Clearly J Smart (LSE:SMJ) has more money than it knows what to do with – see yesterday’s newsletter. The money in bank accounts, shares and other liquid assets is generally not needed for operations.
Indeed, the investment property holding division could easily take on some borrowing to finance itself and/or add to the cash pile in what I call the “Cash-Land-Shares Division” – after all, investment property produces £4.8m rent annually so could support a fairly high level of bank debt. The capital held in liquid form produces very poor returns – less than 1% on the cash. We can conclude that the directors run a very inefficient balance sheet. We can also conclude that one day that money might be handed to shareholders. The directors have been on the path of distribution for some time, but they have room to accelerate this – see table. If the directors continue to produce earnings north of £3.6m but distribute £1.6m to shareholders then they will accumulate an ever larger cash pile or warehouses. A special dividend anyone? Or a large rise in annual share buy backs? Market capitalisation is 42.4m shares x £1.253 = £53.1m Musing on the future of that cash NCAV is £96m and the number of shares is 42.4m therefore NCAV per share is £2.26. By buying-in 1.5% of its shares each year at a price below NCAV per share the controlling family and the other remaining shareholders gain an increase in net current asset value per share. Average profit after tax over the last five years is £3.7m – see bottom of the table (the other numbers are before deduction of tax). The Group profit number has been dragged down by the losses made in the Construction division which averaged an operating loss of £1.9m over seven years. If these losses are now being dealt with by the directors then the average annual profit after tax will be over £5.6m, all else equal. An attempted valuation – conservative approach Assume to start that the company produces £3.7m after-tax profits in all future years. Assume in each future year that this £3.7m is allocated as follows:
Shareholders who do not sell any shares benefit from,
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J Smart (LSE:SMJ), as well as holding a large portfolio of industrial units and offices to rent out has money stored in bank accounts, in stock market shares, in land and in half-finished buildings. I regard this capital allocation as if it were to a business largely separate from the core property holding division (see yesterday’s newsletter).
Most of this money could be paid out to shareholders without much impact on the investment property holding division. You can see from the table that the cash pile is very large, at £23.1m, for a business with a market capitalisation of £1.253 x 42.4 shares = £53m. It also has £0.9m in shares and another £4.2m in land. Working in progress property developments chip in another £1.9m. Even after deducting an overdraft of £10.1m the company is left with £20m in these fully, or fairly, liquid assets. Yesterday I showed that J Smart had £78.6m of property with no debt on that, producing a net income of £4.8m. To this we can add £20m of net liquid assets. But there is a third division which is perennially loss-making, so we need to take that into account when judging the firm’s value. The Construction division This generally engages in building social housing when a deal can be made with a housing association, and in private housing. Much of the time there is no project. The directors describe this industry as “competitive”. So, despite having good relationships with potential clients and a good reputation they seem to have gone through long periods of either low activity resulting in a large group of underemployed tradesmen receiving full wages or periods of work on low margin. When John M Smart was in charge (he retired ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 At one time J Smart (LSE:SMJ), the Edinburgh-based family-controlled property company, concentrated on being a constructor of commercial property for other organisations. Today, that business is diminishing after years of losses. Now the main attraction for share investors is the large collection of industrial units and offices it owns and rents out in the Scottish Central belt.
The company holds 1m sqft of property available for letting. Three-quarters of the value is in industrial units; the remainder offices. Investment property is revalued by the directors each year, with a sample checked by professional valuers. Market capitalisation of J Smart: £1.253 x 42.4m shares = £53.1m. Net income from renting and servicing offices is around £5m. This source of income decreased in 2020 because a lease on one industrial unit came to an end and J Smart directors took the opportunity to demolish with the view of building later. The vacant land is held with inventories as “land held for development”. In 2020 “Excluding the rent from this property, over the remainder of our investment property portfolio our rental income has increased due to both rental growth and increased occupancy” (2020 Report). Not many landlords can say that for the pandemic year. Notwithstanding the 2020 dip, note the steady rise in net rent income in recent years. ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 I’ve bought J Smart (LSE:SMJ) at 125.3p for my Net Current Asset Value portfolio. Market capitalisation is 42.4 shares x £1.253 = £53m. I estimate its net current asset value, NCAV at £96m. It is consistently profitable and has a very low-risk balance sheet.
