Venture capitalist

With a current share price of 23p, Mercia Asset Management (LSE:MERC) has a market-cap of £98m. The UK-based private equity firm invests in various ventures and debt solutions.

It mostly targets new technology, or tech innovations, for funding. For example, it has a stake in nDreams, a world-leading VR game publisher and developer.

As a private equity company, the bulk of deals are with firms not listed on the stock market. Given that Mercia isn’t targeting large, established tech companies, most are likely to be privately held.

The aim is for Mercia to buy a share of a business, help it to grow, and then sell the stake further down the line. This could be to another investor or via an initial public offering (IPO). As a result, it hopes to make a profit.

Why I think there’s large potential

In July, the business released its report for the last financial year. It had £1.4bn of assets under management, up from £959m the previous year.

Revenue jumped from £12.7m to £25.9m, with the team expanding from 93 to 142. These are all positive signs of a firm with momentum. The fact the business has around 570 investments in its portfolio makes me comfortable it’s diversified in risk exposure.

The main reason I believe the stock’s cheap is based on the outlook. Profit before tax was £2.4m, but it expects that figure should average around £20m over the next three years.

The current price-to-earnings (P/E) ratio is 34, which isn’t exactly cheap. But let’s say earnings per share is around 10x in the coming few years. In line with the increase in profits, and the share price that stays at a similar level, this would make the stock very undervalued as we stand today.

Points to consider

Another factor I think is key is its tech focus. This is the future. Even though buying an individual tech name can be risky, buying shares in Mercia is much less risky. It holds so many different stocks that even if just a couple really take off, the benefit to Mercia could see the share price rocket.

One concern I do have is the concentrated exposure to UK companies. I’m also conscious of the state of the economy and how this might keep a lid on potential growth for young tech companies. Finally, being a penny stock is always going to put off some investors.

Yet, on balance, I think the stock looks cheap, based on future earnings. And if its outlook is achieved and some investments take off, this might not be a penny stock forever. Therefore, I think investors who understand the risk might do well to consider buying the stock.

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However, this is probably unsuitable for all investors. Penny stocks can be incredibly volatile. These small businesses may also lack the resources available to larger organisations. 

Still, as a way to capitalise on the UK economic recovery over the next few years, I think buying these equities may yield results. 

Penny stocks to buy 

The first company I’d buy is Fulham Shore (LSE: FUL). This business owns the Real Greek and Franco Manca restaurant brands. 

Like most hospitality businesses, the pandemic has slammed Fulham’s top line. Sales are running at about 46% of normal levels. 

Nevertheless, Fulham is gearing up for the reopening. It has three new restaurants in the works to add to the existing portfolio of 72 properties.  When the economy reopens, I think the company could benefit from increased demand from hospitality-seeking consumers. That’s why I’d buy the stock as a recovery play today. 

That’s not to say the organisation is without risks. Hospitality businesses face many challenges such as high labour costs, rising ingredient costs and the possibility of yet more lockdowns. All of these could derail Fulham’s recovery. Still, I think it’s one of the best penny stocks to buy. 

Diversified investments

Mercia Asset Management (LSE: MERC) is an excellent way to invest in a basket of UK start-up businesses. The group manages around £872m of assets for clients around the world. It invests these funds in both early-stage and established UK companies.

In the six months to the end of September, the group invested £10.9m in 14 portfolio businesses. Mercia also divested The Native Antigen Company for £4.8m, realising a gain of £1.7m.

As penny stocks go, I think this organisation has many advantages. It’s a way for investors to own a diverse basket of UK companies at the click of a button. 

Of course, there are lots of risks with the strategy. Investing in early-stage businesses is incredibly risky, and Mercia is a also relatively small firm. If it struggles to achieve good returns for investors, they could pull their funds, damaging its reputation. Looking past these risks, I’d buy this stock for my portfolio today as a way to play the UK economic recovery.

Spending growth

As the economy recovers, I expect consumer spending to rebound as well. I’ve been looking for penny stocks that might benefit from this theme.

