342. Why small-caps deserve your attention next year

5 December 2024 (pre-recorded 2 December 2024)

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. In this episode, we explore the evolving opportunities in global smaller companies. We discuss the widening valuation gap between small and large-caps and the catalysts for a small-cap resurgence.

Chris Salih (CS): I’m Chris Salih and today we’re joined by Nish Patel, manager of the Global Smaller Companies Investment Trust. Nish, thank you for joining us today.

Nish Patel (NP): Hi Chris, thank you very much for having me.

[INTERVIEW]

CS: No problem. So we talked a few months back about global smaller companies and the attractive valuations on offer, and I believe you said, those sort of valuations come along every 20, 30 years. I just wanted to fast forward it today. Where are we today? Are those valuations still as attractive? And if so, what are the sort of catalysts and what you sort of seeing as the opportunities within those valuations?

NP: Well, I’d say that in terms of the broadening out of the equity market, we have started to see a bit of life certainly from June onwards. It is interesting to see that the S&P equal weighted index has actually started to outperform the S&P market cap weighted index. And July onwards, small caps have started to outperform in terms of valuations in small caps, in absolute terms, they have started to move up. But even so relative to larger companies, the valuation discount is still at wide levels.

I would say that in the US, small cap valuations look fair, but large cap valuations on the other hand do look expensive. In the UK, small caps are at low valuations in absolute terms. And also you know, well, if you look at it relative to history, they’re very undervalued. And Europe is similar to the UK with low value, low valuations in absolute terms as well.

CS: Obviously there’s a few catalysts we talked about, which you sort of felt needed to sort of happen for small cap to see that recovery. We talked about whether the real strength in the large cap market, those tech giants could continue. Going forward, we talked about share buybacks in M&A and also interest rate cuts. Now obviously we’ve seen some cuts, we’ve seen a few things. Are they all at place still, or are you sort of relying on three of those moving in the right direction, or have we seen any of those particularly move in your favour already?

NP: So we’ve certainly had the interest rate cuts. We’ve had that in the US, in the UK and in Europe. So that’s helpful because a lot of smaller companies have floating rate debt. So they are bigger beneficiaries of interest rate cuts and history suggests that in the first 12 months of after the first rate cuts, small caps do outperform mid caps and large caps. So, we have seen the rate cuts and I think that is helping many smaller companies. M&A activity has picked up within small caps, particularly in the UK market. We are seeing share repurchase activity as well within smaller companies, which is helpful in terms of driving the share prices towards intrinsic values and the growth outlook for the really large companies.

We still do think that that will be perhaps a little bit more challenging than what the market thinks, just because many of these companies are now really big companies and for them to continue to grow at the same rate that they have been growing will just prove a little bit more challenging. And many of these companies will start to some bottlenecks. And that’s certainly not priced in into the shares of many of these really large companies.

CS: Obviously that sort of discount, that valuation discount is only one element. There’s a double discount at play, obviously when we talk about investment trust. I mean, your discount currently is sort of in double digits where it was last week when I checked. I mean, first of all, are you surprised by that? And also does that sort of even further the opportunity in your eyes at the moment for the trust?

NP: Yeah, you’re quite right that today we do have a double discount with the trust on a discount as well as the under underlying assets also undervalued relative to what these companies are intrinsically worth.

Now the discount of the trust to its NAV is going to be driven by supply and demand. And whilst this is very much a global fund, it is listed in the London market and in the UK and investment trusts and the UK market in general are particularly out favour. So it very well may be that as the enthusiasm for us passive vehicles calls that other markets such as the UK and active funds in general can come back into favour. And that would be helpful in closing some of the discounts that we’re seeing.

CS: Okay. I wanted to sort of deep delve into the trust a bit more specifically now. I mean, first of all, I guess a lot of people might assume that a sort of small cap just immediately goes for high growth and it’s just, you know, quite aggressive, et cetera. But you guys pride yourselves on sort of being, you know, targeting growth for small companies with lower risk is how it has how I put it. Maybe just explain how you go about this because it has held up well in the past in terms of performance, that sort of process. Maybe just explain what you sort of look for that helps you stand out.

NP: Yeah, now we define risk as the possibility of permanent capital loss. And smaller companies, by their very nature, are riskier investments because many of these companies have less developed business models. The management teams aren’t as experienced, and many of the companies that operate in the small cap landscape have disadvantages versus larger peers because they just don’t have scale and scale is very important in many industries. So we try and manage this smaller cap company specific risk by focusing on the higher quality businesses that are in the small cap universe. And those are the types of businesses, these high quality ones that can withstand these issues better than others. And we also look to buy into these companies when they’re at a significant discount than what they are intrinsically were. So we look for a margin of safety. So if our analysis is wrong, then we do have a cushion that protects us on the downside, and that helps us to avoid permanent loss.

