273. The strong growth potential for UK equities

31 August 2023 (pre-recorded 23 August 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. We’re discussing both private and public markets in the UK this week, as today’s guest tells us more about global events and how market sentiment can impact a trust’s share price.

Chris Salih (CS): I am Chris Salih, and today we are joined by Uzo Ekwue who is one of the managers of the Elite Rated Schroder British Opportunities Trust. Uzo, thank you for joining us today.

Uzo Ekwue (UE): Hi Chris. Thank you for having me.

CS: No problem at all.

[INTERVIEW]

CS: Let’s start with what’s happening with the Trust itself. So, despite the value of the underlying assets within the Trust really holding up well since launch, the Trust has seen its share price fall by sort of around 30%. Could you maybe talk us through why that’s happened and why you feel this might be an attractive entry point for investors?

UE: Sure. So, we launched in December 2020 when the world was still very much getting used to being in a pandemic. Then the share price tracked the NAV pretty closely, and we were trading at a very small premium to NAV at the beginning of 2022. Then with the onset of the Russia/Ukraine conflict in early 2022, we started to see inflation exacerbating beyond the levels caused by the pandemic-driven supply chain bottlenecks. And then as inflation continued to rise even further, we then saw central banks move to increase interest rates higher and higher as part of their aim of stabilising prices. Then last year we saw several changes in the UK leadership at the Prime Minister and the Chancellor’s seats and Kwasi Kwarteng’s mini budget at the end of September was not taken well at all by bond and equity markets.

Then there was the added aspects that the valuation of growth or long duration stocks tends to be more sensitive to rising interest rates than short duration stocks. So, since the beginning of last year, the FTSE 100 has materially outperformed the FTSE 250, FTSE Small Cap and FTSE AIM indices.

Now, because we are a small and mid-cap focused fund, all of that has basically meant that the valuations of our public holdings in aggregate have been priced accordingly. It also means that negative market sentiment has weighed on the private company landscape too, particularly for unprofitable companies who have been burning cash quite rapidly. But I think it’s important to state that there are different segments of private equity and venture capital, and our private equity book hasn’t seen this type of softness, but actually rather – and we talked about this in our annual report – that 8 out of our 9 private equity investments are already profitable or they have a clear pathway to reach profitability fairly soon.

So, in addition, at the end of March 2023 which reflects our Trust financial year-end, we’d seen 9 successive quarters of valuation increases in the private equity portfolio. So, now obviously I don’t want to be making any forward-looking statements and, you know, past performance isn’t a guide to future performance, but we have seen our private equity book be a lot more resilient than perhaps what the scary industry headlines about private equity would suggest.

So, we’ve really seen SBO [Schroder British Opportunities]’s share price react to a combination of this negative market sentiment that I described, and also the negative sentiment about private equity. And so, because of where the discount is today, we talked at the time of our results that the implied annualised return that you would have got from then until a continuation vote, was actually very attractive. I think we talked about it being around 8.5%. So, it’s worth just being clear that whilst we do have a continuation vote, we are quite committed and hope to run this fund for quite a lot of years to come, but it’s just worth just talking about that because it is a feature of the fund that we just have to accept that is there.

Then in terms of why I also think that this is an attractive entry point for investors is because the private equity portfolio has been seeing a lot of really interesting developments, particularly this year. So, they’ve had the acquisition of AgriBriefing [Limited] by Mintec [Limited] and then also recently one of our companies Rapyd [Financial Networks Limited], they announced that they’ll be acquiring PayU [GPO] for $610 million. So, there’s a lot of momentum going on there.

And then perhaps, maybe just rounding off your question, on the public equity side, we see valuations of the stocks that we hold, not reflecting their full fair value.

CS: So, just to be clear, you covered quite a lot of it there, in terms of the mispricing, which you feel is present on the Trust, I mean, even at this level, which you feel, you know, is not right that the Trust is offering sort of 8-8.5% annualised returns from this point, which is still fairly attractive – so, you know, it shows you the upside potential of the Trust even at this level.

UE: Yeah, absolutely. And perhaps if I maybe go in and talk about the mispricing in a different way. So, we think about the mispricing of the Trust in terms of what is the implied discount on the private assets if you back out or if you reverse engineer the current share price? So, if I use the last set of official numbers – so, we talked about this in our retail webinar back in July – there we showed that at the end of May, our NAV per share was around 102 pence, but our share price was just under 69 pence. So, those are two key numbers:102 and 69. Now 33 pence of our NAV was the value of the public holdings. So, broadly speaking, if we were to liquidate them, we would get around 33 per share. So, that would explain the 33 pence of our share price.

Then we have cash, which was around 8 pence per share. So, cash is cash. So, that should also explain around 8 pence of our share price. So, if you’re still with me, you have 41 pence, which so far explains the share price – so, that’s 33 pence plus the 8 pence. So, that means that the rest of our share price must then be explained by the private assets.