As a retailer of cars, bikes and commercial vehicles, Vertu Motors (LSE: VTU) fits this theme. I think the business should benefit if consumer confidence improves and vehicle sales increase. And if vehicle sales don’t increase, the company’s service revenues should provide a stable income stream. 

City analysts believe Vertu can earn 5p per share in 2021, putting the stock on a forward P/E of 7.4. However, these these are just estimates. There’s no guarantee the company will hit these projections.

Vertu faces a multitude of risks that could hold back growth. The economic recovery may not turn out to be as strong as expected. This could hit sales growth. New tech upstarts may also grab market share, which would dent profit potential in the medium to long term. 

Despite these challenges, I’d buy Vertu as part of a diversified basket of penny stocks today. 

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Unfortunately, not all of these investments have turned out as intended. In 2016 shares in Woodford-backed Circassia lost two-thirds of their value in a single day after the company announced that it was abandoning its allergy portfolio following a failed second trial of its dust mite allergy treatment. And this year, Woodford has had to defend his ownership of Allied Minds, which has seen its share price fall 66% over the past 12 months. 

Mercia Technologies (LSE: MERC) is another of his struggling investments. Since listing at the end of 2014, the shares have lost nearly 40% as the company has been unable to convince investors that its portfolio is worth paying for. 

A risky business 

Like Allied Minds, Mercia incubates early-stage businesses. According to the firm’s half-year results published today, at the end of September, the fair value of its investment portfolio was £64.7m. This was up £12.7m thanks to £9.7m of new capital and £3m of “net upward value movements” (an increase in the value of its investments). Total net assets were £123.6m (up from £81m) with cash of approximately £55m. 

As well as investing its own funds, Mercia also invests on behalf of third parties. This extra capital allows the group to scale up its investments as well as generate fees on the additional capital. Funds under management in the period to September were £337m, up from £220m in the first half of September. 

To be able to retain third-party investors the company has to show that it can generate returns that can’t be found elsewhere. And it looks as if the business is proving its worth on this front. During the period to September, Mercia’s RisingStars Growth Fund I realised a £34.5m cash investment in Blue Prism Group plc, representing a 55 times return. 

Unique approach 

Mercia is unique in its approach to managing outside cash. By collecting fees on this money, the majority of the group’s operating costs are offset. In comparison, other similar companies only get paid when they realise value from an investment, which can take years. For the six months to September Mercia booked revenue of £4.8m (up 66% year-on-year) and a post-tax profit of £1.4m after accounting for operating costs. 

Overall, it is a cash-rich venture capital business that’s generating revenue and has a record of producing enormous returns for investors. So why am I avoiding it? 

Well, put simply I think Merica is too expensive. At the time of writing, the shares are trading at a discount to net asset value per share (41.1p at the end of September) of 12.4%, which is just not cheap enough. 

Valuing early-stage tech businesses is notoriously tricky and there’s no guarantee that these investments will ever generate income. With this being the case, I believe that a wide margin of safety (deep discount to NAV) is required before investing in a company like Mercia. A discount of 30% or more to NAV would be more appropriate and protect investors from any failures in Mercia’s investment portfolio.

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The company released its annual results today and I like the look of its business model, the progress it’s making and its current valuation.

Business model

There are two prongs to Mercia’s business model. It’s an asset manager, running third-party investment funds that nurture young businesses. It receives fees for these and other services by which it aims to cover a large chunk of the plc’s operating costs.

As the young businesses develop, it identifies ‘Emerging Stars’ among them and provides direct investment follow­-on capital from its own balance sheet. This is the portfolio of 24 investments I mentioned earlier. It ultimately aims to exit these investments with rich rewards from lucrative flotations or trade sales.

Progress

In today’s results, for its financial year ended 31 March, it reported that funds under management increased to £336m from £220m, with revenue rising to £6.7m from £1.8m. Meanwhile, its portfolio of 24 direct investments increased in value to £52m from £38.1m.

The year also saw Mercia demonstrate the viability and potential gains of the direct-investment element of its business model with the trade sale of Allinea Software to ARM, providing an 88.4% uplift on the group’s direct investment cost. The IPO of Concepta (a digital fertility/pregnancy testing business) was another notable event.