CS: Okay. I want to sort of look at some of the changes that you’ve made on the trust in sort of past 12, well, this year, essentially. Maybe just talk us through them, for example. I mean, you’ve got less external managers now, maybe talk through that. And I believe when we spoke before, you were looking at bringing the number of holdings down a bit, including some in the UK, despite being quite positive. I’ll sort of shut up and maybe let you talk us through some of those changes and why.

NP: Yeah, sure. So this trust was previously managed by BMO Global Asset Management and the European business of BMO Global Asset Management was acquired by Columbia Threadneedle. Now that deal closed in November of 2021, but we only really co-located together last year. And Columbia Threadneedle is a really well resourced company. It is very focused on investment research, and they had a really good Japanese equities team with a very strong long-term track record. Now, previously, in the BMO days, we used to outsource our exposure to Japan’s small caps by using third party funds. Now with this acquisition, we could actually access the internal Japanese equities team at Columbia. So they’re now actually running the Japan part of this trust. And we think that that’s sensible because not only do they have a really good track record but also it lowers costs for our clients. So we thought that this was a pragmatic and very sensible thing to do. So that’s a change that we’ve made and we are looking for other opportunities to harness the resource base within Columbia.

So for example, in the US and in the UK and Europe, they do have central research teams that split by sector. And these analysts know their sectors very well. So we’re looking at accessing their research and having more conversations with the central research teams in picking stocks. So we think that’s helpful.

Now for the emerging markets we are now getting some help from the multi-manager teams at Columbia Threadneedle in picking third party funds. This is the only area of this trust where we are using third party funds. That’s the emerging markets where the emerging markets about 14% of the overall trust. So again, we are trying to make use of all the wider capabilities within Columbia Threadneedle. And that’s an ongoing program. And then finally, we’re reducing the number of holdings, as you said, in a very gradual, pragmatic way, so that we focus on our best ideas and we think that that can help future performance.

CS: I just wanted to talk about the three areas of the portfolio that you sort of focusing, well, the three types of businesses or themes that come out of the portfolio when you’re looking at them. I mean if we take each of them internally, I mean, first of all you look for quality businesses, cyclicals with low expectations and then sort of commodities related businesses. Maybe just talk us through each one, maybe spend a minute on each just to talk us through what you’re looking for and maybe an example of a company that stands out in each if possible.

NP: Yeah, sure. So on on the quality businesses side we’re looking to invest in really good quality businesses that have a long runway for growth. Now these businesses are characterised by strong competitive advantages. So they’re either the low cost producer within their industry or they have a differentiated product or service. And crucially, those competitive advantages are sustainable over the long term. And they tend to lead to high returns or capital. And these businesses have the opportunity to reinvest in their capital in further growth opportunities. So there’s a long growth runway ahead of them.

So for example, Kitwave Group is a UK-based business that distributes food and confectionery to small independent convenience stores and restaurants. So for example, chocolate bars, crisps soft drinks. These are the sorts of products that it’ll distribute. Now we think the company’s got very strong competitive advantages in terms of scale.  A customer that goes to Kitwave will have a wider product selection than if it goes to competing distributor.

And not only that, Kitwave offers superior customer service as well, such as next day delivery. And they’re very reliable suppliers. The fill rates are very high relative to the rest of the industry. So, you’ll generally get what you ask for when you put an order in to Kitwave and they’ve invested significantly in technology that makes life a lot easier for many of their customers who are business owners. Now, because of these factors, the company has consistently grown its market share in what is still a really fragmented industry.

So we think that over the long term kit way should continue to deliver long-term compounding of earnings per share. And that will come through organic growth from market share gains and also M&A where they buy smaller competitors. And the main reasons why they’ll do this is to access a region that they’re not already in or to access a product that they’re not already distributed. The company’s market cap is only £250 million. So it’s very under the radar, but we think that it should become more widely recognised by the investment community as it grows. And typically when that happens, you do see valuation expansion.

So that’s the company we’re really excited about. It is one of the largest holdings within the UK for us. And we’d like to hold it for as long as they continue to grow. So that’s on the cyclical side.

Bodycote is another UK business that we’ve invested in, and they apply thermal processing services such as heat treatment and the thermal processing looks to improve the resistance and strength of the various metal components that their customers are producing.

So for example, Rolls Royce is a customer of Bodycote, and they will send their engine fan aircraft engine to Bodycote to be treated so that it improves the resistance and strength of those components which are often experiencing very harsh conditions.

So the company offers a really strong value proposition to its customers because the customers have two choices produce they can either perform this service by themselves in their own plants, which they’ve invested in, or they can outsource this to Bodycote who have a wider range of services and can do the service for a lower cost.

