Why investors need to keep investing in high-quality businesses

James Yardley 13/09/2022 in Equities, UK

Scott McKenzie, co-manager of TB Amati UK Listed Smaller Companies, talks to us about the “perfect storm” that has impacted smaller companies this year and the resilience of companies. Scott discusses the M&A activity in the market and what the managers deem “red flags” including ESG concerns and key fundamentals such as balance sheet strength. We wrap up with what opportunities the team is looking for in the second half of the year and why the key is to keep investing in high-quality businesses.

I’m James Yardley. And today I’m joined by Scott McKenzie, elite rated manager of the TB Amati UK Listed Smaller Companies fund. Thank you very much for joining us, Scott.

[00:11] Thank you, James. Great to be here.

Scott, I guess it’s been a pretty tough time for UK smaller companies at the moment, they always seem to be in the eye of the storm whenever there’s a crisis. So has this made them cheap or attractive at the moment? And what are you seeing on the ground?

[00:30] Yeah, you’re right, it’s been a really difficult period for small companies, investors in general. If you look over the past 12 months, there’s been quite material falls in the main small cap indices and AIM [index] itself is also down over 30% in the past 12 months so we really have had a dramatic change of fortune as small company investors. Yeah, and I think the issues we’re facing here in the UK are also quite tricky in terms of domestic politics, rising bond yields, rising interest rates so it feels like it’s been a kind of perfect storm. I think from our perspective as small cap investors, we are now seeing some really great opportunities as a result of this. And a lot of the companies that we invest in have seen material falls in their valuations and that’s given us an opportunity now to selectively increase the holdings, particularly in companies that we already know very well. For example, some of the software businesses, we own companies such as Craneware, Spirent [Communications]. Those are companies we’ve been adding to holdings in and those have the benefit of having dollar earnings as well at a time where sterling’s under pressure. So it’s a tricky market but we see some really great opportunities and some high-quality businesses now.

So, do you think the market’s being quite inefficient in some of these cases, as you say, those are two examples, which are actually dollar earners and obviously with the pound having come down so much, I mean, I’m expecting probably their revenues and earnings are probably looking quite good, so are you finding lots of those inefficiencies at the moment? Do you have any other examples you can share with us?

[02:10] Yeah, I think the starting point was that a lot of businesses had become quite expensive going back a year, 18 months ago. And what we’ve seen are valuation falls across the board from high growth companies also to cyclical companies as well. And I guess the problem you have with the more cyclical companies is their earnings are now under extreme pressure as a result of inflation and potential economic slowdown. I guess the good thing about some of the more structural growth companies is that they have less earnings pressure and therefore, the valuations falls that we’ve seen, you can hang your hat on them somewhat more easily than you can with cyclical companies. So, our modus operandi within the fund is really to try and focus on buying the highest quality companies at the best possible prices.

And I think that’s kind of where we are today. You know, we’ve got far more opportunity to do that. And I mentioned Craneware, Spirent, Gamma is another company that we’ve been investing in -the communications company. And we’re also investing in some of the companies that are geared towards financial markets. Clearly we’ve seen some very significant sell-offs in financial markets, so companies such as Rathbones in the wealth management field – we’ve been adding to our holdings there, and more recently Polar Capital, you know, again a really strong active fund management business that we’ve known for some time. So, there are opportunities not just within the growth sectors, but also in some of the financial sectors as well.

And what are you seeing on the M&A front at the moment, obviously with sterling being very weak now, I mean, is that bringing in a lot of overseas buyers for some of these businesses and also what does that mean for you? I mean, do you see that as an opportunity, or do you find some of your sort of better ideas sort of being stolen away from you?

[03:58] Well, there has indeed been a significant increase in M&A activity during the course of this year. That started towards the end of last year and we’ve now seen, I think I was reading some data from Numis this morning, there’s been approximately 60 billion dollars of bid activity in the UK market already in 2022 and we have seen some of that in our portfolio. We’ve had five companies already having received bid approaches in the current year, and some of them have already left the portfolio. So for example, we had HomeServe just a few months ago. We had a smaller business called Air Partners. And we’ve also had more recently Euromoney all of which have now been sold from the portfolio. So, we do have a challenge to replace these businesses, but given that we’re in what’s essentially a bear market at the moment, there are more opportunities to replace the businesses that we’re losing at more attractive valuations, than would be the case in a bull market. So, we do think the M&A theme is here to stay. I think your observation about overseas acquirers is absolutely valid. And obviously the weakness that we’ve seen in sterling makes the UK even more attractive from an overseas buyers’ perspective. So definitely we’d expect to see continuing M&A as a major theme within the UK market.

And you filter out companies for various red flags. Can you talk us through a little bit about what that means? I mean, are these ESG concerns you have or is it something else?