So, you’ll remember I said that our share price was 69 pence at the time, so that would’ve meant that the market was saying that the per share value of our private assets was 28 pence, that’s 69 minus 41. However, in our NAV, the official published number that tells you the actual value of the asset, the private equity was being held at 61 pence. If that implies that the market was roughly discounting the value of our private assets by around 55%, which in our view is just incorrect.

Now, I understand that that people could argue that, well, you know, the market was saying that it didn’t believe our NAV or rather that it didn’t believe the NAV of our private holdings, but what we’ve tried to explain is that the driver of the NAV growth of the private assets has been operational improvements, whilst we’ve actually been taking our valuation multiples down.

So, to help your listeners understand the valuation process a bit more, it’s carried out completely separately by a totally different team. They’re quite experienced. They’re based in Schroders Capital, so none of us on the SBO investment team – or any other investment teams – gets involved in where the valuations are set. And, in addition, SBO’s board critiques the valuations even further. And then also we also have our auditor too, to critique them.

So, when we look at that implied 55% discount on the private assets, in some cases it’s even wider than where pure play* listed private equity investment trusts were trading at the time. And in our view, you know, it is a material mis-pricing. So, our private equity team has a very strong track record of value creation over the very long term, and it’s that same track record that we’re trying to bring to SBO. And actually since that we’ve been telling that story a little bit more explicitly since our results, we’ve started to see our discount begin to tighten. So, whilst the math I explained might be slightly different today as at the time of this recording, we will update the market at our next results with official audited numbers. But the point about an unjustifiable discount is still the same.

CS: When we mentioned that unjustifiable or mismatch, that the word that comes to mind is obviously sentiment. Now, UK equities have not been loved for the last 15 years, but particularly the last 7 since Brexit. Many reasons for that: not having growth exposure, the concerns overseas about what the Brexit impact has… I mean, it’s a really open-ended question, but in a nutshell, what do you think we’ll need to see? What’s the catalyst, what will be the driver that sees that sentiment change in your eyes?

UE: Yeah, it’s a really good question. I think the key catalyst, which probably shouldn’t come as a surprise, is that we need to reach peak interest rates in the UK.

So, markets are quite reactive at the moment to economic data such as CPI, wage growth and GDP. So, we’re seeing that core CPI is still a little bit sticky; wage growth and GDP are still quite strong. So, I think this points to another interest rate hike in September. So, currently the Bank of England base rate is 5.25% and the market is pricing in another 25 bps [basis points] for September. So, the UK market, as we know, is trading at a substantial valuation discount to itself and also relative to global equities. Now, part of that has been driven by continued outflows from UK equity funds for various structural reasons. So, we’ll need to see, I think some continued government-driven directives such as with the Mansion House compact** that was just talked about a few months ago. And that should hopefully help to drive more flows into small and mid-caps in particular over the long term.

CS: Turning to the Trust itself in terms of the structure, at launch it was more exposure to sort of public assets and that’s sort of changed now completely towards the private side, and I think it’s about two thirds in on the private side now. Could you explain that evolution or is it an evolution that was planned? Just talk us through that change in the structure please.

UE: Yeah, sure. So yeah, you’re absolutely right. At launch, the Trust was actually more weighted towards public equity and cash, but then given the active pipeline that the private equity team had been building even prior to us launching, we then began to make a number of deals in the private equity space. So, you saw us investing in the likes of Graphcore [Limited], Rapyd, Cera [Care Limited] and so on. So then, as we continue to deploy that capital towards the private equity deals, the proportion of private assets increased as a percentage of the overall total.

Then we’ve had a situation whereby the private equity portfolio has been upwardly revalued due to buoyant underlying trading as well as just ongoing momentum in their various buy and build stories. But then in contrast, the small and mid-cap public equities have been quite weak. So overall, that’s taken us to where we are today with 65% of the total investments in private equity and 35% in public equity.

CS: Okay. We talked a bit on the private side, let’s focus a bit on the public again now. So, we talked a few weeks ago and you described it as a ‘beat and raise’ phase in markets. Could you maybe explain that to the listeners and whether you are seeing lots of opportunities on the public side at these mis-priced levels as well?

UE: Sure. So, markets have been really choppy in the last couple of years, and when market participants tend to navigate this type of climate, companies that can beat expectations and then raise guidance are the ones where you’ll typically see large bounces in their share prices. So, that’s really what I meant by that. If you’re a company that is conservative when you set guidance and then you exceed expectations, you’ll get rewarded quite materially. If your share price has been struggling, a lot of times is not enough to just meet expectations – and even sometimes we see the company’s share prices even fall after a set of inline results. So, it really all depends.

Then if you think about the ‘beat and raise’ concept in another way – as long-term investors, what we’re actually looking for is those mispricings. Companies where it is very clear that either the company management, that they have set guidance for revenues and earnings just too low, or where consensus is not fully reflecting the opportunity in their numbers so, overall expectations in the markets are really, really low.

