This is the second part of a two-part transcript in which Fool.co.uk's David Kuo chats with Alex Wright of Fidelity Worldwide Investment's UK Smaller Companies fund and Fidelity Special Values Investment Trust. Alex explains what is meant by a small cap and how he goes about finding buying opportunities among the stock market's smaller companies. He also explains his criteria for selling them. They look at a host of small caps that include Micro Focus, Optos, Paragon
EDITOR'S NOTE: What follows is a lightly edited transcript of David Kuo's conversation with Alex Wright.
David Kuo: OK, so what are the managers at Paragon telling you about the subprime lending market?
Alex Wright: Yes, so Paragon's another investment in the fund, and it's something that's been there for a while, and it's still a big part of the fund. I think what's nice about this business is, this is another business that people don't really have the right perception about. So when you mention Paragon, people immediately assume this is an incredibly risky business, so people call it a sub-prime business, whereas actually they don't do sub-prime lending. What they do is, buy-to-let lending, and that lending's actually turned out to be considerably less risky than owner-occupied lending, which a lot of people think buy-to-let is very risky compared to owner-occupied, and I think that's because what has been risky is the sort of amateur buy to lending. So at the height of the last sort of housing boom, a lot of people, instead of selling their house when they moved, kept it and became amateur landlords, and a lot of that funding was done by new entrants to the space, so sort of Bradford & Bingley, Northern Rock, Halifax, HBOS. That lending turned out very badly, because these were people that didn't really have any skill in buy to lending; also, people that were landlords that didn't have any particular insight into it, and just thought there was easy money to be made. So that part of the market did go badly wrong, but actually Paragon's average landlord is the professional landlord, so it's actually their job, that they generally don't have other jobs, or at least buy-to-let lending is one of the main things they do. On average, they own about 12 properties, and so it's very different from that amateur lending space. Also, when you think about the risk of that compared to only owning one property, it's a much better risk, because if you're an owner-occupier, and you've got a mortgage and you lose your job, it becomes very difficult to pay your mortgage, because you don't have an income anymore; whereas if you're a landlord, you've got eleven properties, and one of your tenants loses their job, while it's very bad for that tenant, that's only 10% of your portfolio, so that is by no way a big problem for you, and also, unfortunately, if that tenant continues not to pay, you can evict that tenant and get someone else in to actually pay the rent on that property. So the risk on a portfolio basis for Paragon's actually much lower, and that sort of very much protects your capital in business. You then look at sort of, can this business grow again? Yes, it's been very difficult to get funding in this space, but also, when you look at competition, the competition in the buy-to-let space has completely evaporated. So Northern Rock has gone bust; Bradford & Bingley have pretty much gone bust; HBOS has dramatically pulled back from lending in this space. So the competitive position for Paragon looks much better going forward in terms of growth, as well as having this very core, stable cash-generative base, which is out there. So I think it's a stock that has the kind of attributes that I look for in a company. It has a reasonably safe, cash-generative core, but something quite interesting in terms of growth as well.
David: But hasn't Paragon been expanding its balance sheet by buying up the loan books of some of the bigger banks as well? Is this a positive or a negative for Paragaon?
Alex: Yes, at the edge also there's change in the business model at Paragon. So the core buy-to-lending business continues to be there, and they're writing new business as well. But also, because of the sort of credit crunch, there's a lot of banks trying to get rid of assets off their balance sheets, and so Paragon has quite a lot of excess capital, unlike most banks, which are actually under-capitalized. Therefore, they're able to buy some of those books of business off the banks, because they need to get rid of those assets in order to pay back the government, etcetera, who are taking away their long-term funding. So while these deals, individually you could say those are somewhat riskier deals than buy-to-let lending, that is true, each of them are quite small, and have very quick cash paybacks, so a lot of these books will pay back in sort of nine to fifteen months. Also, the pricing on them is very keen, because you're effectively buying off someone who's forced to sell the assets, when there aren't that many natural buyers of those assets who have the kind of administration teams that Paragon do, because of their base business. So I think that is an added impetus to the growth in buy-to-let lending, which is sort of super-powering, as it were, the short-term earnings of the business.