Now, the shares were pretty depressed because end markets that Bodycote sell into such as automotive and general industrial they’ve been under pressure because the industrial sector been inventories over the, not only that Bodycote was impacted by cost inflation as well, and that hampered profitability. So that produced a really attractive entry point into the shares. We do think the end markets are going to recover over the longer term and the bounce back in organic volume growth should lead to margin expansion because of operating leverage. And the company’s also cutting costs as well. So Bodycote is a quality cyclical business that we’ve invested in. And we were excited about that one too.

CS: Just lastly on the commodity related businesses, because that’s a bit of something a little different perhaps that people wouldn’t initially think of. Maybe just give us an example there.

NP: Yeah. So we have taken a lower risk approach to investing in commodity businesses and a higher quality approach in the sense that many commodity businesses do suffer from many quality related issues, ie capital intensity. And it is hard to differentiate yourself. So Vitesse Energy is an owner of working interests in oil and gas wells predominantly in the Williston Basin in the US and we’ve invested in this company and the attractions of this particular model are that the company doesn’t actually engage in any oil and gas exploration themselves. They don’t have that risk, but instead they collect payments from their partners as they produce in the various oil and gas wells that they have an interest in.

So what that does is it makes Vitesse a highly cash generative business that also has leverage to the oil price. And we were able to buy the shares at a low valuation because it was a very unknown business that was spun out from Jefferies Financial Group. And that meant that because of it wasn’t very well known and it was a spin out that the shares were attractively valued and we took that opportunity.

CS: Okay. Just quickly on obviously I believe the turnover is around the 25% mark on average, but you do hold companies for the longer term. Do those companies you have for the longer term over multi years, do they have specific traits? Do they have to be a certain size? What sort of things do you tend to find those companies look like? The ones that you have for the long term?

NP: Generally it tends to be the high quality businesses because over the long term, the returns that you receive as a shareholder are strongly linked to the returns that the company produces itself. So for these higher quality businesses that are generating higher returns, we want to hold them for as long as they continue to have growth opportunities. So we like to let compounding continue undisturbed. And our longest standing holdings have tended to be the high quality ones.

CS: Just one final thing, last but not least, obviously one other strength to your bow is that you have sort of dividend, you offer a dividend to your portfolio, there’s dividend growth, it’s what over 50 years, about 53 years of dividend growth. I could be wrong about that number.

NP: Yes. This year was the 54th year.

CS: There you go. Corrected me. Since the last time we spoken, maybe just talk us through as it’s a bit different for small cap perhaps. What type of companies stand out and help you achieve that consistency? Is it quite a narrow pool? How do you go about finding those companies that offer you that ability to do so to achieve that dividend income?

NP: Yeah, so this fund doesn’t specifically have an income focus. But the dividend, it is very much a byproduct of the cash generative nature of the businesses that we invest in. And I guess the reason why the dividend has grown is because the companies within the portfolio have been growing themselves and they’ve been returning cash to shareholders. And that’s led to higher dividends over time. And we are really proud of this long record and we’ll look to maintain it. And I think we have a good chance of maintaining it. We continue to invest in these higher quality cash generative companies.

CS: So a lot of it boils back to that sort of less riskier element of the portfolio as well to some of your peers perhaps that are further up the risk. Well, I don’t wanna say the sort of expectation that perhaps small cap is higher risk, you know, there is an ability to do this within this segment of the market.

NP: Yeah. I think one of the attractions, Chris, of small caps is that these are inherently faster growing businesses and they tend to be not well known by the investment community. So they tend to have the opportunity to or they tend to see valuation expansion as they are more widely recognised. The problem is it is a higher risk asset class. So we we’re approaching investment in this asset class with a lower risk way so that our clients can have access to a faster growth asset class, but with lower levels of risk.

CS: Okay. And just lastly before I let you go, obviously as I said with the start, we talked a few months ago and it sort of felt a bit like darkest before dawn. We talked about the small cap market was like 8% of them global market a few years ago, and it was about 4% worth than when we were talking before. Are you feeling more bullish now perhaps than you were even more bullish now than you were then? Or are you starting to see that momentum coming through?

NP: We are starting to see signs of life but it won’t be a straight line upwards. You know, there will be full storms and it’ll be an uneven path. But I think that after a long period of underperformance the background and the environment is there for a sustained recovery. And that’s something that we’re really excited about and this trust is a good way to play that long term small cap recovery across the world.

CS: On that note, Nish, thank you very much for joining us today.

NP: Thank you very much Chris.

SW: This trust invests in smaller companies from around the world. The goal is to go where other equity researchers won’t, in order to find hidden gems at attractive prices. The firm’s small-cap specialists have a well-disciplined investment process and the trust has a strong track record of beating the market. To learn more about the Global Smaller Companies Trust please visit fundcalibre.com