How smaller companies are holding up amidst a difficult economic environment

James Yardley 07/09/2023 in UK

Eustace Santa Barbara, co-manager of the IFSL Marlborough Special Situations fund, discusses how mid and small cap companies have fared in the current economic environment marked by higher interest rates and inflation. Despite challenges faced by smaller companies, Eustace emphasises their long-term growth potential and the benefits of their agility and innovation.

He also highlights that smaller companies tend to outperform larger ones over time due to various factors like entrepreneurial leadership, being in niche markets, and management alignment with shareholders. We wrap up by discussing the increased M&A activity in the smaller company sector – where international firms are willing to pay a premium for cheap UK companies.

Hello, I’m James Yardley, and today I’m joined by Eustace Santa Barbara, the Elite Rated manager of the [IFSL] Marlborough Special Situations fund. Eustace, thank you very much for joining us today,

[00:11] James, thank you very much for having me.

Now, Eustace, your fund invests mostly in mid- and small-cap companies. It’s been quite a tough time in the market for them at the moment. How have they been coping with this higher interest rate, higher inflation environment?

[00:27] We’re passionate believers in the long-term growth potential of smaller companies and our expertise, James, lies in identifying which of these younger, faster-growing companies have the potential to develop into success stories of tomorrow. And when they do, we are free to continue to hold them as they grow into larger businesses.

It’s absolutely true though that high inflation and central banks rapidly increasing interest rates to deal with rising prices has had an impact on smaller company valuations. The economic uncertainty has also led to investors seeking to dial down risk, and that’s meant some have sold out of smaller companies.

These smaller businesses often have less diversified revenue streams and can be more sensitive to a slowdown. They’re viewed as riskier, and investors tend to sell some of them – [or] all of them – in more challenging economic conditions. Small cap shares can also be less liquid because there are fewer people buying and selling them.

The effect of this is that when people start selling, share prices can fall pretty sharply, which is what we’ve seen over the past 18 months or so. But,we are firm believers in the superior long-term growth potential of smaller companies. We have one of the largest and most experienced smaller companies investment teams in the UK and we spend a lot of time analysing companies to identify the ones that meet our rigorous criteria for investment.

The companies we favour are those we believe that have strong long-term growth prospects. We also want to see high-quality management teams and robust balance sheets, with relatively low levels of debt. That means they should be well-positioned to navigate challenging economic conditions, like we’re seeing at the moment. So, the majority of the companies we hold in the fund have been continuing to trade in line with expectations and in some cases ahead of them.

As an example, we hold a company called Alpha Group International [plc]. This provides foreign currency services to companies and institutions operating internationally. This is a business that’s been growing strongly and has high profit margins. It’s also benefiting significantly from the higher interest rates being paid on the client money that it holds. Alpha Group currently has a comparatively modest share of a market that could be worth around $400 billion a year, and it’s continuing to win corporate clients from the major banks that are currently the dominant player in this space. It’s doing this by offering superior services tailored to companies’ individual requirements. Alpha Group’s strong balance sheet is enabling it to invest for growth, opening new offices and using the latest technology to further improve the service it provides for clients. So, Alpha Group, James, is a good example of a company that’s continued to perform strongly in this environment, and we believe it has a very positive future.

Brilliant. And despite these concerns, I mean smaller companies have often performed well during stronger economic times. I mean, obviously there has been a lot of pessimism around the UK economy recently. So, what do you think are the prospects for the economy? I mean, can smaller companies perform in any environment? Or do we need those better economic times before they can do well again?

[03:46] We are very optimistic about the prospects for smaller companies over the medium-to-longer-term. Just like over history, they have continued to perform well over decent periods of time. We believe the case for innovative and agile UK smaller companies, and their ability to outperform slower moving corporate giants, remains as strong as ever.

What the sell-off in smaller companies has done is create, James, what we believe is a very attractive valuation opportunity. It’s rare to have the opportunity to invest in outstanding UK smaller companies at the share prices we’re seeing today. For investors with a medium-to-longer-term perspective, we believe current valuations represent an exceptional opportunity. So, we’ve been deploying cash to add to existing positions in quality companies that we believe look significantly undervalued and strongly positioned to bounce back when those better economic conditions that you allude to return, and investor sentiment improves.

We’ve been increasing our exposure in the company, for example, called Volex [plc], which supplies specialist cabling used in charging points for electric vehicles, healthcare facilities, and data centres, in addition to providing power cords for consumer electronics. The company recently reported its full year results with strong revenue growth and higher profit margins. Volex has also acquired a Turkish company that makes equipment used in agricultural and off-road vehicles and we believe this will further enhance earnings.