The lion’s share of its assets are industrial properties (e.g., modern warehouses and light industrial units on modern estates). The market value of these is £57.9m and they are 100% let even after a year of Covid. It also holds £20.6m of offices and has £23.1m of cash. Rent collection levels at the last rent quarter date before the year end (June 2020) are an impressive 96%. The annual report for the year ending 31st July 2020, published in November, stated: “Rental growth and occupancy levels have continued to improve, as have property valuation levels. Concerns were raised regarding payment of rent, but rent collection levels at the last rent quarter payment date prior to the financial year end, currently sit at 96%. Regrettably, we have lost some tenants whose businesses have been affected by the coronavirus crisis. However, we have been able to fill these vacancies with new tenants.” Its only liability of any significance is an overdraft of £10.1m. There is a tiny pension deficit of less than £1m. And the key directors, members of the founding family, show remarkably good character by frequently waiving their dividend, by taking only modest remuneration, and by deciding that the company should repurchase around 1.5% of its shares each year. I held J Smart’s shares from 30th January 2019, bought at £1.13, until 15th April 2020 when they were sold at £1.102 as my fear of deep recession made me very cautious and I raised cash. I’m very pleased to be able to buy back in at a good price now that the risk of deep recession has diminished dramatically. (Earlier newsletters on J Smart: 1st – 7th March 2018, 23rd 30th January 2019). The three businesses The directors see the company as having two divisions. The first holds property which is then rented and sometimes traded, the second permanently employs about 100 tradesmen skilled in building houses, offices and industrial units for external organisations such as housing associations and councils. To gain greater clarity I prefer to split the company into three by drawing out from the two divisions mentioned above the cash, shares and land not directly supporting either the property portfolio nor the construction business.
After deducting the costs of running this property portfolio we have an annual income of about £5m. 2. Cash, land and shares division. This has £23.1m of cash sitting in various bank accounts. If we deduct £10.1m overdraft (the only borrowings) then net cash is £13m. But that is not the end of the story. It has so much liquid resource floating around that the directors have placed it elsewhere, £0.9m into shares on the LSE and £0.05m into deposits requiring more than three month’s notice to release. On top of this it has £4.2m invested in land held for development and £1.9m in work in progress which is mostly land and buildings. All in all, there is a net (after paying off borrowings) liquid resources, fairly liquid anyway, in this division of more than £20m. 3. The busy-but-unprofitable Construction division. A great grandfather started this business in 1947. As well as building h………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Lloyds Banking Group’s (LSE:LLOY) main business can be simplified to taking in customer deposits through Halifax, Bank of Scotland and Lloyds and then lending that money out, mostly for people buying houses but also for credit cards, unsecured personal loans, for buying cars, for businesses.
At any one time it has about £410bn - £450bn of customer deposits and it lends to customers about the same – see Figure 1. Note the stability over time in both deposits and loans granted. The pie chart – Figure 2 – shows that the majority of the money owed to Lloyds, Halifax and BoS is in the form of ultra-safe and secure mortgages. An important metric used to assess banks is the proportion of its lending that is financed through deposits rather than by the bank borrowing money in the financial markets (going for “wholesale funding”). In the case of Lloyds Group loans to customers are pretty well entirely financed from deposits: Its “loan to deposit ratio” was 107% in 2019 and 98% in 2020. This is good. Funding a substantial amount from financial markets leaves a bank vulnerable to the market suddenly drying up in times of stress. Ordinary people’s deposit money is a much more reliable source. Lloyds does borrow some money from the financial markets, and does have some exposure to derivatives, but this is relatively small and offset by financial assets such as bonds, derivatives and cash. Leverage ratio Figure 3 shows the ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Yesterday’s Newsletter pointed out that Lloyds’ current share price of 41.69p (LSE:LLOY) is only 9.9 times underlying earnings averaged over the last ten years. At face value, it therefore seems cheap if we assume merely that EPS over the next ten years will match those of the last ten. However, there are reasons to believe that Lloyds could do better in the future. If it does, and it checks out on financial stability and qualitative factors then it would seem exceptionally cheap.
