209. Inflation protection, M&A activity and using disruption to invest in the future

1 September 2022 (pre-recorded 16 August 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. 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 your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re discussing the UK’s smallest companies, the importance of owner culture and how companies can move higher up the cap chain. I’m Staci West and today I’m joined by Victoria Stevens, co-manager of the Liontrust UK Micro Cap fund. Victoria, thanks for joining us today. 

Victoria Stevens (VS): Thank you, it’s nice to be with you.

[INTERVIEW]

SW: Now smaller companies have had a difficult backdrop since around 2016, but this fund has remained incredibly resilient in that time. Why is that?

VS: Yeah, I think that the key really to our approach on the team is the consistency of application of our investment process. So we have this relentless focus on the characteristics of companies, which we seek out as part of that investment process that we stick to through thick and thin. And I think that the thing about the market is it is so easy to be pulled in so many conflicting directions all at once by so much noise being out there in the market. And so if you find that you’ve got a framework within which you can make your investment decisions, the importance of that can’t really be overstated when it comes to trying to tune out all that noise that’s going on around you, and really try and just focus in on the attributes of the businesses and the business models, which we think have the power to outperform over the medium and the long term.

So if we take a moment just to just to outline that investment process in very brief terms, it traces its origins back almost 25 years from when Anthony Cross first joined Liontrust. And the first thing that we do right at the very beginning of the investment process is that we – and it’s really important for smaller companies and micro caps – is that we require all of the companies we invest in to be profitable prior to the point of purchase. And that’s really important to us. You know, we think it reduces the risk of those earliest stage investments which obviously can all too easily find themselves in a bit of a bubble where there’s very little valuation support if either the company disappoints operationally, or as we’ve obviously seen in the first half of 2022 you get these wider market bubbles. So that’s a really key point before we start out and then comes what we are looking for in the companies themselves. 

So really for us the first stage is all about the search for intangible assets which we think form this key barrier to competition for our businesses. It’s these intangible assets that we think is gonna make their product or service inherently very difficult for competitors to replicate. And if we get that right, if we’ve assessed that intangible asset strength correctly the company should be able to go on and exploit that barrier to competition over a very long period of time. And that’s, as we all know, can drive very strong, long term share price returns for investors. And so our first gateway for any company into the fund is that it has to possess one of three intangible asset strengths that we value or prize more highly than any others. And those three are intellectual property, a strength in distribution or high levels of recurring income. And any company we buy into the fund has to have at least one of those three before we’ll consider it for inclusion. 

And we’ll also be building up a picture of the company’s intangible asset strengths below that level as well. Things like brand strength, customer relationships procedural skills, format skills, owner culture, and so on. And then the second stage of that process is to test that theory and by that, I mean that we analyse company’s cash flow returns on capital to try and test whether in practice that superior competitive advantage is working for that company in terms of generating these superior financial returns. And really what we are looking for there is something very simple. We’re looking for companies that can consistently earn a return on capital, which is comfortably in excess of their cost of capital, thereby generating excess returns, which ideally they can then reinvest back into the business to help power their future growth path. 

And then the last thing I’ll just say on the process is that we require all the holdings in the Liontrust UK Micro Cap fund to have at least 3% of their equity owned by directors and senior management teams. So it really aligns us with those entrepreneurial founder managers who take a similar kind of long view of capital appreciation to ourselves.

SW: And does investing in those types of companies that you’ve just outlined prepare you for an inflationary environment?

VS: Yes, I think it does. I mean, there are two elements to that question. It’s what’s going on in the market and how the market is reacting to that in on a short term view. And then there’s the other side of it, which is how are the businesses themselves faring amid the current economic challenges. Now we’ll say that as part of our investment process, making macroeconomic predictions does not feature in that process. Of course we’re aware of what’s going on around us, but as I’ve been explaining, we focus exclusively on bottom up, stock picking in terms of our process. But clearly, you know, it’s been an extremely challenging period for all companies to navigate over the past year or two. And there’s a huge amount of uncertainty that remains over, the duration of those inflationary pressures, what the monetary policy response will continue to be and the extent to which that squeeze on the consumer spills over into business to business demand potentially as well. 

And what you’ve seen in terms of the market response to rising interest rates as a way to try and combat inflation for much of this year is that the valuations of growth investments have come under pressure. And that’s thanks to this sort of mechanistic impact of rising discount rates on the perceived, present value of stocks which expect very high growth rates into the future. And so in some cases, what you’ve seen is very sharp derating of companies, which really haven’t really put a foot wrong operationally. 

