A Smart property purchase

Maybe not smart enough…

A hundred years ago company reports in this country didn’t contain much information of use to shareholders. They didn’t even report sales. That’s one of the reasons that for most of stockmarket history the dividend has been the valuation metric of choice.

Opening J Smart & Co (Contractors) (SMJ) annual report takes me back there. It’s a property developer, investment company, and contractor operating in Edinburgh and Central Scotland. Of course it reports sales, and everything else that it must report, but it doesn’t waste words.

The chairman’s statement is one page long, followed by a business review offering us one or two sentences on each of its activities:

• Building
• Plumbing
• Civil engineering
• Investment property
• Manufacture or precast concrete
• Joint ventures

In brief, most of its turnover came from construction, but most of its profit came from rent. It didn’t sell any properties. No pictures, one chart showing total shareholder return, and three-line director biographies; name, start date, and position.

The very first thing an investor might notice about Smart’s share price, and perhaps the last because it would probably put her off, is it’s gaping spread of 75p implying you can buy the share for 510p but only sell it for 435p. If you bought and sold the shares at those prices, in quick succession, you’d make an instant loss of nearly 15%.

At the mid-price of 472.5p, the market values the shares at 10 times earnings over the past ten years. It’s just about a bargain share. Were I to include the company in the Thrifty 30 model portfolio I’d have to include it at a realistic buying price though, and since my broker will sell me £1,000 of Smart shares for 505p I’d actually be ‘paying’ more like 11 times earnings.

The trouble is, I’m not very confident about that figure.

The numbers on the left are Smart’s last ten years of earnings plucked from Sharescope. I’m sure you can see at least three apparently anomalous years, 2005, 2006 and 2009.

J M Smart, the company’s chairman, who at the end of the financial year in July owned 47% of the shares, is quite clear about the cause of the loss last year. In the company’s annual report, he blames IAS40, an accounting standard:

As forecast and due to the requirement of the International Financial Reporting Standards that any unrealised deficit in re-valued property be included in the Income Statement, I am obliged to report for the first time in the Company’s history a headline group loss before tax of £1,208,000.

IAS40 requires that the company revalue its investment properties every year and record any increase or decrease as a profit, or a loss. As property prices fell in 2008 and 2009, the company had to record a loss even though no money changed hands. In 2009 it didn’t sell a single property, yet the reduction in the value of its properties wiped out £4.5m in profit, mostly rental income.

In 2007, however, rising property prices increased its profits by nearly £2m.

That leaves 2005 and 2006, two years I know nothing about as the company only has copies of its last two annual reports (2009 and 2008) on its website. There’s a bit of information about 2007 in the 2008 report.

Since 2005 was the first year the company adopted the new IFRS reporting  standards, it seems likely that since then its profits have been affected by changes in the values of its properties and that in 2005 and 2006, just like in 2007, those profits were inflated.

If that’s so, the earnings denominator in the PE ratio might be inflated too, making it look lower than it really is, and making the shares look cheaper than they really are. What I need is  a full cycles worth of IAS40 earnings, but that won’t exist until the market returns to the state it was in during 2005,

There’s a huge amount of value stored up in those properties, though, £66m at July 2007 prices. Smart’s total net asset value, which includes no intangibles, is £92m, pretty much double its stockmarket value. Although it had an £11m overdraft at the end of the year, it also had £23m in cash.

In other words we can buy a share in a portfolio of Scottish properties plus a bit of cash and equipment for pretty much half price and get a share of a contracting business free. The value of the contracting businesses is another imponderable though as it scraped a profit this year, and made an even smaller sized loss last.

And the outlook is looking a bit grim. This is what the chairman said on 17 Nov:

The amount of contract work in hand is less than at this time last year, prices have tumbled and it is clear that prospective contracts are thin on the ground.

Bearing the foregoing in mind, there are too many uncertainties to forecast the outcome for the current year with any degree of accuracy at this stage.

And the gaping spread is a bitter pill to swallow.

But with a balance sheet as strong as Smart’s and an experienced board who joined the company in the 1960’s and 1970’s, I think this company will reward patience. In happier times, with property prices rising and construction work increasing the shares won’t be so hard to sell.

I’m not going to put them in the Thrifty 30 though. As I mentioned last week it’s already chock-full of companies that depend in some way on the construction industry.

And I may not have unravelled the conundrum of Smart sufficiently. It’s not typical of the kind of share I favour.

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Bolton, the sequel

Open this PowerPoint presentation, rotate it so you can read it, and you’ll find a succinct introduction to three kinds of value investing; screeners, contrarians and activists.

That was from valuation expert Aswath Damodaran, and so is this equally succinct explanation of the efficient markets hypothesis. Browsing his site is rather fascinating, and I find myself doing it late at night!

Buttonwood says the authorities have papered over the cracks but the recovery has been too easy. House prices are rising even though they never fell back to the average. And that’s just one of  a number of reasons to be pessimistic.

Bolton’s back! And he’s going to run a China fund! Exclamation marks valid in both instances I think.