David: OK. So let's go and have a look at a fruit importer now. This is a company that I understand you also like -- it's called Fyffes. What is so attractive about importing bananas?
Alex: Yeah, so Fyffes is, again at its core is a very stable business. Obviously, banana consumption is pretty anti-cyclical -- it doesn't really matter how bad the economy is, people have still got to eat, so it's a very stable business. Admittedly, it's not a particularly exciting business, because again there isn't that much growth in this area. I guess what is interesting though is just quite how cheaply you're able to buy this business. This is something that won't really grow much above inflation, but the business is only trading on around six times current year earnings, and it's paying a yield of around 5%. So I think absolutely, especially given where interest rates are today, this kind of stable, cash-generative, even though it's very low-growth business, is very attractive at that kind of valuation. I think that over time people will pay a higher multiple for this kind of stability, given the sort of very low yields available elsewhere.
David: But in the case of Fyffes, what they recently said was that banana prices may have to rise. How elastic is banana consumption here in the UK? Are they likely to see a fall in demand for bananas, as a result of increases in prices?
Alex: Banana consumption isn't particularly elastic.
David: Rubber bananas, hey?
Alex: Yeah! Like, if bananas rose when prices of other fruit weren't rising, then you may see market share loss from bananas going to other fruit, but I guess the reason why bananas are going up, along with lots of other foodstuff, is that the weather in certain areas has not been particularly favorable, and the overall crop harvests are down. So there's general fruit price inflation at the moment, so you're not really seeing an effect which is banana-specific. Therefore, sort of overall I wouldn't expect that to have a big effect on overall volumes.
David: OK, so people aren't going to split from bananas then, yeah?
David: OK, now let's have a look at another company: DCC. There is a kind of linkage between DCC (formerly it was called Development Capital Corps) and Fyffes, isn't there?
Alex: Yes, so DCC and Fyffes are two stocks which are both dual-listed, so they're quoted in Ireland and in the U.K., and the headquarters are both in Ireland. Actually, I found quite a few stocks recently which are quite attractive, which are quoted with a list both in Ireland and the U.K., and they make up about 15% of the fund today. I think the reason for that is that I'm looking for unloved, undervalued stocks that people are not paying attention to for some reason or another, and trying to identify the stocks where I think that is an inappropriate thing to do. I think the Irish market has been caught in this overall problem in that overall trading volumes are down a lot across Europe, and the Irish market itself is very small. The banks used to be the key part of that market, and those have generally been nationalized. So there's very little interest, or money invested, in the Irish market now, and you can see that in the sort of stockbroking community in Ireland, which has really been sort of decimated by the downturn. That means there's a lot of what are quite interesting companies that primarily have most of their revenues and profits outside of Ireland, which are quoted in that market, only really have coverage by the Irish brokers, and are therefore trading at much cheaper valuations than you might see for primarily quoted U.K. companies, just because of that historical legacy. I think going forward, those companies are acutely aware of the lack of interest and volume in Ireland, and are trying to do something about that. So in fact, another Irish-quoted company, United Drug, which I own, is actually going to cancel their Irish listing, so instead of having a U.K. and Irish listing, they're just going to have a U.K. listing, which will make them eligible for the FTSE 250, and hopefully get more interest in that company going forward. I think that's something you might see more Irish companies looking to do, given that Ireland is now such a small market.
David: So are you likely to look beyond Ireland and the U.K. and into Europe as well? Because Europe is also being trashed at the moment, isn't it? So therefore, are you likely to find bargains in Europe?
Alex: The fund, obviously being a U.K. fund, concentrates on investing in the U.K. So Ireland, because of the dual listings with the Irish and U.K. lines, means I can invest in those, because they are quoted on the LSE as well as on the Irish exchange. While I have invested in a few European companies, they're likely to be a pretty small part of the portfolio, so sort around 5% of the fund. I do have the ability to invest up to 20% outside of small cap U.K., but I actually tend to use that to invest in slightly larger than 1.5 billion cap companies, because I don't like to have to sell a company. If I bought it just below 1.5 billion, it goes up, but I still think the valuation is good, I can actually continue to hold that until I want to sell out, so that restricts my ability to buy too many European-quoted stocks.
