260. Unlocking the income potential of UK smaller companies

Joining us today is Guido Dacie-Lombardo, co-manager of the LF Montanaro UK Income fund, to delve into the UK market and shed light on the extensive resources at Montanaro’s disposal. Given the fund’s specific focus on small and medium-sized businesses, Guido shares his insights on UK small caps and highlights the expertise of the Montanaro team in producing their own high-quality research. Our discussion covers various topics, including M&A activity, as well as both special and ordinary dividends within the fund’s portfolio. Guido concludes by elaborating on the fund’s strong ESG credentials, the company’s commitment to achieving Net Zero, and a notable top holding, Games Workshop.

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The LF Montanaro UK Income fund stands out from typical UK equity income funds as it specifically targets small and medium-sized businesses. Additionally, each holding provides either dividend yield or the potential for dividend growth. The fund’s proven track record, driven by its well-defined approach and emphasis on thorough research, has consistently delivered positive results over an extended period of time.

What’s covered in this episode: 

  • Why small caps been out of favour in the UK…
  • …yet continue to be a good place for long term investors
  • The types of companies the LF Montanaro UK Income fund invests in
  • Why the fund doesn’t invest in large FTSE 100 companies
  • Why the manager describes the AIM market as a lobster pot market
  • The analyst team at Montanaro
  • Will M&A activity continue in the UK?
  • Company takeovers in the past 12 months
  • How the fund’s dividends are holding up this year
  • Why the manager is taking a cautious approach to 2023
  • The focus on Net Zero targets over the past 18 months
  • What is a B Corporation?
  • How Montanaro is planning to remove 100% of all historical emissions since the company was founded
  • The success of the Warhammer franchise from Games Workshop
  • How a potential deal with Amazon could be big for Games Workshop in the future

8 June 2023 (pre-recorded 31 May 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.


Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. Today we’re focusing on the UK equity income sector, notably the small and medium end of the market, covering a variety of topics from M&A activity to dividends and net zero targets. 

James Yardley (JY): Today I’m joined by Guido Dacie-Lombardo, the Elite Rated manager of [LF] Montanaro UK Income. Thank you very much for joining us today.

Guido Dacie-Lombardo (GDL): Thanks a lot for having me on.


JY: Now Guido, your fund invests obviously predominantly in small and mid-cap companies. I mean, it’s been quite a hard time for those companies recently. I mean, we’ve seen a revenge of the mega caps as the FTSE 100 has outperformed the small and mid-cap space. So, I mean, where do we sit today? I mean, are these companies still out of favour? Has sentiment got so negative that we can look forward perhaps a bit more favourably?

GDL: Yeah, I mean, you are absolutely right. Small and midcap companies – particularly actually in the UK – have really been out of favour against their large cap peers for some time now. I think if you look at the 18-month period to the end of April 2023, the Numis small cap index underperformed the Numis large cap index by a full 26%. You’ve got to go back all the way to 1998 – that’s 25 years ago – to see a similar level of relative underperformance of small caps. So, it really has been a kind of once in a generation type period we’ve lived through. 

Why has this happened? Well, obviously small caps are longer duration assets. They tend to be growing faster than large caps. So, when inflation spikes up, when interest rates spike up, you get a valuation-led sell-off of these longer duration assets. So that’s why small caps underperformed. 

And also, you know, clearly, with the war in Ukraine, [the] oil price going up that helped the oil and gas companies, and simply interest rates going up have helped the banks, and you get more oil and gas and banks companies in the large cap [sector] than in small caps. So, I think we’ve had a macro period that has certainly favoured large cap in the last 18 months or so. 

Long term, the small cap effect, which is where basically smaller companies in pretty much every country around the world have outperformed large cap, that small cap effect remains in place in the UK. If you go back to 1954, since then, small caps have outperformed large caps by 3.1% per annum. So, if you compound that over time, actually going back to 1954, small caps have given a return almost seven times greater than large caps.

So, we think that, despite this sort of recent period that we’ve had, we think small cap continues to be a good place for the long-term investor. And actually our CEO has recently written a blog – for those of you who may be interested – on this particular topic. I think the link will be in the program notes of the podcast. So, there’s a bit more detail there on this point. So, as to whether right now they’re still out of favour, obviously, it’s a little bit tricky, you know, without a crystal ball as it were. But given the extreme nature of the underperformance we’ve had recently, it could be that we’re set for an interesting time for investors to look at the asset class.

JY: And why do you not invest in larger companies or AIM-listed companies?

GDL: Yes. So, briefly first to explain what we do invest in, and then I’ll say what we don’t invest in: so, we invest in small and mid-cap companies in the UK. It’s roughly 50% small, 50% mid, so small cap we define as from a hundred million [market capitalisation] to one and half billion. That’s roughly where the Numis small cap index cuts off. And then mid-cap, from one and a half billion up to 10 billion. Now that gives us a huge choice. That’s about 550 companies in that range. And even if you exclude AIM, which I’ll touch on in a second, and put on a dividend yield threshold of 3%, there’s still over 200 companies to pick from. So, we’ve got plenty of choice as active managers. 

