Stockwatch: A company with industry appeal

How much notice should you really take of last Friday's grim Purchasing Managers Index (PMI) showing the UK economy in "dramatic deterioration" since the vote to leave the EU? Media seized on the bad news to grab readers, analysts at Pantheon Macroeconomics adding to doom: "The collapse in the composite PMI to its lowest level since April 2009 provides the first major evidence that the UK is entering a sharp downturn."

If true, then precisely the kind of stock to avoid would be a smaller company geared to medium-term corporate investment - at risk of this being shelved. Besides fundamentals, there's also a technical reason: market makers drop the price of relatively illiquid stocks to help any sales get matched promptly. They're not meant to take positions.

Buying from directors, net trading by institutions

Yet insiders have been snapping up shares in AIM-listed Sanderson, a software/IT group serving retailers and manufacturers with 100% of revenues UK-derived. On 18 July a non-executive director bought 30,000 at 67p, taking his stake to 575,000 shares, and on 20 July the finance director added 10,000, similarly at 67p, to hold 277,421 shares.

Not big amounts, admittedly, yet a finance director is best-positioned to judge underlying momentum. In its last update on 8 June, within interims to end-March, management cited "a very strong order book together with an extensive list of sales prospects" - so we can deduce that during July it hasn't exactly deteriorated.

Directors see the markdown as excessive; portfolio managers focus on macro issuesTo be picky, the medium-term horizons affecting client decisions anyway would not have changed in a matter of weeks. But, with the stock having plunged from 83p to 64p in reaction to the Brexit vote, significantly, two directors judged it appropriate to exploit this.

Earlier, on 4 July, Downing LLP increased its stake above 5% with the purchase of 46,738 shares. Again, small - but this stock is anyway quite illiquid, it's a case of what another trading party is prepared to do.

Lately, on 21 July, however, Helium Rising Stars Fund reduced below 4% with the sale of 267,301 shares; the fund manager was presumably taking the classic view to trim exposure to small-caps geared to business investment, lest the UK economy be at the early stage of a downturn.

It's a small sample, but the "directors buy, institutions trade" pattern reflects what you might expect: directors close to the action view the markdown as excessive, while portfolio managers tend to look more widely at macro issues. The PMI index is just a sentiment index, however such a "flash report" can quickly change.

Technology as an exception to the business cycle

Caution is appropriate, technology replacement being the kind of decision/cost liable to be deferred in a slowdown. Yet a key reason for investing in technology is new developments potentially able to resist the wider business cycle. Sanderson is prioritising its range of mobile and ecommerce solutions in digital retail, quite a "must-have" technology, with digital sales driving most retailers' growth - for example, a European rollout for Superdry fashion across eight countries enables its customers to order from any device using any payment method and able to specify any delivery location.

The client base of small-to-medium-sized enterprises may be more vulnerable to a slowdownAdmittedly, the results don't yet sparkle: Sanderson's interims saw digital revenue up just 5.4% to £2.95 million with like-for-like operating profits (before amortisation and restructuring charges) down from £0.49 million to £0.33 million due to higher investment. Digital's end-March order book was down to £0.78 million from £1.0 million, like-for-like, so better numbers are needed to prove a growth story.

Sanderson's main division, however, is enterprise management software/services to manufacturers and food/drink processors - used for example to trace food products/ingredients through the supply chain to ensure regulatory compliance. It increased interim revenue by 10% to £6.92 million and normalised operating profit from £0.89 million to £1.15 million, helped by five new clients during the period (if down on eight like-for-like) and a higher average order value.

Recurring revenue represents 58% of this division implying the price/earnings (PE) ratio for the stock deserves to reflect an aspect of earnings quality, also dividend prospects supported. At end-March this division's order book was up by a third, helping Sanderson affirm overall growth credentials.

A chief risk is the client base being small to medium-sized enterprises - "SMEs" - which are potentially more sensitive to economic slowdown. A share price drop is, therefore, understandable - but what extent is fair?

Forecast earnings growth over 30%

At 73p, the stock trades on a forward PE in the mid-teens, implying short-term value relative to an earnings boost over 30% expected for the current year to end-September; a consensus forecast the board affirmed with its 8 June interims.

Client commitment to lead times for IT/software mean this year's numbers are likely in the bag, so the medium-term question is whether hesitation now creeps in. A dividend yield just over 3% is not exactly a prop, yet it's a quality yield, the trend in cash flow per share relative to earnings underlining how nearly all profits are converted to cash.

Despite medium-term risks to revenues, the stock merits a patient 'accumulate' tagI've drawn attention to Sanderson various times since they were just 10p in August 2009, when the directors' wives piled into the stock - its low price showing it can indeed suffer from recession, even if providing a buying opportunity.

The group has restructured to pursue digital, although technology is a moving feast where it's necessary to introduce new courses. These get presented by technology firms as "growth", but investors wisely await the numbers. So the market was correct to trim the stock from its 87p highs in May and, without knowing if the UK will genuinely experience recession, it's now in a fair value range.

In this low-growth environment, however, Sanderson has appeal for other IT groups to augment their earnings, and the chairman's 21% stake will otherwise need placing come his retirement.

So, despite medium-term risks to revenues, the stock merits a patient "accumulate" tag: either Sanderson will enjoy more vigorous progress from digital in due course, possibly attracting takeover interest, or if a stall in group revenues hits the stock then a bid becomes opportune. With strong positions in its markets, a healthy financial record and balance sheet, this company has industry appeal.

For more information see the website.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.