238. Will UK smaller companies bounce back in 2023?

2 February 2023 (pre-recorded 23 January 2023)

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. Today we switch our focus to the UK Smaller Companies sector and tackle a few topics: what made 2022 so difficult? Will the sector bounce back in 2023? James Yardley joins Paul Marriage from TM Tellworth UK Smaller Companies fund, to answer these questions and more in today’s episode.

James Yardley (JY): Today I’m joined by Paul Marriage, the fund manager for the TM Tellworth UK Smaller Companies fund. Paul, thank you very much for joining us today.

Paul Marriage (PM): Good to be here with you.

[INTERVIEW]

JY: Now Paul, 2022, that was a tough year for smaller companies. I think you described it as ‘pants’ in your December update. So why was it so bad? 

PM: I think ‘pants’ was a good way to describe a year when we lost investors 25% – as did pretty much every other smaller companies fund. That’s a big number to lose. And you know, it hurts. Frankly, I’m a major investor in the fund myself and it hurts. So, why was it a bad year? So, small caps were just really out of favour last year. And why were they out of favour? Because frankly, they’re a ‘risk on’ asset in a ‘risk off’ year. 

So, if you think about last year, unfortunately dominated by Ukraine and when Ukraine kicked off, one of the assets that people don’t want to own, they’re high -isk assets; they’re things like high growth assets and small caps – due to their liquidity [and] the high growth nature of them – are generally deemed to be high risk assets. So, definitely Ukraine’s a major factor in making the sector unattractive, and I think the UK element [was] probably unhelpful as well as people began to fret a bit about the UK economy, a bit of political turmoil, and all the other things that happened in ‘22, just made small caps a really easy sell for people. 

We particularly noticed that at the end of Q3 / beginning of Q4, where it felt like people had come back from a long summer holiday; maybe some people coming back to the office for the first time and advisors and wealth managers, and they really didn’t want to know UK assets. They definitely didn’t want to know small caps, so, that was a particular sell period. Actually, when we got through that period, small caps started to rally again [and] looked a bit more attractive. So, the year-end gave us a bit more optimism for this year.

JY: Yeah, so, what happened in October to kick off this rebound? Was it just that everything got a bit cheaper? 

PM: [It’s] a little bit like land that gets saturated and can’t take any more water – you know, small caps just got saturated with bad news and people began to say, well this can’t get any worse. So, I think you were looking through …  one of the factors last year in smaller companies was that it took quite a while for smaller companies’ earnings to kind of catch down. One of the things you notice in stock markets is larger caps, with more efficient research, more analysts, generally get forecasts and market forecasts for company profits done earlier, a little bit more efficiently. Perhaps one of the attractions of small cap is that inefficiency, the fact that you can perhaps get something very right and be ahead of the market on timing. But equally the small caps were a little bit behind the market on that last year.

So, it meant that it was a bit of a downgrade cycle and I think people felt that, come mid-October, can the downgrade be any worse? And also, we are pricing in a pretty bad scenario here, so maybe if the scenario is just a little bit less bad than we think – maybe energy prices peak a bit earlier, maybe inflation you know, and by then energy prices were falling probably by then as well – so, a few things in October and it was just like peak bad news. Actually, it’s not so bad, so, a very small rally from quite a big low so it was, that was a welcome way to [end the year] and that kind of carried on till the year-end [to] a little bit into ‘23 as well.

JY: Yeah, and I think one of the things which really hurt last year I guess is not just that the small caps did badly, but actually the FTSE 100 held up pretty well for the first time in a while. So, obviously over the long term, you know, looking over 20 years, small caps have done a lot better than the large caps. [PM: Yeah, absolutely.] So, can this year be the year of catch up? I mean, do you think the worst is in for small caps? 

PM: Yeah, I mean I think that’s “Have the small caps troughed and why was the FTSE 100 so good?” So, the FTSE 100 was good because it’s the national index, [it] had lots of energy [companies] – energy was clearly good – [and] they’re very dominant in mining [companies]. So, you know, the FTSE 100’s representative of the UK economy – not really – [of] international businesses in a couple of the sectors that were most popular last year as defensive places to go or places that benefited from the economic situation last year [so] the FTSE 100 was good, I say yeah, it was a good index to be in last year. 

Small cap had all the things you didn’t want, as I’ve just alluded to; illiquidity, exposure to the real economy, a weak consumer, struggles in the supply chain still working out for corporates. Still lots of reasons why small and mid-cap really underperformed large cap. 

