232. A brighter future for smaller companies in 2023

TRANSCRIPT: EPISODE 232

Published 31 December 2022 (pre-recorded 8 December 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.

[INTRO]

Joss Murphy (JM):

Hi, I’m Joss Murphy, research analyst at Fund Calibre, and this is the Investing on the Go podcast. Today I’ve been joined by Simon Moon and Alex Game, managers of the Unicorn Smaller Companies fund. Hi, Simon, Alex, how you doing?

Simon Moon (SM) + Alex Game (AG):

We’re good, thanks, how are you?

[INTERVIEW]

JM: Very well, thank you. Well, let’s get straight to it now. Smaller companies have had a tough 2022 in terms of share prices and performance, but does this really reflect the underlying earnings and revenues? How have the companies actually fared are, have they been able to refinance, etc.?

SM: Yeah, I mean, it has been a really tough 2022 for all things UK and domestic and smaller companies in particular. I don’t think it reflects how these companies have managed operationally. You know, just speaking to our portfolio specifically, you know, the vast majority of companies have – on an operational level – come in at or above market expectations over the last 12 months. They’re all financially resilient, you know, so the refinancing question is not something we’ve had to face too much within the portfolio, with about half of the portfolio has net cash on the balance sheet.

Of those companies that are indebted, the net debt’s particularly low when you compare it to the market generally. I think, … if I talk to the broader point of the smaller companies’ market, I think that’s financially in far better health than it was say 10, 15 years ago in the wake of the global financial crisis. I think you’re tending to see a bit more of a pragmatic attitude from banks as well, you know, as per what you saw around the Covid period – the first lockdown – you know, you’re seeing covenant waivers more frequently and just a bit more of a collaborative approach to financing for companies. But like I say, we’ve not really seen those sorts of problems within the portfolio. Don’t know if Alex has got anything to add?

AG: Yeah, I mean, so what we have seen, speaking to Simon’s point there in terms of, you know, revenues/earnings still being in line with what we’d expect, we’ve seen a very significant derating in smaller companies. You know, smaller companies in general are more domestically oriented than large companies, so, you know, more sensitive to sentiment towards the UK economy. You know, everyone will be familiar with the political backdrop that we faced so far in 2022, clearly that hasn’t helped. Sterling has depreciated and has been very volatile, and all of these things have played into the fact that sentiment towards UK entities and UK small caps in particular, have been very depressed over the period. Clearly that throws up lots of opportunities though, to buy into very high-quality assets at depressed valuations.

JM: Yeah, well, those are very interesting points and thank you for shedding a light on that. Heading into 2023 and what looks like, you know, quite a large recessionary environment, what is your outlook for smaller companies – can they weather this storm? Do you think some are better placed than others? Once inflation has peaked, will this make a difference?

SM: Yeah, I mean, I think the consensus certainly is that we’re facing a recessionary environment. I think where the consensus is most variable is how long and deep that recession is being … Obviously, needless to say, we’re hoping for a short and shallow one as are all our investee companies, in fact.

But I would say that, you know, small companies are more likely to be domestically focused, so if we have a domestic recession, they’re likely to be impacted. The good thing about investing in smaller companies is that they are nimble, they’re more agile, they’re able to adapt faster. Again, we saw this you know, through the pandemic, that sort of fleet-footed nature of a small business being able to react faster than a larger comparator, and that should enable them to position themselves well in light of recovery and in light of resilience, in a hardening economic condition as well.

AG: Yeah, I think we’re likely to see some divergence in performance across different sectors. Clearly the consumer discretionary sector is likely to face some pressure. You are already starting to see that come through in the earnings performance of some of those companies. And we’d expect that to accelerate going into, you know, the early months of next year as we start to see the updates provided by some of these companies. Interestingly, there are other parts of the market that may perform better than the market consensus is expecting at the moment. You know, capital goods is a good example. There are areas within the industrial space in the UK that are still benefiting from the pent-up demand from the disruption during covid. So, there is underlying recovery trends within some of these markets, which I think will provide an interesting opportunity set for those investors willing to take a slightly longer-term view over the next 12 months or so.

SM: On your inflation point, I think that, anecdotally from our meetings with management teams – and we, you know, as we’ve discussed on these podcasts in the past, we put a lot of weight on those management meetings with companies. And our corporate access tends to be very good as well – it does really give us a barometer on various points of interest and the economic health of the economy … of the nation. And I would say anecdotally, we’re hearing and feeling evidence of inflation peaking, rolling over; that obviously is broadly positive – universally positive, really – and I think if that has happened, then that does indicate a shorter recession, [it] does indicate a shallower recession as well. And it also indicates that inflation expectations are high, are too high.