David: OK, now the company that you mentioned earlier on, United Drug -- can you tell me how big a percentage of your portfolio is in United Drug?
Alex: Yeah, so that's actually the largest percentage of any company in the portfolio today, which is about 5%, and that's quite unusual, because I generally only buy up to around 4% of the fund in an individual stock. That's to prevent too much of the fund being just driven by one specific company. The reason that's up at 5% today is, it's a stock that's done quite well recently, and so it was 4% when I bought it, and has become 5%, because it's outperformed, and I generally don't look to trim companies until they get to about 5% of the fund. I do still think there's an awful lot of upside in this company going forward, and therefore I will only sort of trim out of that name gradually.
David: So you don't believe in running your winners then, do you?
Alex: Yes, I very much do believe in running my winners, and I generally buy stocks in stage one, when I'm sort of getting into a name quite slowly, and generally only buy about 2% in that stage. If the thesis I was then looking for in terms of the positive change happens, the company moves into what I would classify as stage two, and generally this was when stocks would outperform, because you're seeing positive change. That's when I'd be quite happy to allow the position to go up to around 4% of the fund, only sort of trimming once it's reached my upside target price. I guess the thing with United Drug, it's something I bought recently, and it was something that was already showing positive change before I bought it. So again, I think it's because of the Irish connection, the market was just very slow to realize the positive change coming through, so I actually bought a very large position in it immediately, sort of up to that 4% level. Therefore, I have cut it back to stop it becoming too much of the fund, but I am keeping quite a large position in it, because I do see quite a lot of further upside.
David: But when I looked at United Drug recently, the thing that struck me was that the turnover was relatively flat over the last few years. Did that strike you as well as being odd for a growing company?
Alex: So basically, this is a company that's changed a lot over the last five years. So if you go back five years ago, sort of 2006, this was primarily an Irish-based distributor of pharmaceuticals, so effectively what they did is, they bought drugs from the large drugs companies, and they then sold them to pharmacies, and those pharmacies were reimbursed by the Irish state for those drugs, which then went to patients. Now, that was a great business for a number of years -- as the Irish economy grew, the Irish population grew, and people became more wealthy and the government became more wealthy. Now obviously, since the Irish economy's rather spectacular problems, the Irish state no longer has anywhere near as much money, and so the prices they've been willing to pay for drugs has been consistently falling, so it's been falling 5% to 10% per annum for each of the last five years. Now, the good news is that over that five years, United Drug has not stood still, so it isn't now primarily a drugs distribution island. Only 20% of the earnings come from Ireland now, and they've actually got businesses in the U.K. and across continental Europe, and in the United States now. So that part of the business in Ireland is still structurally challenged, because of the state clearly having less money, and there continues to be price falls in that market, but because that's now only 20% of the business, I do think you're going to see growth reaccelerating from all those new areas, and therefore it's quite an exciting company for me going forward, because the story has really changed, and I don't think that many people have yet realized quite how much the story's changed.
David: OK, so I know that you've already got three investments in Ireland -- is there anything left for the rest of us?
Alex: When you look at the Irish market as a whole, there's not too many things there. So I think, stocks with significant trading volume, you're only talking 20 -- 25 companies, and actually there's five stocks quoted in Ireland that I own.
David: You've bought most of them already!
Alex: Yeah, I think it reasonably unlikely that I add any more to the fund in Ireland, although in fact United Drug are about to cancel their Irish listing, so from sort of the 15% that I've got in Ireland today, that's going to be 10% reasonably soon, but I don't intend actually selling my United Drug.
David: OK, that's good news. Now, the last company I'd like to look at is Speedy Hire. Now, Speedy Hire, as far as I know, just hires out equipment to the construction industry. Does that tell me that you are quite bullish on the U.K. construction industry?