Reasons we might see a significant growth in earnings per share:
At the same time investors in the long-term bond market currently earning 0.8% pa will worry that inflation is going to erode the real value of their savings. The result may well be a rise in long-term interest rates and a suppression of short-term rates. This “steeping of the yield curve” is music to the ears of bankers because one of their key societal roles is “borrowing short and lending long”. In other words, depositors usually have access to their money within a few hours or days – banks borrow from them for short periods. These liabilities for banks therefore pay puny interest rates, if any at all. On the bank asset side – mostly lending to businesses and home-owners – they lend for many years. As long-term interest rates rise so will the gap between what banks have to pay to access money at the short end and what they receive by lending it out at the long end. Even over the last ten years this gap, called the “net interest margin” has been respectable, generally in the range 2% to 3% - see table. Now we have reasons to believe that, at least for a while, NIM could exceed the top end of this range. Each 50 basis point (i.e. 0.5%) rise in the NIM should add roughly £2bn to Lloyds earnings before tax. That is around 2.8p per share. Average EPS over the last ten years were 4.2p, so an uplift of 2.8p is considerable. How long the wider gap will last before short-term interest rates are raised is anybody’s guess, but at the moment central bankers seem really determined to hold rates down. Net interest income, £bn Net interest margin Impairment, £bn 2020 10.8 2.52% 4.2 2019 12.4 2.88% 1.3 2018 12.7 2.93% 0.9 2017 12.3 2.86% 0.8 2016 11.4 2.71% 0.6 2015 11.5 2.63% 0.6 2014 11.0 2.40% 1.1 2013 10.9 2.12% 3.0 2012 10.3 1.93% 5.7 2011 12.2 2.07% 9.8The other major element in bank profitability is the “loan impairment” rate, i.e., a provision which estimates the hit caused by loans going bad. Loans are shifted into the impaired category when it becomes probable that not all of the related principal and interest payments will be collected. During the Covid year the directors’ estimate of impairment rose to £4.2m or almost 1% of loans to customers. In more normal years the figure is under £1bn. The directors are targeting impairments for 2021 to be below £2bn. If the economic recovery builds up steam that should be easy to accomplish. Quote from a February FT article: “But this domestic retail and business lender is nevertheless a particularly useful window on the nation. The UK now expects to recover faster from the pandemic than most business planners recently imagined…Lloyds, whose emblem is a black horse, is cantering out of trouble at pace. Loan loss provisions of £4.2bn pushed full-year pre-tax profits down 70 per cent to £1.2bn. But fourth-quarter impairments of £128m were light…core tier one equity, therefore, rose to 16.2% of risk-weighted assets. Allow for software and accounting charges and that is still some way above the minimum target, equivalent to about 3.5p a share. No one suggests Lloyds will pay the lot back to shareholders as soon as the payout cap comes off. But there is plainly plenty of firepower for returns and for investment. Lloyds’s net interest margin is a stout 2.46 per cent. This suggests the pandemic has suppressed price competition, as well as consumer spending. A consequence of the latter is a flood of deposits. A stimulatory grassroots splurge is already apparent in soaring holiday bookings.”