Valuation

When Mercia listed on AIM in December 2014, it raised a net £66m at 50p a share and had a market cap of £106m. Pro forma net assets were just over £75m (34.4p a share), so it was valued at 1.41 times book value.

It raised a further £40m (gross) at 46p a share in February this year and today reported net assets of £121.4m (40.4p a share) at its March year-end. At a current share price of 34p — up 4.6% on the day — the market cap is £102.2m, so it’s now valued at 0.84 times book value.

Despite its increased scale, emerging proof of its business model and management saying today “we can already see several material value inflexion points arising in the coming year,” Mercia is considerably cheaper than at the time it listed on the stock market. It’s also cheaper than a much-higher-profile stock offering exposure to early-stage businesses: Woodford Patient Capital Trust (LSE: WPCT).

Patience

At a share price of 97p and with net assets of 100.3p a share, Patient Capital trades at 0.97 times book value. It also happens that Patient Capital has given Mercia the Neil Woodford seal of approval. It owns a 25% stake in Mercia and both companies are chaired by Susan Searle.

With 76 holdings, Patient Capital can be seen as a lower-risk proposition than this article’s other subject, particularly as only about half its holdings are unquoted businesses, with the portfolio also containing some relatively large and familiar quoted names, such as Purplebricks and US-listed Prothena.

Nevertheless, I see Mercia’s 24 investments as reasonable diversification and the company’s third-party fund management arm as providing a useful degree of relative stability. Both businesses have potential to deliver excellent long-term returns for patient investors and I would rate them as ‘buys’ at their current discounts to book value.

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One such opportunity is power station owner Drax (LSE: DRX). 

Contrarian buy 

In a recent interview, Woodford admitted that his fund added to its existing position in Drax during February, after the company’s recent stock declines. 

Following a number of profit warnings, Drax has fallen out of favour with the wider market during the past two years. The company, which runs the UK’s largest wood pellet-fired power station, has been hit hard by the government’s flip-flopping on energy policy and the removal of green energy subsidies. As a result of these changes, Drax’s earnings per share have slumped by 90% from 52p per share in 2012 to 5p for 2016. 

As earnings have crashed, so has the company’s share price. Since the beginning of 2014, shares in Drax have declined by 60%. But it seems Woodford senses value here. Drax is currently trying to reduce its dependence on power generation and recently acquired a business energy supplier. Thanks to this acquisition, City analysts have pencilled-in earnings per share growth of 160% to 13p this year and a further 45% to 18.9p for 2018. These are impressive growth rates, but even if the firm hits these high targets, the shares will still look expensive. 

Earnings per share of 18.9p suggest a forward P/E multiple of 17.3 for 2018. Considering Drax’s past, it does not seem wise to pay such a high multiple for the shares. 

Blue-sky buy 

Alongside Drax, Woodford also revealed in the interview that he had been buying shares in Mercia Technologies (LSE: MERC) and Homeserve (LSE: HSV) over the past two months. 

Mercia is an investment company with the goal of generating capital growth for shareholders in the creation, funding, incubation and development of technology businesses. It is a venture capital business, working on behalf of investors in businesses it believes have the potential to change the markets they operate within. 

This operation, which is similar to many of Woodford’s other venture capital style-businesses, recently won two contracts to manage funds associated with the UK government’s Northern Powerhouse scheme. The contracts include a £57.5m equity fund and £51m debt fund under the control of the state-owned British Business Bank. 

These deals show that Mercia is clearly an important business with connections in all the right places. If you have a high risk-tolerance, this could be a share for you. 

Growth buy 

Meanwhile, year-to-date shares in Homeserve have lost nearly 10% of their value. However, even after these losses, the shares look expensive trading at a forward P/E of 21.5 for the year ending 31 March 2017. Next year City analysts have pencilled-in earnings per share growth of 18% to 30.5. If the company can keep this growth up, it could be a solid long-term growth buy. The shares support a dividend yield of 2.6% while you wait. 

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