The third key to unlocking value in the UK small cap space

Since late spring and early summer the net positioning of the Volantis strategy has quietly crept higher. The strategy has been increasingly positively positioned as the sands have begun to shift more favourably for UK listed smaller equities. 

In this third of a three-part series, we examine the acceleration in mergers and acquisition (M&A) activity in the UK that recently took place.

The three keys

Like trust, building confidence is an iterative process. A number of investors have noted the tonal change of our monthly newsletters, informed by a handful of increasingly definitive emerging themes. Today we are sharing our first analysis on three keys turning and promising to unlock the deep value in arguably the most unpopular equity market of the developed world…

There is a danger that as long-standing investors in UK listed companies, we slip into the trap of protesting just a little too much that too many of the strategy’s holdings and prospective investments are only guilty of being small, UK listed, or both. That is not the spirit in which we share this white paper on the real state of the smaller company nation. Instead, explicit in the picture we paint here is recognition that the macroeconomic debates and the related issues of market structure/fund flows have been in the ascendency for an extended period, feeding a narrative that UK smaller companies are ‘cheap for a reason’.

In contrast, in the last six months we have begun to identity three keys to reversing those trends and unlocking the value in UK equities.

We might not be right on each and every aspect but if we may stretch the metaphor, the ‘master key’ is far simpler. The list of reasons to reengage with the UK small cap market has been lengthening, and therefore the probability of being rewarded for doing so is increasing. A more considered debate is already emerging about the health of the UK economy, combined with a recognition that the UK economy and UK equities are not necessarily proxies for each other. When a space is so unpopular, with valuation and investor positioning in extreme territory, the risk/reward equation has a very asymmetric shape to it. 

We hope you find the insight from the UK equity frontline thought provoking but most of all a reason to cut through the noise that has crowded out the conversation about the stocks themselves, at which point the real investment proposition comes alive.

Another way of describing the lack of diversity in the market structure is the absence of confident, patient and strategic capital. Investors who are accountable for target returns delivered over a number of years. Private equity and corporate buyers of UK public companies are exactly that. Though of course the outcome is those target companies are taken off market.

In the second half of last year there was a material acceleration in M&A activity. Corporates and private equity are the first mover where other investors have feared to tread, exercising their advantage of a longer holding period. They are not preoccupied with the debate whether the UK is cheap for a reason. They are not hostage to or concerned by the daily, weekly or even monthly mark of value provided by a share price. Nor are they proving deterred by a higher cost of debt, Federal Reserve policy or events in the Middle East, given just how depressed UK valuations have become. Their value, and their arrival en masse is the social proof that the perceived valuation discrepancy in the UK is real and can be unlocked. The message is there is not an issue with UK company fundamentals or prospects. Instead that companies are guilty only of being UK listed, small, or both.

The canary in the coal mine in this respect is Hotel Chocolat.¹ The ideal acquirer is always a corporate buyer. They are likely to spend more for strategic assets as they can extract synergies from scale and enhance revenue from greater distribution reach. Which will be the reason why Mars is acquiring Hotel Chocolat, the specialist in sustainably sourced luxury chocolate, for £534 mn at a staggering 170% premium.

In some cases there has even been competition for assets. There were three suitors for motor retailer Pendragon which eventually agreed to be acquired for an approximate 80% premium by Lithia Motors, leaving the larger part of the UK motor distribution industry under US ownership.

There were almost 50 transactions announced last year at an average premium of 65% across a wide array of sectors and industries. The buyers have been a mix of corporate and private equity buyers and include some very well-known corporate brands and some of the largest PE firms in the world. Reassuringly the Volantis strategies have been beneficiaries.

VOLANTIS DESK TAKE OUTS²

In addition to the social proof of the UK equities value proposition, M&A releases capital to be recycled in the UK small cap space. The closure of deals in Q1 2024 will see well north of £3bn returning to UK small cap equity funds, enabling fund managers to contemplate investing in new ideas and is an inherent part of the clearing process.