It has the largest UK branch network and is the largest digital bank with 17.4m online active customers (12m are mobile app users). It concentrates in the geography where it has competitive advantage with 97% of revenue coming from the UK. It claims a one-quarter share of UK consumer credit cards, slight less than one-quarter of share of personal current accounts and deposits, mortgages and small business len………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 I’ve bought shares in Lloyds (LSE:LLOY) at 41.69p (Market capitalisation £29.4bn). The group, which also owns Halifax, Scottish Widows and Bank of Scotland, seems on a low price relative to proven earnings over the last ten years, and it has a strong balance sheet providing plenty of downside protection.
While its shares have risen from last autumn’s lows of 24p on relief at having escaped the prospect of mass loan defaults they have not yet incorporated a conservatively estimated earnings power number based on analyses of, (a) the historical record, and (b) an allowance for the positive impact on earnings power of the economic recovery on customer defaults, on net interest margins and on expansion of lending and other activity such as insurance. Nor does the current share price fully take into account the potential for significant rises in dividends and/or share buybacks. This greatly increased flow of cash to shareholders seems likely to occur given the overly cautious balance sheet. The Group has a 16.2% risk-weighted reserve of shareholders’ equity backing up loans, etc. This high level of equity reserves becomes increasingly anomalous (too timid and inefficient) as profits grow in the recovery and are stacked up on the balance sheet. For comparison, Lloyds’ risk-weighted reserve back in 2007 was 8.1%, the same as in 2012. Regulators today like to see a larger pot of money coming from shareholders to back up lending than they did a decade or so ago and so we should expect an elevated level. However, even the ultra-cautious regulators are only demanding 11% for Lloyds, not 16.2%. The more stringent metric, the leverage ratio, which basically compares the amount of shareholder equity capital as a percentage of total exposure via loans to customers, etc. (i.e. raw bank assets without any risk-weighting), has been built up to 5.8% in 2020 compared with about 4% in 2012. Currently the banking regulators require a mere 3.25%. The risk-weighted equity reserve (called CET1) and the leverage ratios both indicate that Lloyds, (a) has not lent out so much that it is vulnerable to financial distress should a normal recession occur with its attendant customer defaults, and (b) has plenty of room left to expand its balance sheet, i.e., lend a lot more, before it comes close to turning a very strong balance sheet into one that poses a worrying risk for holders of its shares. A history of earnings Before considering the earnings numbers over the last ten years we first need to think about the inclusion of deductions in each of those years for Payment Protection Insurance, PPI. The selling of PPI was stopped in 2006, but the compensatory pay outs from the banks did not really get going until a few years later. In the period 2011-2020 Lloyds made payments totalling a massive £22bn. The accounting treatment in those years was to deduct provisions for PPI before arriving at “statutory profit before tax”. So here is the question: in order to understand underlying earnings achieved in each of the last ten years should we add back the PPI provisions? After all, none of sales of PPI occurred in the last decade and nor are such pay outs going to be repeated in future years, which is where our focus really lies. If we are trying to estimate future earnings power then I suggest we add back 80% of PPI provisions each year (a 20% deduction is made because tax was lowered due to the PPI expense – it’s a rough estimated rate, tax was actually at a wide variety of rates over the last decade). Profits 2011-2020 £bn 2020 2019 2018 2017 2016 Net interest income (interest income minus interest paid out) 10.8 12.4 12.7 12.3 11.4 Other income 3.6 4.7 5.1 5.2 5.2 Net income 14.4 17.1 1………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 In the early 2000s Joe Brandon and Tad Montross really turned around General Re. In thirteen of the next fourteen years between 2003 and 2016 this part of Berkshire reported an underwriting profit – see Figure 10.6. It did so on a decreasing level of business: premiums fell from $8.25bn in 2003 to only $5.64bn in 2016 – see Figure 10.4. In 2017 the data for General Re was subsumed within the Berkshire Hathaway Reinsurance Group when Ajit Jain was put in charge of all insurance activities in early 2018.
