Our Managers
James Hanbury
Partner | Portfolio Manager
Current Outlook
One of the concerns that has been overhanging the market was lifted in July. The banking sector benefited from a watered down Basel III proposal, which gives banks longer to raise capital ratios and should be an incremental positive for lending. More good news for the banking sector came from the results of the European "stress tests" which almost everyone passed. Although it was a missed opportunity to recapitalise European banks, it improved visibility and restored confidence. The fund benefited from its holding in Barclays (+0.66%) and in Lloyds (+0.56%).
A good month for the fund would have been better still had it not been for an unmitigated disaster in the form of our holding in social housing contractor Connaught which lost the fund (-1.27%). As recently as 08-July, the company management assured the market that under 'current board expectations we fully expect to be able to operate within our existing covenant levels'. This was followed by share purchases from the Chairman and reassuring calls with the finance director. Over the next few weeks there was effectively a run on the company's finances as trade creditors demanded to be paid with delivery or even in advance. In under 3 weeks the net debt guidance for an August year end had gone from £120m to over £200m. Following the subsequent profit warning we sold our holding at a significant premium to where it now trades as the likelihood of equity being worth zero was too high. A bitter lesson learnt and a reminder of the importance of balance sheets and market leadership in what is still an uncertain financial environment.
There are several positions in the portfolio that we are very excited about and after visiting Hargreaves Services in July our enthusiasm was further fuelled. Hargreaves Services is a UK based coal and coke producer/trader that is trading on a PE of 6 x; at this valuation the market is pricing in terminal decline. However, we believe the company has a good chance of growing earnings at c. 20% per annum for the next three years. The company is high quality; the current management team has compounded revenue and earnings at 32% and 41% respectively since IPO in 2005, the CEO owns 11% of the equity, 50% of profits derive from an oligopoly that the company dominates (wholesale of coal for niche UK markets), and the company has attractive growth potential via European expansion.
Our visit to the company's coal mining operations in Yorkshire provided further evidence of high quality operators. In our view the company should be trading on at least 10 x earnings; this derives a fair value that is more than 60% above the current share price. So why is this company so cheap? We believe that investors are overlooking the stock for several reasons. Firstly the company's relatively low market capitalisation (£171m) and AIM listing makes it un-investable for many fund managers. Secondly, whilst we are excited by Hargreaves' high returns on capital and strong growth prospects, we suspect that others are deterred by the fact that the overall coal industry in Europe is dirty and in structural decline. Finally cash flow in the last year and a half has lagged earnings; investors may require evidence of strong free cash flow before according the company the rating it deserves. We believe that there are good reasons for the weak cash flow (working capital, intensive European expansion, and heavy investment in the Yorkshire coal mine) and that cash flow will recover sharply over the next two years. The growth potential, high visibility of earnings, and low multiple, are part of the reason for our 6% holding in the fund.
30th July 2010