But if I take the other side of that coin and just focus and zoom in on the operational performance of our companies, which is all really that we, in terms of our investment process can control. I think that we really strongly believe that our companies should prove to be quite well set in terms of managing a period of higher inflation. And the real key to that is pricing power. So what we think is that thanks to those intangible barriers to competition, that we are seeking out as part of the investment process, our companies should have a greater degree of pricing power than your average company. So they should be able to be better placed to be able to pass on input cost inflation to their customers. And already we’ve seen lots of our companies so far this year, updating the market and talking about having been able to do that, to pass on those rising costs to customers, which of course means they themselves are better able to protect their margin, amid a period of high inflation.

And then there’s probably another point to be made about the types of companies that we invest in, which is that, I’ve explained that we focus on intangible, not tangible asset strengths, and so on the whole, our companies tend to be less capital intensive than your average. And then because they’re run by these typically conservative owner managers, they also tend to have stronger balance sheets than the market. These owner managers are, as I say, quite conservative with taking on lots of debts. They tend to be quite averse to that type of behaviour. And both of those two things that are really key in times of rising inflation and rising interest rates to try and counter it, because if you’ve got a business which is less capital intensive and has a stronger balance sheet, it doesn’t have to spend so much of its short term cap cash flow on simply maintaining heavy asset bases or servicing a heavy debt burden. Instead, they’ve got a much better chance of being able to continue to allocate their capital to investment and growth, taking that long term view, which hopefully we believe should position them well to continue to take market share. And then power ahead once these are challenging times recede in the future.

SW: And you just mentioned their owner culture as this intangible asset strength that you’re looking for, has that changed throughout COVID?

VS: No, I don’t think it has. I think really what we’ve seen there is it come into sharp focus. So what we tend to see from our owner managers and that culture is a couple of things. I think that the aligning yourself with this really powerful entrepreneurial founder manager is probably quite well understood by investor. You know, they’ll kind of innately grasp why that’s an attractive dynamic to be aligned with, often they’ve got this long termism to the business, a keen focus on innovation, nurturing, investing in talent and training and development and so on. And that can be really powerful when it comes to driving the business forward. 

And then what you’ve got on the other side, which probably perhaps is slightly less well understood is this these real characteristics of risk aversion. So what we tend to find from our owner managers is that they are much less willing to take on those big risky acquisitions that can so often go wrong for the market. And they’re also much less willing to take on loads of debt. You know, if you think about, I mean, it’s a back of the fag (cigarette) packet sort of type stat, but I think it’s quite powerful and illustrating just so much of their own capital is at stake. The average company in the Micro Cap fund is around about £125 million market cap. And on average, I mean, I know we look for 3% management equity ownership as a threshold, but in reality it’s much higher than that. The average is about 20%. So these companies, these owner managers of our businesses have about £25 million worth of their own capital at stake in these businesses. So it doesn’t really come as that much of a surprise that they are careful to protect that capital. 

And so regarding your question about COVID, really what we saw is that those, both of those two characteristics came right to the fore in the first part of the the crisis where the whole market was panicking. You know, it was amazing. Our owner managers were really, really benefiting from that balance sheet strength that I referenced in the market obviously was paying a lot of attention to how financially secure companies were. So the companies benefitted in that sense, but then also in terms of that long term outlook you know, we also saw that time and time again, where the companies were using the disruption to invest for the future. I’ll give you an example there to try and illustrate it.

So we had a company called Mind Gym which is a corporate training business. So it’s whole raison d’être is using the principles of behavioral science to try and catalysed change via training within a corporate environment. So they provide these bite sized tutorials or workouts as they call them mind workouts. And they own the content within those tutorials. And they used to deliver them face to face via this network of hundreds of self-employed coaches all across the globe. But of course, what you saw in the first part of COVID was that all the clients were beginning to cancel that face to face training. 

And so the founder Octavius Black, him and his wife still own over half of the equity of the company, thought, well, I’ve got this really strong balance sheet, substantial cash reserves. I’m gonna accelerate investment into my virtually delivered and digital training proposition. Because that’s something they were thinking about anyway, as a company, it was somewhere where they needed to go, but of course COVID dramatically shortened the time horizon for that digital investment for so many businesses. And the company was able to do that because it had that long term mindset about investment. And it’s a great example of what we so often see those owner managers doing in terms of taking that long term approach to capital investment and to capital allocation investment, even at a really tricky time when others might sort of put their duvet up and try and hide.

SW: You mentioned there in your answer the acquisition of these companies, how challenging can that be? M&A in terms of losing companies in your portfolio?

VS: Yeah. So in terms of inbound takeover activity for companies in our portfolio what we’d always say is that it can be really, really bittersweet. So you’ve got this shorter term advantage because you are getting, what’s usually quite a decent premium that’s paid by the buyer and that’s obviously helpful to fund returns in the near term, but then you’re having to offset that against the fact that you are losing a business, which you believe has really strong ability to compound away and deliver you strong growth over a much longer time horizon, which is the whole reason why you’re invested in it in the first place. 