In the long term, as you allude to, small caps generally outperform larger companies because small caps in the life cycle of the business, you’re buying them at their fastest point of growth. And therefore, you’ve got the chance to make multiple times your money as a company is kind of growing up; when it matures, it’s more difficult to get those big returns. But last year was definitely a year when mature larger companies … in certain sectors – and those sectors that are quite big in the FTSE 100 – it was the right place to be and it’s the nature of being in an index that can outperform significantly a long period of time. You’re going to have years where it just doesn’t work. And last year it was definitely one of them.

JY: Sure, sure. And what are your thoughts on M&A and IPOs? I mean, both fell off a bit last year. I

[PM: Yeah, it did] I mean, M&A, [is there] a bit of a comeback to them?

PM: Yeah, you know, there’s been a bid this month – or two bids this month already. One for Devro [Devro Plc], which makes sausage skins amongst other things. And one for Dignity [Dignity plc], which is the funeral director. So, you know, that might suggest that M&A’s going to pick up in ‘23. 

I think [if] we look back a bit … why was there less M&A in ‘22 than perhaps we might have expected? We expected lots of M&A because valuations are low, sterling was weak, overseas buyers found the UK market attractive historically when that combination’s been there; political uncertainty as well, that’s generally attractive to buyers. I think last year, there was probably a bit more nervousness about funding because of, you know, the rise in long term rates probably made people who use debt to fund M&A, much more cautious. If you look at some of the more attractive M&A that did happen last year, were generally trade buyers. So Emis [EMIS Group Plc], which is a stock we own, software was bought by a US trade buyer – [so,] those kind of transactions are much more common, Devro, in fact, was a trade buyer. I think Dignity Funeral Directors was infrastructure, private equity. 

So, I think that one of the reasons we … Probably the big reason we have less M&A was continued uncertainty about how things are going to pan out, given Ukraine, but also just the higher cost of funding. I think, you know, if we see a little bit more clarity in cost of funding, I think people are probably, probably would look through a situation like Ukraine – historically, people have looked through some pretty bad news before in M&A – [and] I think we’ll see more trade buyers taking advantage of good companies on low valuations of which we have plenty in the UK.

JY: I mean, do you bother to focus on the macro at all? I mean, it’s obviously quite difficult to call. 

PM: I’m not a macro investor. I mean, anybody who’s followed Tellworth funds or any of the other funds I’ve run in the past, will be aware that I’m very much not a macro guy, not a person to answer your inflation/interest rate questions. 

Macro’s become a big market driver in the last year, kind of unsurprisingly I think, given global economic concerns, but no, I’m not a macro guy. I’m a ‘bottom-up, meet companies, pick stocks’ [kind of] guy and that’s delivered really good returns for investors over a long period of time. So … but not last year. 

I think it’s worth just going back to IPOs; you know, a good IPO market should be an IPO market that generates good returns for investors and introduces great new companies. If we talk about M&A, we lose companies in M&A, they’re no longer listed. And we want new growth companies to join the market at IPO and we haven’t really seen any of those in ‘22. 

I think we will see … A healthy IPO market’s usually the sign of a good overall equity market. So, I think there’s plenty of companies that want to float. I don’t think there’s a lack of people who want to float. I think the bar is quite high in terms of, you know, good quality long-term businesses with good market positions, and probably market caps in the kind of 200 million plus are going to be interesting. I think it’s going to be a tough market I think for micro caps. It’s just as generally investors have moved away from the bottom end of the market. But yeah, IPOs need to come back, I think for a healthy market and, you know, I’m hopeful they will.

JY: And are you getting a lot of ideas at the moment when you are, you’re doing that bottom-up research? I mean, are you getting excited by some of these valuations?

PM: And I think we are getting … we‘ve got plenty of ideas at the moment and actually one of the interesting things that happens in a tough year is you generally focus your portfolio a little bit more. You know, you really focus on the things you think are going to work. So, [we’ve got] quite a tight portfolio at the moment, probably 10 holdings less than we had at the beginning of ‘22. And that gives nice competitive tension for the best portfolio. So, we’ve always got four or five stocks on the bench that try and fight their way in. And clearly, we’re trying to remove the weakest links. So, no shortage of ideas. I mean, we’ve seen probably already seen this year at least a dozen companies – January’s quite quiet for the companies  – I’ve been seeing a couple of companies last week. I’m seeing another company tomorrow. So, I’m doing a lot of visits, going out and seeing companies on their own turf, which I think is a really helpful thing to do. It’s a good time of the year to do it.

JY: So maybe now if we just dive into your portfolio a bit. I mean one of your top ten holdings, well yeah, one of your top holdings I think is Stelrad [Stelrad Group plc], which makes radiators, I mean, is anyone using them as we all try to reduce our energy bills?