Another name we’ve been adding to recently is Moonpig, which is the clear market leader in the UK and the Netherlands in the growing e-commerce market for greetings cards, gifts and flowers. The group has strong brands, first class technology and very strong data science capabilities that should further enhance the experience for customers. Moonpig is a strong performer, and we believe it has excellent growth potential.

Now, over the last couple of years, I mean as we’ve been saying, larger companies have massively outperformed smaller companies, but over the long term, smaller companies typically outperform larger companies. Why is that and why should we expect that to continue in the future?

[05:54] There are a number of reasons, James, why we believe smaller companies can continue to outperform the corporate giants over the longer term. Smaller companies are often led by entrepreneurial individuals, bringing highly innovative products and services to the marketplace. And when a smaller company with an innovative product succeeds, the returns can dwarf those that might be possible for larger businesses.

One of the great strengths of smaller companies is that they can be very agile. While some large companies can be more like oil tankers taking a long time to change course, smaller companies can be very nimble, acting quickly to seize on new business opportunities. Culturally, many people running smaller companies are ambitious and keen for their business to be lean and imbued with an entrepreneurial spirit. That can be more difficult for larger companies, which can have layers of bureaucracy. And, operationally, smaller companies tend to be freer of drag factors that can slow them down, such as legacy IT systems or lengthy property leases.

Many UK smaller companies provide niche products or services for markets that larger companies may regard as simply not big enough to be worth their while. Niche players like this can achieve strong growth when they’re the dominant player in a small but expanding market. This provides a potential to increase earnings significantly faster over the medium term than larger companies focused on bigger but slower-growing markets.

In addition, when these smaller companies grow, it’s from a smaller base and it’s easier for a minnow company to grow its relatively modest revenues by, say, 10%, than it would be for an international juggernaut already selling huge quantities of its product into a more mature market. Smaller companies also have management teams who are large shareholders in their business, and we believe this can be a positive for other investors.

When those running a company have a high proportion of their wealth tied up in a business, it ensures their interests are aligned with other shareholders. Many of the companies that have achieved the strongest performance for us are run by individuals with significant shareholdings in these businesses.

Other advantages of smaller companies for investors are that there are fewer analysts researching businesses at this end of the market cap spectrum. This allows large, experienced investment teams like ours, to identify growth potential others might not yet have spotted.

And finally there’s the sheer number of investment opportunities, James. We have around 2,000 companies from which to select – the most attractive opportunities – and these businesses are in a huge range of different fields, many of them tapping into the growth trends of tomorrow.

And what is the M&A activity like at the moment at the smaller companies end the market? We’ve heard a lot about the UK being cheap. Are the private and international buyers coming in? And what is your feeling on this? I mean, are you happy about this or are you seeing some of the better companies being sort of taken out at cheaper prices than you might like?

[08:57] Well, in our view, James, UK equities are looking fundamentally undervalued. And this discount is even more pronounced among the smaller companies.

Simon French, who’s a chief economist at a broker called Panmure Gordon, calculated earlier this year that valuations of UK companies are on an average discount of around 18% to comparable businesses listed in other developed markets. This is in part because international investors remain concerned about political uncertainty and potentially the lingering effects of Brexit. The value of available though, as you alluded to, has not gone unnoticed by private equity houses and international buyers. And that’s why we’ve seen a flurry of M&A activity so far this year. And it is our belief that that will continue.

In recent months, we’ve seen three companies we hold in our fund targeted for acquisition; veterinary drug maker, Dechra Pharmaceuticals [plc] received a private equity bid at a 40% premium to its share price. Software company Blancco Technology [Group plc] has received a private equity bid at a 25% premium. And restaurant operator Fulham Shore [The Fulham Shore Limited] was bought at a 35% premium by a Japanese company that plans to expand the business internationally.

So, clearly the acquirers there believe these companies look cheap at current valuations and we would agree; UK smaller companies look undervalued in absolute terms, in comparison to other developed markets, and relative to their own historic averages. And we don’t think this discount will last forever, but while it exists, it’s enabling us to invest in high-quality, UK smaller companies at significantly reduced valuations.

Thank you very much, Eustace, it’s always great to get your thoughts. And thank you for joining us today.

[10:39] Thank you again for having me, James.

And if you’d like to learn more about the [IFSL] Marlborough Special Situations fund, please visit

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