Quarterly Research Outlook April 2019 UK Equity Research www.arden-partners.com Arden Partners Arden Partners is a research-led firm, offering The relationship with Pershing Securities institutional, agency, broking services Limited, which acts as settlement agent for principally in small and mid-cap. stocks Arden Partners, enables the group to provide together with corporate finance advice to this significant transaction capacity. sector of the stockmarket. Sector coverage includes many of the areas The business was founded in 2002, rapidly associated with the team and a number of new establishing a strong record for its research and business sectors. The focus is predominantly, distribution capabilities. This enabled Arden but not exclusively, on the small and mid- Partners to establish a robust financial record capitalisation constituents of the stockmarket enabling the business to join the AIM market in under £1.5bn market cap. 2006 (ARDN.L). Our analysis is built on in-depth research, which The group is firmly focused on providing values close relationships with the uncompromising analysis, sound advice and management teams of our research fair deals for both corporate and institutional companies, thereby providing added value clients. With a strong balance sheet and a investment perspectives to our fund manager flexible cost base, the business is able to build client base. on its long-term strategic goals. This research material is a marketing communication and has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any legal prohibition on dealing ahead of dissemination. 11 April 2019 Welcome to Arden’s Quarterly Research Outlook for Spring 2019 We’re just over three months in to 2019 and we’ve seen a 10% UK market rally, retracing much of the Q4 decline, such is the nature of fickle market sentiment. That said, many of the issues we wrote about three months ago that were impacting markets remain: notably Brexit, trade wars, geopolitics and global monetary policy. The 2019 rally thus far feels somewhat fragile, with competing forces of optimism on a potential trade deal that could underpin the rally, against the deterioration in underlying economic data that could ultimately undermine the recent market gains. In this context, we look at what the lead indicators and the market are telling us about the industrial cycle and the stocks most exposed to various industrial trends. The Q4 derating in short cycle industrials and autos had been vicious and, while these sectors have seen a more solid footing in 2019, with earnings downgrades being priced in, it will likely take a trough in lead indicators before short-cycle stocks can start to perform again and rerate relative to the market. Against this market backdrop, in January we published our Best Ideas piece for 2019, with good performances from a number of stocks, notably Asiamet, Macfarlane, Anexo, Cloudcall and Vianet. We continue to see value in these names as we highlight later in this research note. In addition, we have added 11 further stocks to our overall research coverage in Q1 2019, initiating on the litigation funders Burford Capital, Manolete Partners and Litigation Capital Management, the streaming localisation company Zoo Digital, CyanConnode, Somero Enterprises, Lok’nStore, Plant Health Care, Hydrodec, Phoenix Global Mining and Pantheon Resources. Please revisit these initiations and engage with the team at Arden to discuss. The Arden Research Team Spring 2019 | Quarterly Research Outlook 1 11 April 2019 CONTENTS Welcome Introduction: Fragile rally or reignited Bull 3 Best Ideas for 2019 19 Featured companies Asiamet 22 CyanConnode* 30 Hydrodec* 38 Litigation Capital Management 48 Pantheon Resources* 56 Somero Enterprises 62 Stocks added to coverage 70 Diary 71 Company profiles 72 2 11 April 2019 Fragile rally or reignited Bull We’re just over three months in to 2019 and we’ve seen a 10% UK market rally, retracing much of the Q4 decline, such is the nature of fickle market sentiment. That said, many of the issues we wrote about three months ago that were impacting markets remain: notably Brexit, trade wars, geopolitics and global monetary policy. The 2019 rally thus far feels somewhat fragile, with competing forces of optimism on a potential trade deal which could underpin the rally, against the deterioration in underlying economic data that could ultimately undermine the recent market gains. In this context, we look at what the lead indicators and the market are telling us about the industrial cycle and the stocks most exposed to various industrial trends. The Q4 derating in short cycle industrials and autos had been vicious and while these sectors have seen a more solid footing in 2019, with earnings downgrades