'Head over Heart' - (or exclude emotional baggage)

Thursday, 25th June 2015 09:35 - by David Harbage

Sensible private investors in equity will no doubt have a diversified portfolio of collective investment vehicles and company shares, but within the latter they may well be inclined towards a few favourites. All individual stocks, however apparently successful, must have a price at which the prudent intelligent owner would consider them as being overvalued and would decide to sell.  

When unexpected bad news emerges, investors should reconsider the merit of an investment and make a fresh assessment of the business, and its market worth (based on amended future profits and asset value). Perhaps the ‘new’ adverse news is merely a temporary exceptional blip or maybe, like the proverbial ‘London bus’, the profit warning or other adverse event might prove to be the first of several. If a stock is highly valued – in anticipation of a strong earnings outlook – then it clearly has further to fall upon any disappointment.

Two of the company stocks mentioned in the 15 January blog ‘A final 10 stocks to follow in 2015’ represent interesting and somewhat painful examples of businesses that have encountered and reported difficulties. This Blog seeks to proffer further thoughts on each of Gable Holdings (GAH) and Plus500 (PLUS), beginning with a reiteration of the writer’s comments on those companies from the 15 January blog:

“A forward-looking PEG ratio (which compares the PE multiple of a stock with the pace of anticipated growth in earnings) is one of the key metrics an investor can employ to assess a business – taken in conjunction with an assessment of the quality of the earnings (by which I mean the reliability, in particular the extent to which profits equate to actual cash received, as well as the sustainability of the earnings). Insurance is an area where future EPS is typically subject to pricing annual premium renewal and the risk underwritten, as well as the ability to win new business. GAH is a fast growing non-life insurer offering specialist policies for commercial sectors in the UK and across Europe, characterised by a low cost online underwriting platform, exploiting niche insurance segments (neglected by the majors) and growing its broker distribution channel. The business is highly profitable (combined ratio 72%), features a strong balance sheet (£27m cash) and, like most of this article’s selections, an attractive PEG (of below 1.0). This £75m cap is forecast to deliver 7.87p EPS this year representing a PE of 7.2 and PEG of 0.2; a growth vehicle, profits are wholly reinvested and no dividend is envisaged.” 

“Continuing the theme of online businesses, PLUS is a web-based (smartphone & tablet friendly) platform for retail customers to trade CFDs in equities, foreign exchange, indices and commodities, featuring a very low cost base as compared to the peer group. The company believes its platform’s ease of use, targeted online marketing and an emerging market focus (available in 50 countries via 31 languages) is a winning differentiator. This Israeli-based, £728m market cap launched on AIM in July 2013 @115p and a succession of trading upgrades has jet fuelled the stock price, aided by a strategy to pay out at least 50% of retained profits. Based on EPS of 72.6p forecast for 2016, the stock is on a forward looking PE multiple of 8.8x and an income yield of 6.9%. Plans to move from AIM to a full listing would broaden the investor base and aid credibility.”   

On 12 February, GAH advised the market that premium growth had been strong in 2014, (35% higher than 2013), and that this trend was expected to continue through 2015 and 2016. However, management also commented on the company’s exposure to a particularly large fire claim in France and, although 80% was covered by reinsurance, acknowledged that its underwriters had under priced this particular French market risk. Exacerbated by a weak Euro, profits for 2014 were set to be lower than 2013 and fall short of broker (including Finn Capital and Numis Securities) forecasts. The final results for 2014, when announced on 28 May 2015, showed an eventual £3.1m loss on the French fire claim and another £2m, net of reinsurance, loss on a single domestic claim. Big, unacceptable ‘hits’ for a business of this size represented the consensual view.

A small company perceived to be in growth mode, sentiment towards GAH has turned negative despite director purchases – notably CEO William Dewsall buying another 100,000 shares in June to take his stake to almost 25m shares, or 18.3%. This stock should be regarded as a typical insurance business: operating in a cyclical industry with inherent uncertainty. Planned new product launches will progress diversification, alongside new distribution agreements, can improve the quality of the business by reducing specific claim risk.

Sharing the good times with its investors would be a good start to reversing a share price slide that has seen the stock halve from the 52p level that prevailed at the beginning of the year. Paying a dividend, of say 2p (in respect of 2016’s forecast 7p EPS) appears reasonable and would attract income seeking institutions and have appeal within personal investors’ tax wrapped vehicles. But an upward re-rating of the stock may have to await evidence of better numbers, and an absence of further significant ‘banana skin’ liabilities, in the interim results (due mid-September) covering the half year to the end of June.      

By contrast with GAH, PLUS released a very positive trading statement on 16 April 2015, featuring record revenues and customer numbers alongside growth in market share, but a month later the company began to announce that it was in dialogue with the FCA in respect of its client on boarding and anti-money laundering processes. Clearly, back office administration had not kept up with the company’s acclaimed marketing-led capability and most UK clients (50% of total business, by revenue) have been unable to trade pending a costly (time and financial) remediation. In short, the reputation of PLUS was ‘shot’, the share price (which had appreciated from 602p at the beginning of the year to 770p on 13 May) fell to 248p on 22 May until an opportunistic predator emerged in the form of another Israeli technology business, Playtech (PTEC) whose £4 per share cash offer was accepted by the board of PLUS on 1 June.

What should shareholders do now? On the face of it, PTEC’s offer is lowly pitched (if PLUS’ problems prove to be short-lived) and is immediately earnings enhancing to the more highly rated technology business, which provides software to the gaming industry. Post its profit warning, brokers (including Liberum Capital and Numis Securities) reduced their earnings forecast for calendar years 2015 and 2016 from 69.2p and 77.6p respectively to 48.5p for both years – implying a PE multiple of 8 times and a 28.8p pay-out indicating a dividend yield of 7.5%.

That hedge fund Odey Asset Management and JP Morgan Chase have increased their stakes to 19% and 7.5% respectively, suggests they believe PLUS is worth more than £4. However, unless they can find a ‘white knight’ or engineer a counterbid, PTEC are likely to succeed (under the terms of Israeli take-over rules) and dissenting shareholders can expect PLUS shares to fall sharply if PTEC walk away. In which case, longer term investors – be it in PLUS shares, or via PTEC - will have to make a call on whether PLUS’ business has suffered mortal damage from its administrative misdemeanours.

Now that emotional froth – like the share price’s momentum – has been blown away on both PLUS and GAH, investors should be able to make a decision in the ‘cold light of day’. A fresh assessment of the company’s ‘raison d’etre’ (or special appeal), a sober hard-headed review of the firm’s activities and clarity of its business model (to deliver sustainable profits) should be carried out in an unhurried way before considering if its valuation is appealing compared to its industry peers and the wider equity market. Considerations like “would I buy today (at this price)?” can be helpful in making active positive decisions, be it to Buy, Hold or Sell, rather than allow lazy inertia to prevail. Finally, the merit of owning a broad spread of businesses, across a wide range of industrial sectors, is also reinforced by unforeseen events such as have impacted upon GAH and PLUS.                                           

David Harbage                     

25 June 2015