange with Professor Aswath Damodaran at New York University (eminent author of key texts on investment valuation and the stimulating Musings on Markets blog) asking if he could examine Patisserie’s recent accounts. He was gracious enough to take a quick look and reported no obvious warning signs.

Thereafter, an astute online commentator noted that alongside the reports of £21m cash balance in the September 2017 Patisserie accounts and £28m cash balance in the March 2018 interims were figures for interest received of just £44,000 and £1,000 respectively which were perhaps more telling than was realised by anyone reading those reports at the time.

For the record last Friday whilst the company’s fate hung in the balance I did re-acquaint myself with the lemon cheesecake from a nearby branch of Druckers, but still hanker after the original pre-Patisserie takeover Druckers recipe.

From 2017 to 2018: the perils of 'success'?

Like most reasonably diversified investors 2017 was a positive year for my portfolio.
General market conditions all over the world were surprisingly benign with gains largely across the board, ranging from about 12% for the FT All-Share and S&P 500 indices, to double that for emerging markets.

I have had an extremely good run with a number of high-yielding smaller company shares purchased in late 2016 and early 2017, moving from the 'cut your losses' to the 'run your winners' part of that well-known investment saying.

In a September 2017 post I mentioned a number of those individual stockpicks, notably XL Media (XLM) which at the time of writing this in early January 2018, along with Caledonia Mining (CMCL), and Polar Capital (POLR), are up over 50% on purchase price, more than making up for the errors in KCOM (KCOM) and Coral Products mentioned previously.

Given that (investment) pride can come before a fall, the 'good' problem confronting me with some of these smaller-caps is whether to continue to hold or take profits. At the moment although it's unlikely that the next 12 months will see further spectacular gains in share price for those companies, the main reason for investing in them remains - high dividend income. Indeed, slightly to my surprise Polar Capital increased its latest interim dividend from 5.5p to 6p. I'll keep these companies under review as 2018 unfolds.

2017: Year of personal transition

More broadly, 2017 marked my exit from full-time employment, the sale of a second property, and a now almost complete reorientation of my portfolio to provide the income and capital growth to (hopefully) sustain me for the rest of my life.

As I suggested in a July 2017 post , political uncertainty in the UK underpinned my allocation of a higher proportion of the property proceeds than I'd originally envisaged in overseas-focused investments, notably investment trusts such as JP Morgan Global Growth and Income (JPGI).

A holiday in East Asia strengthened my conviction in that region, and emerging markets more generally, as a key component in any long-term investment strategy, so as well as topping up Jupiter Emerging and Frontier Income (JEFI), I invested in JP Morgan Asian (JAI), and despite its relatively low dividend of just over 2%, the Vietnam Opportunity Fund (VOF).

2018: more of the same?

Looking ahead, although investment returns in terms of 2017's capital growth without much volatility are unlikely to continue indefinitely, my investment strategy is now firmly set on the path of weighting in favour of dividend-paying vehicles, with about 5-10% of the portfolio at the margin available to explore potential capital growth opportunities, both tactically, and strategically.

As well as having a personal bias in favour of dividends and smaller companies, the stubborn contrarianism of value investing appeals to me on both intellectual and emotional grounds. The strong overall investment returns of 2017 concealed a considerable dispersion between the returns to so-called 'Growth' and 'Value' styles. In US dollar terms the MSCI World Growth Index grew by 30% in the year to 5th January 2018, MSCI Value by 'only' 16%. Consequently there may be even more value in 'value' than usual; but how to capture this possibility?

In an attempt to invest in 'global value' I've invested in the River and Mercantile World Recovery fund for several years, and being both pragmatic over the active/passive debate and quite impressed by the returns to the one ETF I currently hold, Wisdomtree Emerging Markets Small Cap Dividend (DGSE), I have opened the year by taking a small holding in a global value ETF: the Lyxor SG Global Value Beta ETF (SGVB).

It took an E-mail interchange with the ETF provider to clarify that due to its synthetic replication of the value index it aims to track, the SGVB fund holdings (a pool of liquid assets in familiar names like Banco Santander) do not match those of its underlying index. It is the underlying index performance which drives the daily value of the SGVB ETF.

At the moment SGVB's index has a 54% weighting to Japan, and only 12% in the USA, a marked contrast to another possibility I considered, the Vanguard Global Value Factor ETF (VVAL) which has over 60% invested in the USA.

SGVB's index aims to offer exposure to the 200 most undervalued global equities, above a $US 1billion market cap. threshold, rebalanced very quarter, according to this methodology.

Over the last 3 years SGVB has risen by 71%, compared to River and Mercantile World Recovery's 61%. It will be interesting to see if the more Japan-focused SGVB outperforms the actively managed and more geographically dispersed World Recovery fund. 

Either way one of the few predictions I'll venture for 2018 is the importance of having a 'value' element to one's investments.