And what we’ll often say is that, you know, we get quite a lot of takeovers from our funds across the market cap range, including the Micro-Cap fund. And we think that’s because the very characteristics that we are looking for in businesses as part of the investment process, those intangible assets strengths, which allow those businesses to deliver superior financial returns are obviously also interesting and attractive to buyers, whether they be corporate or private equity buyers, is that difficulty of replication that unique nature of the whatever product or service the company is providing, which is the very thing that’s appealing to the acquirer as well as to ourselves.

But in terms of how we think about them, it’s definitely true to say that some of them are harder to swallow than others. You know, particularly if you feel that a company’s been taken out on the cheap at a point in its own evolution, which doesn’t fully reflect its future potential. So one example there perhaps was you know, we had a financials holding in the firm Nucleus, which is an investment platform business, which was taken over last year in 2021. And it had, it was quite a decent premium for the takeover on the screen, but we really strongly felt that the company was at a real inflection point in trading and operational performance after what had been a couple of quite challenging years. And that sort of inflection point, that recovery, wasn’t yet reflected really at all in the share price. So that is one example of where it’s really, it can be quite frustrating. 

But you know, that’s the beauty of the stock market, isn’t it? Effectively, it’s hoisting this for sale sign over the door of every company all the time. And you get that transparency of what the market is willing to pay for the assets and you get transparency when confirmed corporate activity comes to light. So that should theoretically invite competitive tension between any potential rival bidders to play out. And if it doesn’t well, you know, we might not agree with the price, we might choose to vote for or against, but overall, if it gets voted through, we have to accept that and move on, but it is definitely a double edged sword.

SW: And UK companies, smaller companies in particular, seem to be once again in the eye of the storm, so has this made them cheap at the moment, from a buying perspective?

VS: Yeah. Cheapness that concept, it’s a slippery fish. So you’ve got two sides to it, haven’t you? So you’ve got the, obviously the price side of the equation, but also you’ve got the other side, the earnings that you’re basing that valuation off or sales or free cash flow or dividend or whatever you’re choosing to use. And we’ve definitely had a big old crunch in the price side of that equation over the year to date. We’ve had some, as I said, some really significant deratings of particularly of expensive growth style stocks, but what you’ve got now with the economic environment, looking a lot more challenging is the extent to which the earnings or the free cash flow forecasts of the business might or might not prove to be reliable in the face of these economic challenges.

And so the obvious question is, well, where does that leave you as a fund manager in terms of trying to call where we are and make decisions. And I think I’d always come back to the fact that we are really fortunate with the Liontrust UK Micro Cap fund, because we’ve got this long term time horizon for our holdings, we can try and look for the opportunity in short term disruption. We don’t necessarily have to call exactly correctly what’s going to happen over six months. We’ve got the advantage of predominantly generating our alpha from long term compounding of companies that we hold for many years. So we’ve got this opportunity to try and look for longer term value in our holdings. Although obviously we have to be aware of those shorter term risks to the investment case. And I think what I would say that we are probably a lot more excited today sitting where we are today with the market, having fallen to where it’s fallen in valuation terms, and then where we found ourselves towards the end of last year.

I mean, the market had been really roaring away post COVID and certain areas of the market and certain company valuations did look quite stretched at that point. So we’ve been really trying to be active in terms of using that short term disruption to top up holding where we’ve got long term conviction. And that’s been particularly the case where we’ve seen perhaps an update to the market where we fully understand why the companies put something out that’s disappointing the market, but we can take that longer term view. And we can perhaps be contrarian in the moment because we’ve got that longer time horizon. 

So a really great example there is a company we own called Instem. Instem’s a provider of software and services to the pharmaceutical and life sciences and biotechnology sector. So it helps clients to manage clinical trials. It helps them to make submissions to the regulator about drugs and then analyses all that critical data and provides it back to the company in various ways. And they came at a couple of months ago and it was a strong set of results, but they were looking forward and saying, well, we can see spiraling wage inflation, and that’s going to impact our forecasts for the coming period. 

So we took a meeting with them and we heard about how usually they put up their wages by kind of mid-single digits all every year in the early part of the year. But this point this year, obviously they were seeing really strong wage inflation coming through in that early part of the year. So they delayed a couple of months and actually made a much bigger increase to their people’s wages than they might perhaps usually would do (as they were) cognissant of needing to retain that talent. But critically, what we also heard was that they were putting up prices to their clients by 12% across the board to counter the impact of that on the business. And the reason why the second part of the year was being impacted in terms of the forecast was simply because there’s a lag in being able to implement those price increases. 

