I have a flurry of trades to update on for June as I’ve responded to various opportunities and threats, including a recent profit warning at erstwhile favourite Best of the Best. I’ve made more trades than ideally I would have liked to, but hopefully the portfolio is sufficiently improved as a result.

I traded a ‘breakout’ in JD Sports, as the price recently broached its pre-pandemic highs. My breakout trade of Impax Asset Management from last month is progressing well so I felt motivated to try another. Broadly the idea of these trades is to invest at inflection points, where businesses that are ‘on a roll’ have their share prices break out to new highs following a period of consolidation. JD Sports seems to fit this bill. It has traded remarkably well during the pandemic, even managing to grow revenues despite many of its stores being shut down for large parts of the year (though part of this is due to inorganic growth). I haven’t put my finger on exactly what JD does so well, but its retail brand seems to really resonate with consumers. Its long term track record of growth through acquisitions of various retail brands that are then gradually converted to JD fascia is nothing short of spectacular and there still seems to be plenty of opportunity for it to continue to apply its magic formula to international expansion, particularly in the US.

I made space for JD by selling IG Group for pretty much the same price as I bought it a couple of months ago. While IG Group’s cheap rating and the fact that it benefits from volatility are attractive characteristics, I feel lukewarm on its near term prospects because of the uncertainty around how much of its growth last year was temporary and pandemic-related. The Tastytrade acquisition is another source of uncertainty. I prefer my other similar position in CMC Markets at the moment so decided to give IG Group the axe.

My second June trade was to sell Focus Home Interactive and replace it with Flatex Degiro. This trade was prompted by some rather negative reaction to Focus’s latest release of Necromunda: Hired Gun (which incidentally licenses Games Workshop’s IP). In itself this probably wasn’t a very strong reason to sell as the reviews weren’t catastrophically bad and this game is one of many in Focus’s catalogue. Note that Focus is a publisher rather than a developer – though Hired Gun was developed by a studio Focus has just acquired, Streum On Studio. More importantly, looking into this in more detail has brought home that I do not understand a great deal about the video games market and what I do understand suggests that Focus may not be one of the best players to invest in. So, feeling a bit of buyer’s remorse, I thought the best course of action would be to get out again at break even and do a bit more homework before revisiting. I think this sector has excellent long term prospects in general and is worthy of a more detailed post looking at how the market works and what the best opportunities might be.

My final June trade was prompted by a thinly veiled profit warning from Best of the Best, which included the following quote:

We are excited about the opportunities that the year ahead holds for BOTB, with a recovering economy and hopefully a return to normality.  However, in contrast to the summer 2020 period, we have experienced somewhat of a reduction in customer engagement since the latest easing of lockdown restrictions on April 12, 2021, specifically relating to the understandably long-awaited re-opening of hospitality and non-essential retail.  We are closely monitoring this, but with our flexible model, growth strategy and plans for the year ahead, we expect customer engagement to return to normal levels before too long. I look forward to updating shareholders in due course.

It is not surprising for growth to stagnate after the pandemic boom but this update makes things seem significantly worse than I was expecting. The share price responded accordingly on announcement of these results, falling by around 25% (and already some way off the highs of a few weeks prior). It is unclear how serious a profit warning this is and how quickly BOTB might recover. My default response to profit warnings is to sell first and ask questions later, unless there are clear reasons to believe there has been an overreaction. The base rate share price performance in the months following profit warnings (even after the initial fall) is not good – partly because investors and management teams have an understandable tendency to try put a positive spin on things rather than bluntly acknowledge the changing circumstances. Given the vagueness of BOTB’s statement I am inclined to be pessimistic in this situation. I think it is more likely than not that the news flow here will get worse before it gets better. There is a chance that this turns out to be a storm in a teacup and it rebounds quickly but the the reward to risk seems poor.

I am glad to have offloaded a lot of my shares last month not too far off the top, for the reasons discussed in my previous post. While it’s a shame this ended in a profit warning, it has been my most profitable investment ever by quite some margin – a large position that almost ten-bagged in less than two years before falling back again. I replaced BOTB with a new position in Calnex.

Flatex Degiro

Flatex Degiro is an European online broker worth about £2.6bn. It was formed from a merger last year between Flatex, a leading German broker, and Degiro, a Dutch broker. It is one of the largest online brokers in Europe and naturally is particularly strong in Germany, Austria and the Netherlands.

