How will public and private markets fare in 2023?

2022 was a tough year for public equity markets, especially UK small and mid (“SMID”) caps. Amidst a backdrop of rising inflation, increased interest rates and geopolitical troubles, the market favoured more international, larger UK companies.

As we head further into 2023, Uzo Ekwue, UK small and mid cap analyst, and Peraveenan Sriharan, investment director of the Schroder British Opportunities Trust, tell us more about the prospects of UK smaller and medium sized companies in both the public and private markets.

Why did larger companies outperform in 2022?

Both banking and oil sectors, largely represented in the FTSE 100, saw robust share price returns in aggregate, boosted by trade conducted in US dollars which translated favourably to their sterling earnings. Meanwhile, UK SMID caps came under pressure due to the greater sensitivity of their valuations to rising interest rates. This naturally impacted the performance of the portfolio’s public equity allocation, as we invest in fast-growing SMID businesses.

What happened to valuations?

While private equity (“PE”) valuations held up better than that of public markets in 2022, the asset class was not immune to global economic headwinds, inflation, and increased interest rates. Fundraising in Europe was at its lowest since 2014 in terms of capital raised and portfolio exits dropped to their lowest value in nine years as a result, in large part due to decreased appetite for public listings. Meanwhile, less freely available capital and higher interest costs has meant debt will cost a lot more and leverage levels, which have helped boost returns in the recent past, will be lower. With all of that said, we are pleased with how our private equity holdings performed, in aggregate, in 2022.

How do you feel going into 2023?

With this context, it may come as a surprise that we are excited as investors. This is principally for two reasons. Firstly, we believe now represents an incredibly opportune moment for us as long-term, active investors to make high quality, growth investments across selective areas of the public and private equity markets in the UK. Secondly, we employ an investment process that focuses on characteristics that we believe will enable our portfolio companies to withstand and even thrive in the current challenging economic environment.

Tell us more about the publicly listed companies you own

As mentioned earlier, the underperformance of publicly listed UK SMIDs (typically a faster growing and more domestically focussed area of the market) was stark in 2022. Our philosophy when investing in public markets is to identify and capture mispricing – i.e., opportunities where we do not believe that the market is discounting the long-term growth or cash generation potential that a company holds. As such 2022’s retreat in share prices (which was driven by weaker macroeconomic sentiment) provided us with an opportunity to increase our existing positions in companies such as City Pub Group and Sosandar.

The sell-off in UK SMIDs in 2022 was indiscriminate, and not discerning between the “good” and “less good” companies. As such this led to inbound M&A activity from corporates and private equity investors, who bid for some of our holdings (i.e. Euromoney, EMIS Group and Ideagen), to the benefit of the trust’s performance.

Despite the market backdrop, our approach is to remain steadfast and calm. We believe that when there is expectation of an economic recovery and market sentiment sustainably improves, small and mid-caps should be the first to re-rate in response. Furthermore, our analysis shows that such market underperformance in the past by UK SMID caps has usually been followed by outperformance over three-to five-year periods relative to large cap companies in the FTSE 100*. This combined dynamic provides us with confidence that the valuations of our public holdings will
recover.

What about the private market?

With leverage and rising multiples unlikely to propel returns in the near term, there could be a sweet spot for strategies focussed on strong financial performance: revenue growth and profit margin improvement. For example, expansion of product lines, geographic footprint, and professionalising management to improve profit margins. This is all easier to do among small-and medium-sized companies. This is typically harder to achieve at larger companies, which have often been through several rounds of private equity or institutional
ownership.

For example, portfolio company EasyPark, a leading parking tech company that helps drivers find and manage parking spaces and charge their electrical vehicles, has evolved as a company in terms of product offering, maturity in the marketplace and thorough geographical expansion – the company now helps drivers in over 25 countries and more than 3,200 cities.

Buy and build strategies are also positioned to do well, with opportunities to buy smaller companies with the intention to improve profitability and sell at higher multiples in the future. One example in this regard is the portfolio’s holding in Waterlogic, a leading designer, manufacturer, distributor and service provider of purified drinking water dispensers. The company embarked on a successful buy and build strategy from 2015 onwards and completed a merger with Culligan International (an innovative brand in consumer-focused, sustainable water solutions) in 2022, which benefitted the portfolio.

Meanwhile, an investor’s ability to access deals, whether direct or co-investments, with or through the very best investment partners is paramount. We would argue even more so now. In Europe, the number of first-time funds hit record lows in 2022, suggesting that investors are prioritising experience and track records at times of uncertainty, making these partners potentially even harder to access. We are well positioned here, as our private equity team has established a formidable network in the UK (as well as globally) over the course of 20 years, with relationships with hard-to-access investment partners.

What kind of characteristics do you look for in your holdings?

We invest in growing companies that have a number of attractive characteristics that we believe should allow them to withstand this tough economic environment and prosper. Whilst the macroeconomic environment will ebb and flow, our core focus is to invest in high quality companies that have strong balance sheets and that can sustainably compound their earnings over the long run. These are typically companies that have considerable pricing power, market leadership (or an opportunity to gain scale via consolidation), attractive unit economics and strong management teams. Our investments are typically profitable, but where we have invested in loss making companies, there is a clear pathway to profitability, with a strong runway of cash.

Several of our holdings, whether they are public or private, exhibit characteristics that should result in stable revenues in an economic downturn. This typically includes one or more of low customer churn, strong net revenue retention and high recurring revenues.

Finally, our differentiated public-private equity strategy enables us to continue to invest without boundaries, whilst providing access to a broader investable universe to the benefit of shareholders. We believe this differentiates Schroder British Opportunities Trust from other investment trusts and provides us with an advantage when seeking out attractive investment opportunities.

*Source: Schroders, when comparing returns of the FTSE 250 ex IT index vs FTSE 100 index. Based on rolling 12 month performance from 30 September 1990 to 31 October 2022.

Important information
This article is a marketing communication. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rates may cause the value of investments to fall as well as rise. Any reference to sectors / countries / stocks / securities are for illustrative purposes only and not a recommendation to buy or sell any financial instrument / securities or adopt any investment strategy. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on any views or information in the material when taking individual investment and/or strategic decisions.

Information herein is believed to be reliable, but Schroders does not warrant its completeness or accuracy. Before investing in an Investment Trust, refer to the prospectus, the latest Key Information Document (KID) and Key Features Document (KFD) at  www.schroders.co.uk/investor  or on request. Issued in January 2023 by Schroder Unit Trusts Limited, 1 London Wall Place, London EC2Y 5AU. Registration No 4191730 England. Authorised and regulated by the Financial Conduct Authority.

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