Alex: You're right -- Speedy Hire's primary business is renting out mainly small tools to the construction industry in the U.K. I don't actually have a positive view on the demand for that industry going forward, because I guess, when you look at what's been happening to construction, the demand side has been falling quite a lot, and I think that's going to continue to be the case. Obviously, there were things like the Olympics were a positive boost, but that was all finished a little while ago, and while there are a few big projects like Crossrail out there, there were a number of the large projects that were working off from the boom years, and not coming back. So I think the demand outlook will continue to be poor, and that's why the stock is very cheap versus history. I think what people miss with this stock is that, over the last five years, since the start of the downturn, the supply side of the business has changed very dramatically. So Speedy Hire is the number one market share in the U.K. It's a reasonably consolidated market, so the top three businesses have about 45 -- 50% market share, and outside of that there's a lot of little mum and pop businesses, which are really finding it very difficult to finance their kit, and very difficult to actually stay in business. So a number of those have actually closed up, and the top three businesses as well have reduced the amount of kit that's in the market. Because of that, you're starting to actually see positive pricing in the market now, that supply has actually fallen faster than demand. So the returns that this business has been making, which have been very poor through the downturn, are starting to improve, because of that positive price dynamic. When you look at the valuation, this business is actually trading at only 0.75 times book, so that means they're trading at only three-quarters of the value of the kit they've actually got on their balance sheet. So that shows you the business is very cheap compared to liquidation value, if you just sort of sold all their assets, and therefore returns are very likely to rise, because there's no incentive for people to buy new kit currently, when you can buy Speedy in the market at less than the value of their kit. So I do think it's an interesting story because of the supply side, not because I think U.K. construction is necessarily going to recover very quickly, which I don't think it is, unfortunately.
David: So if you're not that bullish about the U.K. construction industry, what is your gut feeling about the U.K. markets on the whole, over the next few years?
Alex: That's a really tough question!
David: I didn't say anything was going to be easy!
Alex: Yeah, I suppose it's very much a bottom-up style, so I like to see what companies are doing, and are companies attractively valued. I definitely think there is a lot of value out there in the market today, especially in the small cap areas. So most of those companies that I've talked to are trading at less than 10 times earnings; dividend yields in the sort of 3% to 4%, if not higher area. I think certainly absolutely versus the yields that are available on other assets, especially bonds, that that is a very attractive valuation. So for absolute returns from the companies that I look at, I do think they're going to be good over the next two to three years. In terms of how that plays out, sort of day-to-day and week-to-week, it's a much tougher call, and I try not to be too swayed by the macro, because there's a lot of things happening, and if you spent your time on that, you could spend an awful lot of time and not really get anywhere.
David: Yeah, I have to agree with you there. I don't fully understand why anybody would invest in bonds at the moment, but I am sure there are some very good bond fund managers out there who are doing a cracking job.
Alex: Yeah, no -- there certainly are. I could mention some names, but I will resist.
David: I'm sure you can. Well, thank you so much for coming in today, Alex. I have one more chore to perform, which is to sum up today's podcast with what I hope will be a suitable quotation, and the quote comes from Hugh Allen, who said: "Jumping at several small opportunities may get us there more quickly than waiting for one big one to come along," and I presume you're actually looking for loads and loads of little small opportunities among the small caps?
Alex: Yeah, I certainly am -- that's very much what I'm looking to do.
David: Excellent. Now, thank you so much for coming in today, Alex.
Alex: Thank you.
David: This has been Money Talk, I have been David Kuo, and my guest today has been Alex Wright of Fidelity Worldwide Investment. He is also manager of the U.K. Smaller Companies fund, and is also in charge of the Fidelity Special Values Investment Trust. If you want to find out more about investing, you can sign up for a copy of our free report, 10 Steps To Making A Million In The Market, by going to fool.co.uk/podcast. Until next week, happy investing!
That was the second part of a two-part transcript in which Fool.co.uk's David Kuo chats with Alex Wright of Fidelity Worldwide Investment's U.K. Smaller Companies fund and Fidelity Special Values Investment Trust. They discuss Paragon, Fyffes, DCC, United Drug and Speedy Hire.
In the first part of the transcript, Alex explains what is meant by a small cap and how he goes about finding buying opportunities among the stock market's smaller companies. He also explains his criteria for selling them, and looks at a host of small caps that include Micro Focus and Optos. To read the first part of the transcript, just click here.
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