The bright side of bleak: opportunities in UK smaller companies

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Hi, I’m Joss Murphy, research analyst at FundCalibre. Today I’ve been joined by Scott McKenzie, manager on the [WS] Amati UK Listed Smaller Companies fund. How are you, Scott?

[00:13] I’m well, Joss. Thank you for having me today.

Great for you to be on. Let’s kick things off. Why are valuations so attractive right now?

[00:23] Well, certainly in the UK in general, we’ve had a pretty difficult economic environment in recent years. We’ve had significant increases in interest rates to levels that we haven’t seen for many years, and we’ve also had, even more importantly, a huge spike in inflation; at one point we were at double digits. Thankfully, both of those things are now beginning to dissipate, we believe. So that should hopefully give us a slightly more supportive background for future returns from UK stocks.

We’ve also seen a lot of selling of UK equities; our own fund  specifically concerned with smaller companies. And that part of the market really has born the brunt, from poor liquidity in markets. But in general, we’ve seen very significant selling of UK equities in recent years. So that in itself, I think has been a very dominant factor in why the valuations today are so particularly low, particularly at at the smaller cap end of the spectrum.

Scott, it seems like there may be some light at the end of the tunnel with regards to interest rates and inflation here in the UK. Are you still worried about recession in the UK or perhaps it’s maybe already priced in?

[01:38] Well, I don’t think it does to be complacent about the economic outlook. We’re living in pretty challenging times and the UK, as with most countries in Europe and the US are facing pretty big economic growth challenges. So, I think as we move into 2024, those pressures are unlikely to dissipate. If anything, they’ll remain fairly pronounced. I don’t think there’s a lot of hope now from economists and market commentators about economic growth. Most people have a very, very modest improvement next year, if any, certainly the UK, if you look at the range of forecast is between zero to 1% GDP growth next year. So not exactly heroic assumptions. So we may or may not flip with recession, I think those things are entirely possible.

In terms of pricing in, certainly in our universe at Amati and smaller companies, there’s already been a very severe valuation dislocation that we’ve experienced in the past two years. So, you can never say never, but in many cases, we believe there’s a significant amount of bad news already priced into the majority of the companies that we invest in and follow.

And obviously with regard to the – you made reference to interest rates and inflation there – one can only hope that we’re seeing the worst of interest rates now. We’ve had a couple of months of interest rates being put on hold by the Bank of England. The feeling is that that is likely to persist in the short term. I find it difficult to see why interest rates would rise from here. And I guess the only reason would be if inflation deteriorated, again. With regards to inflation, that feels unlikely today we’re probably on a downward trend, and even the governor of the Bank of England believes that; he’s now suggesting that we get below 5% pretty quickly. So, I can only hope that we’ve seen the worst of interest rates and inflation, and if that’s the case we have a good sporting chance from here of valuations improving in the UK.

Well, I think we’re all hoping exactly the same, Scott. You have a new holding in Trainline, an app which I actually used over the weekend. Are you confident in travel or is there more at play on the return to office and commuting?

[04:03] Well, I’m also a power user as a <inaudible> so, like many people, I’ve discovered Trainline in the last year or two. And , one looks back towards, , the lockdowns in 2020. You know, clearly train travel was severely disrupted for a long period of time. And, , and that was an existential moment for Trainline. They had to keep on investing at a time where they had very little income. I think this is a company we’ve just recently invested in the fund, and what struck us was how much they’d improved the business during that period, despite the challenges that they faced. Bear in mind, we’ve also had significant strike activity as well, which continues to an extent.

I think what Trainline have achieved in the last couple years is enormous dominant position now in digital ticketing here in the UK. You know, by most estimates, they have 65% – 70% of the digital ticket market. I think the vast majority of people who use the trains in this country are familiar with Trainline. It’s a relatively well trusted and reliable brand. So, I think the foundation of our investment was very much the dominant position that they have in the UK and that’s now becoming quite a profitable business forum. As you allude to, we’ve seen people return to offices, we’ve seen leisure commuting actually, leisure activities actually, are if anything greater now than it was post covid. Clearly business travel is well below where it was three years ago, but if you take the UK in total, the business is now making a very meaningful profit.

The second leg to the story, and the thing that’s possibly even more exciting is the fact they’re now in Europe in quite a big way. And the European rail industry is beginning to deregulate and Trainline’s main two countries at the moment are Spain and Italy, and they’re making very dramatic progress in terms of the regulation of trains in those countries. And further down the line, we think France and Germany will also have a pretty big opportunity. So, we could see a scenario where eventually continental Europe becomes larger than the UK for train line. And that’s something that we didn’t think was reflected in the valuation of the company when we bought it.

Certainly all very exciting indeed. Another new but modest holding in the fund is Kooth, which operates a platform offering mental health support to children. Can you tell us a bit more about this company and what you like about them?

[06:29] Yes. It’s another recent holding. It’s a much smaller business than Trainline,  the market capitalization of Kooth is about £100m today, so clearly quite a different risk profile, and it’s at a much earlier stage of its development.

You know, we’re all aware of the impact that recent years I’ve had on mental health, particularly, for young people, young adults and children. And Kooth has been actually been around for a considerable period of time, it’s almost 20 years now in the UK it’s been delivering, digital support. And it’s a digital platform. It’s very easy to access. It works with the NHS and with clinical practitioners, but the beauty from the user’s perspective is that you can access it, you don’t have to referral. As we all know, there’s significant waiting lists for people to get professional referrals for mental health at the moment. And Kooth just helps to alleviate some of those pressures.

So, the business is already relatively well established here in the UK. But again, similar to Trainline, the exciting part of the story, which is emerging is its development in the US. It already has a small contract with Pennsylvania State in the US, but more excitingly, it’s just announced a very significant contract with the State of California, which is obviously an enormous potential market. And that’s backed from the Californian governor and the health authorities in California. So the business at the moment has a turnover about £20m, mainly here in the UK. And we think that turnover could get to around about £75m over the next couple years as the US kicks in. So a well established business, respected amongst practitioners, but really expanding from the UK into the US is what’s going to make it for us quite an exciting investment. Important to note that it’s a more risky position than many of the holdings in the fund. Therefore, it’s quite a modest starting position, but nevertheless, one that is very exciting.

Well, Scott, thank you very much for your time today.

[08:33] Thank you, Joss.

If you’d like to find out more about the [WS] Amati UK Listed Smaller Companies fund, please visit FundCalibre.com. Thank you.