[05:37] I mean the two big ones that we’re really focusing on at the moment – I’ll come back to ESG in a second, – but the two major ones that we’re looking at in the portfolio just now, are the strength of the balance sheet and the strength of the profit margin. So, we’re taking quite a lot of care to make sure that the companies we invest in have got very strong balance sheets. Most of the companies we own within the fund actually have net cash. And we think that’s very important in an environment where things are likely to get worse before they get better. The economic outlook will almost certainly deteriorate from here, and with that companies’ earnings are also set to come under significant pressure as inflation continues to be very, very high. Obviously, we’ve got an energy crisis, a fuel crisis, that impacts companies as well as individuals. So, the earnings outlook in the short term is poor, we cannot deny that but we do firmly believe that companies with strong balance sheets are well placed to weather that storm, and when things get pretty ugly, they can actually take advantage of opportunity having the cash to do so. So, I would say balance sheet strength is a key thing that we look for.

Have you actually sold some holdings then, perhaps because they were a bit more highly geared? Obviously now, interest rates [are] rising and it’s getting harder and harder for companies to fund themselves – or we haven’t had to worry about it for so long because of quantitative easing – so we are in a different environment. Have you sold some holdings on the back of that?

[07:04] Well, the main area where there has been concern on this kind of front are in the more consumer-facing sectors – your retailers and your travel and leisure companies. Those are companies which are really in the eye of the storm and things are set to get considerably worse for those types of sectors. So, we have reduced our exposure to retail in particular and sold a couple of actually quite good companies, companies like Dunelm, for example, a perfectly good business, but we just don’t see how these kind of companies can buck the trend forever. We don’t hold anything in travel and leisure within the fund, so that’s at least something that we’ve avoided and we continue to avoid. So, those are just a couple of the examples of the things we’ve been doing more recently. And it also goes back to my second point about the profit margins within the businesses that we own, it’s really, really important that we invest in companies that have got high profit margins and high returns, because what we find in a downturn is the companies with the smallest profit margins are the first to be affected, and their profits can disappear very, very quickly and that’s one of the reasons why retail remains a pretty vulnerable sector.

Are you finding that across the board at the moment? Obviously it’s a challenging environment with depressed consumer sentiment and obviously higher costs because of inflation as well, are margins holding up across the portfolio? I mean, as you said, you are starting with higher margins in your case, so I guess you are probably slightly better positioned than the wider market hopefully?

[08:30] That’s what we believe, that’s why we structure the portfolio that way, to have companies which have inbuilt resilience; you are generally speaking, if companies have high profit margins, it means they’ve got sustainability to their business and a robustness to their business that lower margin businesses typically don’t have. So, we feel that structuring it that way gives us a very good chance of avoiding the worst. That’s not to say we will not get caught with earnings downturns, like every other fund, but we certainly think it gives ourselves a real fighting chance of coming out of this much better than if we didn’t have them. So I think those two things are important.

You mentioned the ESG angle as well. I mean our view on the ESG is relatively straightforward. We very much approach it on a bottom-up basis and we really take a lot of time to engage with the companies individually. What we don’t do is have box ticking exercises across the fund. We don’t believe that works, and to give you some small examples, going back a year ago, we were under pressure to divest of oil companies and divest of defense companies, for ESG concerns, and I think we all know what’s happened since the situation with the Ukraine has really turned that completely on its head and I’m kind of reasonably happy that we kept those investments, they’ve helped us kind of weather some of the recent storms. So, I think the ESG thing can be too prescriptive and our approach is just to treat every company as a special case.

Yeah, fair enough. And just finally then, so I believe you’re holding a bit of cash back at the moment so are you hoping for some more opportunities in the second half of the year?

[10:17] Yes. I mean the approach to liquidity within the fund, we do tend to keep a small cash holding of circa 3% most of the time, at the moment it’s closer to 5%. We also have a couple of companies which are subject to takeover bids [which] I referred to a moment ago and all going well, those will become cash in the months ahead. So, we’ve typically got between say 5-7% cash to deploy. And the question for us is, when do we do that really? We’re now at the phase of the market, we believe that we’re now seeing earnings adjustments and those are going to be quite difficult across a number of sectors. So, we’re not overly concerned about valuation per se, but we’ve seen a lot of change in valuation already. The current concern is mainly to do with the earnings outlook and obviously the threat of recession. So, we’re watching it very closely, but the key thesis for us is to just keep investing in high quality businesses that have been devalued, that is our key theme for the investments that we’re making. And ideally they’re out with the UK. You know, we’re typically buying companies with dollar earnings, that I referred to earlier, those types of things.

Fantastic Scott, well, really good to get your insights. That’s been really interesting. Thank you very much for joining us today.

[11:37] You’re very welcome. Thank you.

And if you’d like to learn more about the TB Amati UK Listed Smaller Companies fund, please visit FundCalibre.com. And please remember to subscribe to the channel as well.

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice.Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.