Quality

• Business economics: online broking businesses generally tend to have good economics. It is a capital light business model and much of the costs are fixed rather than variable leading to substantial economies of scale. Hargreaves Lansdown, the largest UK provider by some distance, is a good example of just how profitable this sort of business can be, with large margins and returns on capital consistently north of 60%. Flatex Degiro is some way off this with more modest returns on capital in the mid-teens and a healthy operating margin of around 30%. However, it is in rapid growth mode at the moment and has just made a large acquisition. I would expect these ratios to improve substantially over time as Flatex grows.
• Track record: Flatex is a relatively youthful business, and has operated as a discount broker for about 15 years. Degiro has operated over a similar timescale. Both businesses have excellent though short track records in consistently growing revenues and profits since then. Investors in Flatex have done very well with the share price up around 20 fold over the past decade.
• Competitive advantage: in some ways online broking is quite commoditised and competitive on price. However, competition is muted by the fact that there are substantial costs to customers in switching providers. As long as customers receive a high quality, consistent service customers are likely to tolerate somewhat higher charges rather than switching. There are also material advantages to scale both in reducing transaction costs and in allowing investments in IT and customer UX to be spread over a larger pool of customers. Hargreaves Lansdown is a good example of a similar business that effectively exploited its scale, and arguably its customers, by focusing primarily on improving quality while relying partly on high hidden charges to monetise. This allowed it to become phenomenally profitable, though in the long term competitively vulnerable. Flatex has clear ambitions for scale but appears to be more geared towards being more competitive on price as well as quality. This seems like the better long term competitive strategy but is probably partly just a reflection of its relative immaturity compared to a more established player like HL. The incentives to win new customers versus make high profits off the existing customer base should change change as this sort of business grows in size. Flatex’s future success is by no means guaranteed but I’m encouraged by the fact that it has already become one of the main players across Europe and is growing faster and taking market share from its peers.
• Growth prospects: these are the main draw. Online broking is a secular growth market that seems in a sweet spot right now, benefiting like many similar businesses from a pandemic tailwind. The current high growth rates are very promising and there still seems to be a lot of addressable market for it to go for across Europe. Another important growth drive comes from the fact that it has a relatively youthful customer base.

Price

Momentum at Flatex is very strong. It has been a beneficiary of the pandemic as retail interest in its services has blown up over the past year or so. The share price has done spectacularly well and after a short consolidation is looking close to breaking out to new highs again. As with many other pandemic beneficiaries there is the risk that growth slows by more than expected, as happened with BOTB. In this case I am more sanguine. Flatex continues to be extremely bullish in its investor relations and has recently revised its five year growth targets substantially upwards. The valuation seems quite reasonable all things considered.

Calnex

Calnex is a Scottish provider of testing and measurement technology for the telecoms sector. It is a small business, only worth about £80m, and listed on AIM very recently with an IPO in October last year. I don’t very often invest in very recent IPOs as I tend to prefer businesses with a longer track record and they don’t often get picked up in my screens. In this case my attention was drawn by the fact that many other private investors I follow have shown an interest. On paper the narrative looks great – the management seem to say the right things to make this fit the bill of my ideal sort of investment.

Calnex’s products are little black boxes that enable its customers to test communications equipment to ensure it meets rigorous standards so it can be synchronised with other equipment in a network. The IPO documents are a good place to start to find out more. The business model is straightforward – to sell this equipment to customers such as telecoms network operators, equipment vendors and large tech companies like Google and Facebook. Calnex relies on other businesses to distribute its products – in particular most of its sales come via Spirent Communications.

Quality

• Business economics: Calnex does make quite a bit of capital expenditure in developing its products looks like it has good economics. It is cash generative and highly profitable. It has decent margins and returns on capital above 30%, though these have fallen as you would expect following the IPO.
• Track record: Calnex doesn’t have much of a track record, being founded only in 2006, though it has been successful so far. It appears to have been very quick to carve itself a key role in the sector and has an impressive customer list.
• Competitive advantage: Calnex seems to have a strong market position in its specific technical niche. Calnex is confident that its equipment is the best out there at what it does. This claim is somewhat supported by Calnex’s global presence with all the major players as its customers. A bit of online research also seems to support this, though there are several other players doing similar things. It is not so straightforward to understand the nuances in how various specialised synchronisation testing equipment differs from each other without more background communications engineering knowledge. I’m not wholly convinced that Calnex is protected from competition or changes in technology. However, I can see that there is a strong need for this sort of testing equipment to meet precise industry or regulatory product standards and that this could create a very material barrier to entry. Overall, I think there seems to be a compelling narrative here sufficient for me to invest but I will need to keep this under review as I try to learn more about the market.
• Growth prospects: Calnex makes a big deal about all the secular growth drivers it has on its side due to ever increasing demands for upgrades to the capabilities of telecommunications networks. The main thing for the next few years is the rollout of the 5G mobile network standards. I don’t need much convincing to see that there should be plenty of growth opportunities for Calnex for the foreseeable future.

Price

Momentum had been very strong since the IPO but has waned following the last trading update as the price dropped back quite a bit. Calnex has been another pandemic beneficiary and its results this year have been flattered by certain orders being pulled forward. This means there may not be much growth next year but it seems fairly clear that when you account for this the long term trajectory is positive. This is not a wholly dissimilar situation to the slowdown at BOTB, which could also turn out to be a temporary blip, but in this case I feel more confident. The valuation seems very reasonable.