I’d also say that, you know, we’ve looked at inflation over the last 60 plus years. We’ve looked at the data of inflationary environments within the UK and then we’ve looked at small cap returns post those periods of peak inflation, and there’s been three peak periods, or periods of peak inflation, very defined periods. And after each of those periods, small companies have tended to outperform over a number of years. So, that gives us a fair amount of reassurance that, despite smaller companies being a pretty unpleasant place to invest in 2022, a good future might be ahead of us.

AG: And historically, smaller companies have underperformed going into peak inflation, which is exactly what we’ve seen so far year to date; as inflation has been increasing, smaller companies have come under a lot of pressure. So clearly, you know, people need to take a view on where we are in that inflation curve. We are increasingly confident that we’re reaching the top end to that curve, the peak of the inflation curve.

JM: Yeah. Well, thank you both for that. I believe you’ve kind of touched on it there, so, you know, what do you think it would take for smaller companies to do well once again, what could be the catalyst? I mean, possibly, you know, that inflation peaking and coming down. Do you think that would be the main catalyst to see these smaller companies perform well again?

SM: Yeah. I certainly think that’s an element of the catalyst, the catalysts. You know, we’ve been saying for about six years, that the UK’s cheap, and smaller companies are cheap, you know, ever since the Brexit referendum. It’s been very difficult to pin down, after this really bad year for smaller UK companies, what a catalyst might be, but there’s various elements of it. There’s a political backdrop which Alex just touched on earlier. It’s been appalling in the UK and it was putting people off before 2022 anyway, so if you have a decent period of stability on the political backdrop, that will help. Peak inflation being lower, and that terminal highest interest rate being lower [than] the market expectations and rolling over, that’s probably the strongest catalyst.

AG: Yeah, I think the relative performance of Sterling as well. Clearly Sterling has depreciated over a number of years now since the Brexit referendum and, this year in particular, has been [a] particularly challenging year for Sterling. But any reversal in the strength of the dollar in particular, relative to Sterling, I think would be beneficial for UK equities and also UK small caps in particular.

SM: And finally – sorry, long answer this! There’s lots of these factors coming through! – M&A activity; you know, the international market especially, or in international companies, especially looking at the UK and seeing cheap companies, low valuations and that sort of depressed sterling too. It’s a double discount. After a busy first half of the year when it came to M&A activity, I think you saw a general reluctance because of that worsening political backdrop we saw in the UK and ‘Trussnomics’ [former Prime Minister Liz Truss’s economic policies].

Now more recently, you’re seeing just a bit more activity in the market. One of our investee holdings in our very concentrated portfolio, was bid for two weeks ago, at a sort of 65 plus present premium to the prevailing share price. So, it is still out there, a flurry of M&A activities can really sort of sharpen people’s attention back to allocating towards the UK.

JM: Perfect. While some smaller companies are domestically focused, some are perhaps surprisingly international. What impact, if any, is this move for countries anchoring activities and bringing supply chains close to home, having on this area of the market?

AG: Yeah, I think that’s a really interesting question. First and foremost, it’s important to say that smaller companies in general have shorter supply chains. You know, clearly that was beneficial during covid when there was very significant supply chain disruption across the world. That allowed them to manage some of those dynamics a bit better than their larger counterparts.

But I think interestingly, we’re starting to see evidence that there is this move to reshoring happening. Clearly, domestically we are an island; any additional capital spent on those reshoring activities would be positive for our domestic economy and positive for certain areas in particular within the domestic economy. So, you know, a greater level of investment in the UK would be beneficial for the smaller companies, absolutely.

SM: And you look at sort of the last sort of 20, 30 years in the UK as well, and what we were very open to as a country was globalization. It was a benefit, you know, to the populous of the UK. It was something we disproportionately imported the inflation basically, … through globalization, through getting it cheaper elsewhere and bringing it in, and what we see this certain sort of increased capital investment within the UK, not only will it just sort of generally help domestically focused companies, but should also as well, disproportionately benefit the UK, given that there should be more coming back into it.

JM: Perfect. Very interesting. Looking at the portfolio now, I noticed you have a large weight to engineering companies. What do you like about companies in this sector?