Then conversely, we also keep our eyes on the lookout when operational expectations or other KPIs are too high and the valuation multiple is overstretched, because then that is also usually a course for concern.

CS: I wanted to touch a bit more on the sort of spectrum of companies you invest in. I think you mentioned before when we talked, to sort of 1£15m to £2bn in size on that mid and small cap space. So, obviously the UK is known for its innovation, so you’ve got quite a number of companies to choose from. Could you maybe give me an example at each end of that spectrum in terms of the types of companies you’re investing in?

UE: Yeah, sure. So, it’s £15m to £2bn. And an example of the top end of that range is a company called Bytes Technology [Group plc]. And this is a £1bn market cap company, and it’s one of the UK’s leading value-added resellers. And it sells primarily software products made by companies such as Microsoft  [Inc.] or in the cybersecurity space, the likes of Darktrace [plc] for instance. And it also serves just both public and private sector clients. So, we like this business because it’s got high renewal rates. The revenues are really sticky. It’s supported by increasing industry tech spend particularly in software, so that is acting as a tailwind towards its growth. The total addressable market is very large, so the runway for growth is significant. It’s highly cash-generative and so on. And the reason that we added it to the portfolio earlier on in this year was because three of our companies were bid for last year, so we needed to replace some of the quality that was lost in the fund. So, the stock’s done really well for us this year, and we see this as a long-term compounder.

And then another company that perhaps I’ll talk about is a company called Judges Scientific [Plc], and that’s around a £610m market cap, and that specialises in the design and production of scientific instruments. So, it’s got a great management team at the helm, and the stock’s been one of the best performers in our portfolio since inception, as well as generating significant value for shareholders over the last 20 plus years. So, the individual portfolio of businesses that they’ve acquired operate pretty much autonomously, so there’s a decentralised model in place, although there is oversight and support for the companies at the group level. But the main attraction and the reason why we hold it is that each business operates in niche markets and that gives them pricing power and an overall competitive advantage. So yeah, so that’s a stock that we like a lot and we see that as a continued long-term compounder in the fund.

CS: So, one thing I did want to ask about was mergers and acquisitions and some of the activity that you’ve seen on the Trust. I mean, is what you are seeing, given the valuation of UK companies, always sort of welcome or is it sometimes you feel companies are potentially being sold, perhaps not at the premium they should be sold for? Could you maybe give us a bit more insight into that, please?

UE: Sure. So, we’ve had five bids in the fund since inception and we had three last year. So, the three last year were Ideagen [plc] Euromoney [Holdings Limited] and Emis Group [plc]. Now, you’re absolutely right that, because of where UK equity valuations are, that it has meant that the likes of corporates or private equity can come in and take advantage of those low valuations. And you know, this over the last 20-odd years, has led to the de-equitisation of the public equity markets where the public equity markets have shrunk. So, on the one hand, it isn’t great when we see these public companies go a lot cheaply, but then arguably you could say that it is the responsibility of public equity market investors to price these accordingly. So, I can understand why private equity or various other corporates come to take out cheaply-valued companies, but it’s probably worth saying that still the companies that we have invested in, particularly last year, the IRR [internal rate of return] on our investments [has] been pretty strong.

So, we wouldn’t have voted for any sale in a company by using our proxy power if we didn’t believe that that valuation was attractive. So, just for context, the IRR on Euromoney that we made about 20%, sorry 22% IRR; on Emis, it was about 41% IRR. You could argue that, clearly, you know there was a bit of upside left on the table, but we still think that the value that has been added in the portfolio from holding these investments has been quite strong.

CS: And just lastly to sort of bring it all together, I mean we’ve talked about the mismatch and some of the sentimental challenges that the Trust faces that, you know, we feel potentially are a long-term opportunity. We’ve also gone through the both segments, the public and the private mean. What would your message be to investors today, I guess would be the last thing I’d like to sort of get from you really?

UE: Yes. So our message will be is that we think this is a really exciting opportunity to be a shareholder in the Trust. You know, we’ve talked about the private equity sleeve just continuing with its really strong growth and strong momentum there. And you know, we think it provides democratised access to unlisted opportunities as well as access to Schroder Capital’s pipeline. And then there’s also a lot of latent value within the public equity sleeve that we think is well poised to do well as equity markets recover.

CS: That’s great Uzo, thank you very much for joining us again today.

UE: Thank you for having me.

SW: As we’ve heard, what makes this trust stand out is its ability to invest in both public and private companies. With four managers and over 60 investment experts working together, there are a lot of resources to handle the unique challenges of investing in private companies. For more information on the Schroder British Opportunities Trust, please visit fundcalibre.com — and don’t forget to subscribe to the ‘Investing on the go’ podcast, available wherever you get your podcasts.

*A pure play is a company that focuses solely on one type of product or service.

** The agreement is between some of the biggest names in pensions, who have committed five per cent of their funds to private equity and early-stage businesses.