But for us that was a really great sign that actually the long term investment case was intact, because the business really did believe in the power of its products and services and their ability to maintain that price discipline with their customers. And that was a good sign to us that the market’s initial reaction to that news was actually overdone. So we were topping up on the back of that and that approach trying to see that long term value behind the short term move. It is really important. I think in these times where the market is disrupted.

SW: You and your co-managers aim, as you said, to be very long term holders of companies where they can actually graduate from the UK Micro Cap fund that we’ve been discussing to the UK Smaller Companies fund, which is also Elite Rated, and I was just wondering, can you give us an example of this happening between the portfolios, this graduating in a sense?

VS: Yeah, absolutely. You know, it’s the beauty of having this range of funds across the market cap range. We operate all of them under the same investment process and they span the whole of the UK equity spectrum. So obviously it does what it says on the tin. The UK Micro Cap fund focuses on the smallest companies in the market. But you know, we run other funds which look higher up the market cap chain. And for Micro Cap, we looked to buy stocks, which are capitalised under £175 million. And then we’ll look to start our exit. Once the stock grows to £275 million and above, it won’t necessarily be immediate, but that will sort of start our selling clock in our heads. And as I said, the average company in that fund is about £125 million. But the idea very much is that with this range of funds, that that ideas can graduate up the chain, as you said, if they’re successful.

And we can really benefit from having that really long period of ownership, really long period, of getting to know these companies and getting under their skin for many, many years. And I mean, there are numerous examples of it happening over the life of the Micro-Cap fund so far. But probably still the best example that I could give you was, would be YouGov. Simply because it was the largest holding in Micro Cap fund when we launched the fund. It’s since left Micro Cap territory far behind, we do try and keep the Micro-Cap fund as a dedicated vehicle for investors trying to access those smallest businesses on the market, but it was added subsequently to the UK Smaller Companies fund and our larger Special Situations fund as well. So a really successful example of a business that we identified earlier on when it was much, much smaller and has gone on to combine way that they have a really significant value for the funds across our suite of products.

SW: Great. And then just, maybe we can finish with another example. I’m hoping that you can take us through a more quirky example. So maybe something a little bit different that our listeners might not be familiar with. As you mentioned, you get to talk to the smallest companies in the UK. So I’m hoping you have one quirky example you can leave us with.

VS: Yeah, absolutely. I’m going to tell you about a company which I love talking about, I think it’s an absolutely fascinating business and not only is it not very well known on the market, but it’s also hides within the corporate umbrella, such an interesting kind of subdivision of the company. So the company in question is James Cropper. 

So James Cropper’s history is a paper mill, which was founded I think it’s over 175 years ago in Burneside, England and that paper mill business, you might sort of think to yourself, well, can’t really see where the intangible asset strengths might be in a kind of traditional paper mill business. The really interesting bit of the business for us is not that traditional paper division it’s that in more recent times, they’ve taken their experience in what they call non-woven to apply their expertise to newer more advanced material markets via a division, which it calls technical fibre products.

And this division produces these ultralight non-woven carbon fibre veils, which are used to coat composite surfaces. So it’s used in industries like aerospace and defence, high end automotive clean energy and so on. And it’s these fibres are amazing, they’re so light that when the company comes in to present you they’ll hold one up above the desk and they’ll take their hand away. And it will literally float down as if it’s almost a feather, the lightest version of it. But the idea is that these veils provide this superior finish to composite surfaces and also can imbue them with a range of different qualities. So for example, electromagnetic shielding so they’re used on steal fighter jets in the defence sector. So a really fascinating business growing far faster than the paper mill business, much less subject to the vagaries of input cost prices buffering around.

So the paper mill side of the business is really impacted for example, by the pulp price going up and down by energy cost, for example, and so on. And I think what’s also super interesting about the the TFP division is that it has a range of solutions for the hydrogen industry, so of particular elements, of course, to the climate transition. So it makes the gas exchange layer within hydrogen fuel cells and has quite high market share in that N but growing markets. So a really interesting, highly technological business, which has emerged out of what you might look at on paper – no pun intended –  and think is quite an old school, dare we say it quite a kind of dull industrial business. So a really fascinating one, I think and one which we hope will do well for the fund over many years to come.

SW: That is very interesting, way more than just a paper mill as you alluded to. Well, Victoria, thank you for your time and your insights.

VS: You’re so welcome. Thanks very for your time today, allowing me to come onto the podcast.

SW: The Liontrust UK Micro Cap fund follows in the footsteps of the successful Elite Rated Liontrust UK Smaller Companies and Liontrust Special Situations funds by applying the teams proven ‘economic advantage’ investment process to an area of the market that tends to be under-researched – Britain’s smallest businesses. To learn more about the Linotrust UK Micro Cap fund, visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

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.