So, what’s the reason that we don’t invest in large cap? Well, to be honest, we’re just not convinced we can add value there. Firstly, as I mentioned earlier, there’s a lot of oil and gas, a lot of banks in large cap land. You know, an important part of the value driver for those companies is what the oil price is doing, what the interest rates are doing and frankly, we’re not macro specialists; we don’t spend a lot of time thinking about the macro, we’re not sure we can add much value there. 

And secondly, if you think about the amount of sell-side coverage that there is, so, if you look at Shell or HSBC, these companies have between 25 and 30 sell-side analysts writing coverage on them. So, in our view, again, it’s quite hard to add value. Our companies tend to have a low single digit number of sell-side analysts covering them. Maybe one or two of those might be house brokers. And we have a very large team of analysts and portfolio managers here, about 16 of us in total, really kicking the tyres on these small and medium-sized companies. And because of that lack of focus from the sell-side, we think that gives rise to some pricing inefficiencies that we can take advantage of. So, that’s why we like fishing in our small and mid-cap space. 

On the other side, why don’t we invest in AIM-listed companies? Very quick answer, really. I mean, it just comes down to liquidity. We’ve been known to say in the past that AIM is almost like a lobster pot market – you can get in, but you can’t get out! And we’ve just taken the view that given the lack of liquidity in AIM, we don’t think it’s an appropriate place for an open-ended strategy like ours to be investing in.

JY: And what are your thoughts on takeovers at the moment? I mean, obviously, there’s a lot of talk about private equity money out there. We’ve seen this big underperformance in the small and midcap space with some of your companies potentially looking vulnerable. I mean, have many of your companies received takeover offers, and are you expecting more in the future?

GDL: Yeah, so, in short, yes. You know, as you rightly said [and] as we touched on earlier, UK small cap has had a very tough, you know, call it eighteen, twenty-four month period, certainly relative to the large cap. It’s trading towards the bottom of its historic P/E range. And, of course the pound: I know it’s had a bit of a bounce recently but it’s still relatively cheap compared to history. And as you rightly said, you know, private equity is sitting on a lot of dry powder, very well publicised. So, I think all the ingredients are there to make this – or the UK specifically – an attractive market for bidders looking to buy companies. 

In terms of our fund, you know, we invest in high quality companies, cash-generative companies, companies with strong balance sheets – actually 40% of the companies in the portfolio have got net cash. And so, you know, we think that those kinds of companies can be very attractive to a private equity company or a house to come in, lever up the balance sheet, service the debt using those strong cash flows and make a decent return. So, last year we had two takeovers in the fund. We had Brewin Dolphin [Ltd] and Biffa [Waste Services Limited] got taken out. And this year so far Dechra, [Pharmaceuticals PLC] the vet pharmaceutical company, has announced they’re in discussions with [Swedish private equity firm] EQT [AB] about a possible takeover. Now, that hasn’t been formalised yet. And with M&A in general, it’s always kind of tricky to predict exactly what’s going to happen and when. But, you know, given the ingredients, the setup that we have, I wouldn’t be surprised if we do see more approaches this year.

JY: And your fund is an income fund of course. So, how are the dividends actually holding up? I mean, of course, capital values might have come down a bit, but are the dividends still there? Are you expecting dividend growth in the future?

GDL: Yeah, absolutely. So, dividends are holding up well. If you look to last year, to 2022, and you think about it [as] between the ordinary dividends and the special dividends, the ordinary dividends, which were distributed by the fund, they actually grew by 22%. So, despite what was happening with the share prices, the ordinary dividends grew 22%. Now, the specials did go backwards a bit, and that’s because in 2021 there were a lot of special dividends, which were making up for the skipped dividends in 2020, which was the Covid year. So, you know, ordinary up nicely, specials down a bit. Overall, the distribution last year was broadly flat. 

And this year, you know … I do a sort of forecast – a detailed bottom-up forecast – at the start of January, and at the start of July, and I came into the year, you know, obviously with everything that was going on with the macro context, I took a slightly cautious approach. I thought the ordinaries would be broadly flat this year. But as it happened actually, so far this year, the dividends have been coming in a little bit better than I expected. So, we’ve had some very nice ordinary dividends from Games Workshop [Group PLC], which is one of our larger holdings. 4imprint [Group, Plc] has announced a special dividend which was very large. And we’ve also, just generally across the board, dividends have just been a bit better than I was expecting. So, the fund today is yielding about 3.8% or so. And I think it’s also important to remember the growth. So, the fund has grown its dividend at a compound annual growth rate since 2014, of almost 6%. And that actually compares to 0%, actually moderately negative for the FTSE All Share [index]. So, if you combine that yield of 3.8% with some growth, that’s what we’re trying to achieve.

JY: Brilliant. And the fund is known to be pretty ESG friendly. I mean, you exclude certain companies from the portfolio and the company are looking to be net zero by 2030. Can you tell us a little bit more about this?