PM: Yeah, I think one of the interesting things about radiators is, as you switch from perhaps a gas or an oil-driven central heating system to perhaps air source heat pumps and things, the amount of hot stuff that they produce is lower, so you need to distribute it more around your house to get the same effect. I’m clearly not a plumber or a physicist – I haven’t explained that brilliantly! – but that should be a positive driver for needing radiators. So, you might need more radiator space in the same-sized room if you’re going to some of those more eco-friendly, less fossil fuel-based heating systems like air source heat pump/ground source heat pumps, solar, et cetera. So that’s a positive driver. 

I think the fact that you’re not using a radiator as much is probably, at the margin, not that much of a concern for Stelrad, but I think this is a business that’s currently valued on six times earnings or 5% yield, so no one’s expecting great things. 

The concerns about Stelrad will be mainly around new build housing and the concerns around the general housing sector; a property market slow down, less new build housing and therefore less new radiators going in. So, Stelrad is into both things – they sell into new build housing, [and] they sell into you fixing your radiator. So, this is really important point. And if your radiator’s broken now, you are going to get it fixed yeah, because you need the heat and you don’t want an inefficient radiator. So, the retrofit market – not as much – is probably quite good. The new house build market might be more, more difficult. The longer-term trend for radiators remains pretty positive. 

Stelrad is the market leader in the UK [with] a leading position in Europe as well. So, it’s one of those companies that we quite like for its P3M – ‘Product, Market, Margin, Management’ – type differentiation. It’s also extremely cheap, so it’s a bit of a value opportunity as well. So, IPO from ‘21 and the company’s actually done really well so far. It’s not really missed numbers in a really horrible market. It’s just a bit lost, but [it’s got a] pretty tight shareholder base. So yeah, high hopes for Stelrad, I think it’s a high-quality business, well managed. But yeah, in the maelstrom of smaller company bad news and noise, it’s probably not in a good part of the Venn diagram.

JY: Yeah. And IG Design [IG Design plc] group, another one?

PM: Yes. Thinks a stock we’ve, we’ve had a long time, but IG’s an interesting company. It originally [JY: Do these guys do wrapping paper or did I imagine that?] Yeah, that’s right. International Greetings was the old stock market name for it if you go back probably a decade or so now. And International Greetings was a business that originally came out of incentives to develop new industries in post coal mining areas, so one of its main factories is on top of an old coal mine in Wales. So that’s a bit of a site, but it is the UK’s leading manufacturer of wrapping paper, gift paper, gift ribbons, tags, all that kind of stuff. Christmas crackers as well. So, it manufactures those in the UK and in other locations around the world, [and] sells [them] globally. So, a fair amount of some of the more giftware stuff would come out of China and go into the US. In the UK, a lot of that’s kind of vertical integration from UK manufacture into UK supermarkets.

So, that full range of kind of shiny sparkly stuff that you generally use on occasions like Christmas, Christmas obviously pretty important, but also birthdays. I think one of the interesting trends we saw last year was that, while people were very worried about the consumer and consumer behavior, generally people spent on Christmas and also if you’re spending maybe less on a present, you’re probably still going to wrap it nicely <laugh> you want that impact of a nice present. So, they seem to have fared reasonably well through Christmas. 

Now, this is a company that had some severe supply chain issues [if] you go back 18 months – and management change! It was really hit by freight costs and making some of the wrong things in the wrong places and some demand hiccups. So, it went from a bit of a hero company to a bit of a zero company in a very short space at time. [Then a] New management team came in. We actually really like the new CEO; we know him from one of our previous investments where he did a great job [that] also had a turnaround and then eventual sale. So, with IG, I think we’ve got a really interesting scenario where some of the headwinds they had have gone away, like freight costs, and the management team have gone from crisis to “I’m worried about survival of the company and the balance sheet” to being more front foot, to growing potential acquisitions again. Again, a really, really lowly-valued share, global positioning [is] pretty attractive, and a little bit different to most of the other things you might find in the portfolio. So yeah, I think IG’s probably back on the front foot, it’s got plenty of scope for share price recovery, which is why it deserves its place in the top half of the portfolio.

JY: Great. Well, that’s been a great update Paul, thank you very much for that.

SW: The TM Tellworth UK Smaller Companies fund is a pure smaller companies portfolio run by two very experienced and highly regarded managers. It focuses on smaller companies, avoiding micro-caps and mid cap stocks and, as Paul explained today, meeting company management is integral to the investment process. To learn more about the TM Tellworth Smaller Companies 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.