ES R&M UK Recovery: Well-positioned to benefit from cycle low and move into the recovery phase

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Chris Salih (CS):

Hello, I’m Chris Salih, investment research analyst at FundCalibre, and today I’m delighted to be joined by Hugh Sergeant, manager of the Elite Rated ES R&M UK Recovery fund. Thank you for joining us again today, Hugh.

Hugh Sergeant (HS): Yeah, thanks for inviting me along, Chris.

It’s no problem at all. Let’s start with smaller companies. They always seem to be in the eye of the storm, but they’ve started to rally a bit in the last month. Could you maybe tell us why that’s happened? And do you think it will continue? Are there still some attractive areas there for you?

[00:31] Yeah, good question. We’re positive about the outlook for small and mid-size companies from here. [We’ve] obviously had quite a severe bear market over the last 18 months. The background to that was, first of all, I suppose their starting valuations were higher than normal, and they were also extremely popular and lots of fund flows had gone into smaller companies. And then obviously the fundamentals started to deteriorate, the more exposed to downturn in the cycle. So, those three elements have created quite a bear market in smaller companies. But we think all those three elements are starting to, you know, significantly improve.

The valuation – starting valuations – for small cap are really attractive again; the fundamentals we think are bottoming out. Probably peak ‘anti-small cap’ was the same time as the mini-budget crisis. And looking out towards next year, I think the fundamentals will be more supportive.

And then smaller companies have gone from being loved to quite hated. So, a lot of the cash that was going to come out of smaller companies has probably happened. So, I think the liquidity background would be more supportive of small caps. So, yeah…

Are the opportunities across the piece, or are there certain areas that are particularly attractive within small cap?

[01:58] Well, there, as ever, our kind of hunting ground is in our recovery value. Some of the derated platform stocks, so, structural growers which have become recovery-type stocks, those kinds of areas are of most interest to us.

There are some really modest valuations, still paying three- or four-times earnings – some small caps have rallied. There’s still some hugely anomalous valuations, so, [as] I said, three to four times earnings at the low points. So, but our hunting ground is that area. And actually, I would say that the hunting ground is probably as broad as I’ve seen in my career, because it’s this additional element of derated structural growers alongside the classic deep value and recovery-type stocks. So, it’s [a] really attractive hunting ground for us.

Ok. And let’s go a bit further into, … you talked recently about certainty stocks being very expensive and uncertainty stocks being very cheap. Could you maybe just elaborate on that for the viewers?

[03:05] Yeah, I mean, I’ve talked about that [at] various times over my career because we’ve had one or two cycles, it’s fair to say. And when you have difficult, negative cycles which we’ve been going through over the last year, all sorts of uncertainties that has meant that the average investor has wanted to put their capital into stocks which are seen as more certain – so where revenue and profits [are] seen as relatively certain in the context of an economic downturn, or all those other elements of uncertainty out there. So, the likes in the UK of AstraZeneca have been natural recipients of the capital that’s looking for more certain stocks.

The uncertainty stocks, which isn’t the above, I suppose, anything that’s perceived as exposed to the economic cycle, anything that’s had those kinds of exposures, has been significantly derated.

So, there’s a huge valuation gap between certainty and uncertainty stocks, and the world will become less uncertain over the next couple of years. [I] don’t know exactly when the low point will be, but it will become less uncertain. And after that, the uncertainty stocks, which is a huge hunting ground at the moment, they will do well. And I think there’s some indication that [it has] started to bottom out.

Well, let’s turn to the portfolio in a bit more detail. One area you have been adding to recently, in recent months, is real estate companies, particularly in London. Could you maybe give us the rationale for that, please?

[05:11] Yeah, I mean, real estate, we were slowly building up from an underweight position, but the big catalyst was the shock to the system created by the ‘go for growth’ mini budget. And the fact that that made bond yields and corporate, both sovereign debt and corporate bond yields spike up very aggressively. And obviously real estate is, to a reasonable extent, valued off those. And, as a result of that, you saw real estate stocks – which had already been weak – come back another 20 or 30%, so, they ended up trading at 50% + discounts to their underlying assets. Obviously, the NAV, as bond yields move up, will fall. But from our calculations, it wouldn’t fall more than 10 to 15%. So, we are buying those stocks on a very big discount, to kind of more realistic estimates of value.

Actually, for the first time in my own personal investing career, I’ve been a relatively aggressive purchaser of sovereign debt and corporate bonds, as yields on sovereign debt moved towards 5% [I] felt that was quite attractive, so, it made sense at a portfolio level to look for sectors that have been derated on the back of those moves.

So yeah, real estate and in particular, as you mentioned, London, just, people have got … London’s a great, great, great city with some fantastic real estate, which will remain popular for forevermore really, and with a very depressed sterling, over the next year to 18 months you are likely to see some strategic buyers from outside the UK become interested in some of our fantastic assets. And one example is Capco, which I’ve held for a while, but it’s just completely the wrong price at the moment; owns [a] big chunk of Covent Garden, with its merger with Shaftsbury is owning up, it’s going to be the owner of Carnaby Street etc. So, just a fantastic real estate asset which trades at half NAV and is [a] strategically valuable asset.

And just finally then, given what you’ve said there, could you maybe give us a bit of an outlook beyond those couple quarters, what you were looking to, and I mean, the name of the fund perhaps gives it away slightly; are you – you mentioned the defending nature you’ve taken on the fund – are you very much in a recovery positioning now rather than, you know, recession position? Are you sort of looking towards the upside now on the fund?

[10:32] Yeah, I agree. As a recovery fund, I suppose, we’re never the best positioned to be full-on defensive. But I think as I mentioned, we’ve done reasonably well in the context of big drawdowns elsewhere over the last year. Definitely it is right for us to be moving onto the front foot, as a recovery fund. At the bottom of the cycle, it’s right to be looking for classic recovery value, multi-cap. And also, you know, the area of out-of-favour structural growers, to be looking for opportunities in that area. And I think the fund’s well positioned to benefit from [the] bottoming out of the cycle and a move into the recovery phase of the cycle – whenever that happens over the next couple of quarters. And we’ll be gradually applying more capital to follow that theme.

Hugh, once again, thank you very much for your time and thanks for joining us.

[11:34] Thanks very much. Thanks for all your questions.

No problem. And if you’d like to learn more about the ES R&M UK Recovery fund, please visit FundCalibre.com

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.