GDL: Yeah, absolutely. So ESG, you’re right, it is a quite an ESG-friendly fund. And actually, many of our clients use the fund in their ethical portfolios for their client. So, we have some ethical exclusions, so areas that we will not invest in. So, those include no oil and gas production, no tobacco, no alcohol, no controversial weapons, no gambling, no high-interest rate lending, and a few other areas. So, we have those exclusions. 

And then from an ESG perspective, we also spend a lot of time actually engaging with our companies, again, with that big team of analysts I talked about. And one real focus over the last, call it 18 months – two years, has been on encouraging our companies to put in place net zero targets. But not just any old net zero targets. Having these targets actually verified by the Science Based Targets initiative or SBTi to give some real credence to those targets and the pathway to achieve them. And actually, pleasingly, about two thirds of the companies in the portfolio have now put in place these net zero targets verified by the SBTi. Which, you know, if you go back even just a couple of years, we think it’s almost an unthinkable number. So, we’re pleased with the progress there. 

Moving to the company itself, Montanaro Asset Management and our ambitions as a company, well, firstly, we’re a B corporation; we renewed that status for a further three years with a higher score recently.

JY: And can you tell our listeners what a B corporation is? 

GDL: Yeah absolutely. So, a B corporation is essentially a company that has gone through a process and been verified to be at the highest standards of ESG, you know, environmental, social and governance, but throughout the whole organisation. So, we have even had to change our articles of association, for example, to make sure that we comply with the rigorous standards to be a B corporation. Some of the most forward-looking brands and ethical brands in the UK and around the world are B Corporations, including, for example, Patagonia [, Inc.]. But we were one of the first asset managers to become a B corporation. 

So, in terms of our ambitions as a company, aside from being a B corporation, we also in March this year announced that we want to be actually carbon negative by 2030. What does that mean? Basically, we want to remove 100% of all of our historical emissions since the company was founded in 1991. Now, obviously data records and everything back then, [it] might be a bit difficult to know exactly what carbon was emitted, but we’re going to be, you know … to counteract that, we’re going to make sure that we sort of overachieve and make sure that we really have got rid of all of that. So, we’ve partnered with a Danish carbon removal platform called Klimate [ApS.]- that’s with a K – and essentially, we’re going to be partnering with them and funding some carbon sequestration products to take carbon out of the atmosphere, really. So, we think this is an ambitious target, but hopefully one that we can achieve and hopefully one that will also inspire others to follow suit.

JY: So, can you tell us a little bit about a couple of your holdings? I mean, I see Games Workshop I think is your largest holding … what do you see as the outlook for some of these companies?

GDL: Yeah, absolutely. So, Games Workshop; hopefully some of your listeners will be familiar with it. It’s the largest hobby miniatures company in the world. They’re a very focused business. They’re you know, they’ve got a strong brand with War Hammer, and they’ve got a very diversified, and importantly a loyal customer base, which gives them some element of repeating revenue, if you will. They’ve got a good manufacturing base, well invested, and they use that to produce the figurines, which they then sell unpainted but then they also sell their proprietary paint alongside it, which is very high margin, so that’s quite a nice little business model there. But their key asset really, what is Games Workshop’s key asset? It’s their very rich intellectual property, their IP. They have created fantasy worlds, fantasy storylines, fantasy characters, and the great thing about this is, because they’re fantasy, that gives them an unlimited pipeline of coming up with new characters, new storylines and essentially an unlimited pipeline of new products. So over time, we think that’s going to continue to drive growth. They’re launching their 10th edition of War Hammer this summer, so we’ll see how that goes. And also in terms of adoption around the world, this is a global business but the US is certainly underpenetrated. They’re barely scratching the surface there. So, we think that could be a very big driver of growth in the coming years. 

And the last leg to talk about really is, because of this key asset I talked about, their IP, they can actually license that out, and in return receive a royalty fee. And royalty fees basically drop straight through to profit. So, they’re very obviously high margin and transformational for the economics of the business. So, historically they’ve been licensing their IP to video game manufacturers who’ve been making War Hammer games, for example. But there was an exciting piece of news towards the end of last year, when they announced that they were in discussions with Amazon about Amazon potentially creating a TV series and maybe a film based on War Hammer, and then also merchandising. So clearly, if that, you know, that hasn’t been signed yet, but if it does get signed and if it takes off, that could be a very material royalty fee for Games Workshop. And also you’d have thought that that would have a virtuous cycle effect of kind of encouraging existing players, but also new players to play the core game as well. 

So overall, this is a business with net cash on the balance sheet, strong return on capital, and it’s delivered a five-year historic earnings growth and compound average growth of 33%. Very impressive growth. And the dividends have followed that. So, we think it’s a high quality, structurally growing company.

JY: Sounds very exciting. Well, look, that’s been a really good update, that’s been really interesting.

GDL: No worries at all. Thank you for having me on.

SW: The LF Montanaro UK Income fund stands out from typical UK equity income funds as it specifically targets small and medium-sized businesses. As we heard in this episode, Montanaro has an extensive team of experts giving the manager the potential to uncover opportunities that are frequently overlooked by others. For more information on the LF Montanaro UK Income fund visit fundcalibre.com – and dont forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice.Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.