being priced in, it will likely take a trough in lead indicators before short cycle stocks can start to perform again and re-rate relative to the market. Global equities have rebounded from a tough Q4 The start of 2019 has seen a welcomed rebound in global equity performance following the sharp deterioration in markets in Q4 2018. To expand on this further, UK equities have rallied in Q1 19, with the FTSE All-Share Index up 8.3%, rerating from a 5-year low 11.7x to current levels of 12.9x. The rebound across the Atlantic has been marginally stronger with the S&P 500 rallying 13.1% in Q1, re-rating from 14.8x to 17.1x. Interestingly, we highlight that the P/E spread between UK and US equities has now widened further. FTSE All-Share and S&P 500 forward P/E multiples 2014-2019 22.0x 20.0x 18.0x 16.0x 14.0x 12.0x 10.0x FTSE All-Share 1FY P/E Ratio S&P 500 1FY P/E Ratio Source: Arden Research, Bloomberg. 3 11 April 2019 That said, many of the issues we wrote about three months ago that were impacting markets remain: notably Brexit, trade wars, geopolitics and global monetary policy. The 2019 rally YTD feels somewhat fragile, albeit with optimism on a potential trade deal that could underpin the rally. While this might help markets and overall investor sentiment, it’s possible that this could delay the inevitable as underlying deteriorating economic data could ultimately undermine the recent market gains. Analysing this in more detail, we note that the Q4 ’18 derating and subsequent 2019 re-rating have been driven by a combination of volatile market sentiment, following China slowing and then rebounding and the flip-flopping of the Federal Reserve outlook, while consensus earnings have weakened slightly with the US Q1 earnings season about to kick off. FTSE All Share Index - Price and Earnings (2014-2019) S&P 500 Index - Price and Earnings (2014-2019) 4400 340 3100 180 4200 320 2900 170 2700 160 4000 300 2500 150 3800 280 2300 140 GBp USD 3600 260 2100 130 3400 240 1900 120 3200 220 1700 110 3000 200 1500 100 S&P 500 Index S&P 500 1FY EPS (RHS) FTSE All-Share Index FTSE All-Share 1FY EPS (RHS) Source: Arden Research and Bloomberg. Source: Arden Research and Bloomberg. Economic surprise indices tell a worrisome story Despite the equity rally, feedback from investors continues to reiterate a view of caution, particularly in the context of a confluence of political and economic headlines capturing the attention of markets, namely (but clearly not limited to) concerns over the global economy slowing, US-China trade wars, signs of Europe flirting with a recession and, of course, the political drama at Downing Street. In our view, economic surprise indices provide for an interesting read. As the chart below illustrates, despite positive returns from UK/US equities in Q1 2019, we are still in a phase of negative (and perhaps troughing) surprises, albeit not as severe as what has been recorded in previous years. In light of this, we pose the question over whether the start of Q1 19 has in fact been a potential overreaction in equities or an appropriate reversal of Q4 performance with negatives priced in by the turn of 2019. 4 11 April 2019 Citi Economic Surprise Indices (2014-2019) 150 Citi Economic Surprise - USA Citi Economic Surprise - Eurozone Citi Economic Surprise - China Citi Economic Surprise - Global 100 50 - (50) (100) (150) Source: Arden Research and Bloomberg. As with all these things, the answer at this stage is “a bit of both” although more recent data suggests caution remains warranted and we would favour more defensive or idiosyncratic (self-help, share gainers, recovery and structural growth) equity stories at this stage of the cycle. Recent PMI data mixed to say the least To further assess recent equity performance, we look towards recent PMI/ISM data as an initial guide over whether industry sentiment is supportive of a Q1 rebound. Beginning with the US, PMI data is suggestive of the expansion phase continuing, with ISM data reinforcing this view. That said, the surveys show “lower highs” more recently, which are likely weighing on investor sentiment. US PMI Manufacturing & Composite (2014-2019) US ISM Manufacturing & Composite (2014-2019) 70 70 65 65 60 60 55 55 50 50 45 45 40 40 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 US Markit Manufacturing PMI US Markit Composite PMI US ISM Manufacturing PMI US ISM Weighted PMI Source: Arden Research, Bloomberg and Investing.com. Source: Arden Research, Bloomberg and Investing.com. However, concerns around the risk of a recession, a yield curve that is showing signs of inversion, and an unexpected change in the Federal Reserve’s outlook for 5 11 April 2019 future rate rises, remind us that underlying trends may be hidden.