SM: Well, it’s what we do well in the UK, it’s … in the UK, we’re lucky to have, [as] the birthplace of the Industrial Revolution, we’re lucky to have an incredibly rich industrial heritage. Yeah, I mean that is … these are world-leading companies, absolute market leaders. And … we’re very good at talking ourselves down in the UK. We certainly don’t do enough of talking about what we’re very good at. And, just because of that heritage, we’ve naturally been left with a lot of these very specialist, niche engineers.

AG: And I think in many cases, particularly in these smaller, niche, industrial businesses, they’re often seen as very, very cyclical, very sensitive to the broader economic backdrop. We think when you look under the bonnet that there are some really interesting structural drives in some of these businesses.

So, a great example, it’s a company called Severfield [Severfield plc], which we invested in for a number of years. This is effectively a fabricator of structural steel, which goes into buildings, offices, data centers, distribution warehouses, stadiums. So, there’s some really interesting long-term structural drivers within that business. It’s been undervalued for a significant period of time because the market has seen it as very, very cyclical and economically sensitive. This is a company that also has a JV [Joint Venture] in India, so it has some interesting exposure to a high-growth market overseas. The market at the moment – the stock market – is placing very little value on that JV. We can see an event at some time in the medium term, where Severfield will try and monetize the value of that joint venture in India, potentially through an IPO [Initial Public Offering] which could be, you know, very material in terms of an event to realize value within that business.

SM: And I’m conscious of time, but we’ll just throw in another example as well. And we’ve sort of touched on this dynamic when we were talking about the outlook. There’s a company we invest in, in the fund, called Castings [Castings P.L.C.], which makes components for light trucks, so Scania, Volvo primarily.

Over the last two years, you’ve had various sort of supply chains snafus primarily around semiconductors. That’s led to sort of a pent-up demand for these end products. So, I mean, a concern that a lot of people have when they’re looking at engineers is that if you are facing the recessionary environment, you’ll have this… a fall-off in demand in unison, which sort of compounds itself and makes a painful recession for those companies, especially. However, there’s so much pent-up demand in the end market for a lot of these companies that should really help see them through a, well, a more traditionally recessionary period, hopefully unscathed.

AG: Yeah, that’s a great example. Castings has about, you know, 18 months or so of pent demand in terms of volumes, to just catch up the shortfall during the pandemic, which will clearly, you know, dampen any impact of a reduced economic environment.

JM: And kind of on that, what changes have you made to the portfolio in recent months? Any sales or purchases of note?

SM: Yeah, I mean, a period like this year is always awful to go through on a day-to-day basis, when you’re sort of looking at stock market performance, looking at share price performances, but it does throw up tremendous opportunities. So, there is always a silver lining. Our watch list of companies is currently … probably hasn’t been as long as this for many years, maybe even ever.

What we did see was sort of dynamic, over the summer, of high-quality structural growth companies, selling off and the fund operates a relative value approach, so it’s not out and out value, but we’ll always try and invest in companies when they’re positioned well on the value curve against their historic long-term averages or against competitors in the market. That gave loads of opportunity to add growth companies, add good valuations to the companies. So, you know, likes of Ashtead Technology [Ashtead Technology], FDM [FDM Group], GB group [GB Group plc], NCC [NCC Group], all growth companies that a year or so ago would’ve been too expensive for inclusion within the fund, [but] found themselves at very attractive valuations. And, we may have touched on this in the last podcast, on small co.’s [companies] but at the beginning of this calendar year, you know, we did take a very serious exercise in reducing consumer exposure so that sort of trend continued over the year. And I think that if you are going to have a consumer-led recession, I think that that places the fund fairly well.

AG: And just expanding on that relative value approach. You know, we are very disciplined in terms of how we apply that relative valuation appraisal to potential new holdings in the fund. Our investable universe [is] the NUMIS smaller companies index plus AIM [London Stock Exchange’s market for small and medium size growth companies]; if you look at that index 12 months or so ago, 20% of that index would’ve been trading at discounts to their long-term averages. We’re looking at it today at just about 70%. So, our investable opportunity set has increased materially over the past 12 months as a result of the market moves. And clearly, that’s allowed us to buy names, which historically looked too expensive. You know, the likes of GB Group, NCC, FDM which Simon listed before.

JM: Well, thank you very much Simon and Alex, that was both extremely interesting and informative.

SM + AG: You’re welcome, thank you.

JM: If you’d like to find out about Unicorn UK Smaller Companies fund, please visit FundCalibre.com. And don’t forget to subscribe to the podcast via your usual channel.

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.