The lower revenue also pushed down float from $23.65bn in 2003 to $17.70bn in 2016 – see Figure 10.5. It seems that Joe, Tad and the rest of the team at General Re really were dedicated to Buffett’s philosophy of focusing only on profitable business even if that meant saying no to business, pithily summarised by Buffett as “size simply doesn’t count”. Source: Berkshire Hathaway Annual Reports Source: Berkshire Hathaway Annual Reports Source: Berkshire Hathaway Annual Reports While General Re held back its volume growth to become a “jewel” in Berkshire’s crown on account of its zero-cost float, Ajit Jain’s BH Reinsurance was powering ahead both in volume and in profitability. Its handful of ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Once inside the Berkshire fold insurance giant General Re’s executives were encouraged to feel free of the previous constraints that limited growth. This helped to lift annual premiums from $6bn in the year it was bought, 1998, to $8.7bn in 2000 – see Figure 10.1. Buffett wanted them to continue “increasing the proportion of its business that is retained [rather than passed on to other reinsurers], expanding its product line, and widening its geographical coverage” (1998 letter).
Source: Berkshire Hathaway Annual Reports General Re’s float was building up nicely, as were the floats of Ajit Jain’s operations at Berkshire Hathaway Reinsurance and at GEICO and Berkshire Hathaway Primary Insurance see Figure 10.2. Source: Berkshire Hathaway Annual Reports Buffett sounded a little worried with the “huge” underwriting loss at General Re when he reported Berkshire’s results for 1999, a total of $1.18bn, the worst in 15 years – see Figure 10.3. But said he thought it “aberrational” (1999 letter). In contrast, GEICO reported an underwriting profit of $24 thus supplying float for Buffett to use at better than zero cost. Primary insurance also produced a profit, at $22m, so again Berkshire was paid for holding and investing other people’s money. The 1999 underwriting loss at BH Reinsurance of $251m sounds a lot but it was only 4% of its float compared with the US government 10-year bond rate of 6.7%, and so was relatively cheap float for Buffett to employ. General Re’s float cost, on the other hand, was 7.8% of float in 1999. Source: Berkshire Hathaway Annual Reports Although seeing worrying signs at General Re, for example writing in his 1999 letter that its business was “extremely underpriced, both domestically and internationally”, Buffett maintained that General Re had “the distribution, the underwriting skills, the culture, and — with Berkshire’s backing — the financial clout to become the world’s mos ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Yesterday's newsletter showed that showed that in the eleven years before Warren Buffett purchased it General Re was firing on all four cylinders, in the later years making almost £1bn in profits. It also held $14.9bn of float, which was available at apparently no cost because underwriting pricing was so good.
But would you pay $22bn for this? It seems a high price to earnings ratio, and shareholders’ equity (net assets) was just over $8bn so the price to book ratio was 2.7 times. Buffett must have anticipated some synergies that would considerably enhance profits. Shortly after agreeing to buy he described his thinking:
Berkshire, on the other hand, happily accepts volatility, just so long as there is an expectation of increased profits over time. “As part of Berkshire, this constraint will disappear, which will enhance both General Re's long-term profitability and its ability to write more business. Furthermore, General Re will be free to reduce its reliance on the retrocessional market over time, and thereby have substantial additional funds available for investment.” wrote Buffett in the Berkshire Hathaway News Release June 19, 1998.
On acquisition General Re’s common equities comprised only $4.7bn of the portfolio, less than one-fifth. Until that point it had taken a very conservative approach, placing around three-quarters of funds in bonds. This resulted in low returns compared with Buffett’s investments or those of Lou Simpson over at GEICO.
The Deal The connections between Berkshire and General Re go back a long way. In 1976, for example, General Re helped resuscitate GEICO from near-death by taking some risk exposure off its books. General Re was ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 |
Glen ArnoldI'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact Jackie.Tran@henryspain.co.uk investing is about making the right decisions, not many decisions.
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