Back to basics – fundamentals, Ick investing and slugging ratios

In 2022, for the first time we published our UK small cap golden rules of investment. They are attached, unrevised, as an appendix. We are extremely aware of the time and attention spent in this white paper on variables we are less likely to be able to forecast with complete accuracy. By implication we are therefore breaking our own rule 4: ‘know what you can and cannot forecast’. Politics, economics, and broader markets do not score highly, but stock specifics do. What we are really saying is those things that investors are notoriously poor at forecasting are getting in the way of forecasting and focusing on what they can. Or as Michael Burry might put it, investing in UK smaller companies is ‘ick’ investing, ‘taking a special analytical interest in an area that by its very name or circumstance inspires an unwillingness, accompanied by a wrinkle of the nose on the part of most investors to delve further’. This is when inefficiency is at its greatest. This is when the risk-reward profile has a deeply asymmetric character. The sole purpose of this paper has been to allow investors to test whether they are justified in feeling queasy about lifting the bonnet on UK small cap equities and exploring what is actually on offer. What have private equity and corporate investors seen that other investors can’t or won’t?

The table of our Top 10 Volantis holdings hopefully provides a little taster in that respect. For those who would like to take the conversation further and test our investment process and stock selection then please reach out.

1798 VOLANTIS – TOP TEN LONG POSITIONS

Strategically, something of a barbell is evolving in the long book from the application of our long standing focus on the business cycle in the investment process. At each end of that barbell are ‘Growth’ and ‘Quality Value’ companies respectively.

The ‘Growth’ companies are typically stocks that have been heavily de-rated, whose prospects typically have little or no connection to debates about the UK economy but are guilty by association, and are delivering significant strategic milestones, locking in future growth. Of note:

• In the technology sector, Seeing Machines, who have secured 40% of the contracts awarded to date for driver monitoring systems, which are mandated for all new passenger vehicles in the US and Europe beginning in 2024
• In the financial sector, Just Group, where the demand for pension fund risk transfer exceeds the supply of players regulated to provide bulk annuity solutions

The ‘Quality Value’ companies are stocks that are in more mature industries, having often been in the value bucket for many years and are consequently disproportionately neglected. Most investors perceive these businesses as either cyclically exposed or value traps. Our process, by contrast, has identified change often under new management, including:

• Improving earnings quality, cash generation and returns on capital
• Growth driven by market share gain rather than via the economy

The second factor is particularly interesting as it reflects changing industry structures and favourable and so far unrecognised changes in the balance of supply and demand. Why? A combination of Covid-19 induced capacity reductions, highly indebted peers (often private) and inflationary pressures raising the cost base have reduced investment, quality control and customer service. In many cases competitive advantage and market share have been locked in by publicly listed peers for the next five years. To many investors’ surprise will be the observation that a public quote is proving to be part of that competitive advantage. Yet these companies often trade on high dividend yields and low to mid-single digit P/E’s. As these transformations become evident to a wider audience there are two sources of upside. Firstly, earnings progress in line or ahead of expectations. Secondly, a rating expansion to reflect delivery of higher returns on capital and better growth than the market currently perceives. Stocks in this camp are just as likely to be M&A targets, as DX Group has recently demonstrated. DX Group is a market leader in some niche areas of the logistics industry, whose largest competitor Tuffnells failed over the summer. Private equity has spotted the opportunity the market has not and acquired the business at approximately a 70% premium to the position the funds have built over the last two years. Other companies of note in the portfolio on a similar journey but yet to be recognised include:

• In fleet management and commercial vehicle hire, Redde Northgate, whom we expect to take market share from Enterprise
• In the provision of toilet tissue, Accrol, the private label supplier taking share from big brands

Hit rates, slugging ratios and alpha analysis

Back to basics for Volantis means putting fundamentals first, for which hit rates, slugging ratios and alpha analysis are a measure of the power of stock selection.

In recent years, and during a time of correlated and factor driven returns, the ‘hit rate’ and ‘slugging’ ratios have crept into the investor vernacular. These are measures of the accuracy of stock selection and the extent to which good stock selection outweighs poor stock selection. The approach seems particularly appropriate to the smaller company investment process and as we would hope, the combination of the two numbers is strong by industry standards.

Since the beginning of 2017, across both the long and short book, the Volantis strategy has generated³:

When looking back over the almost 22-year track record of the Volantis strategy, it is also reassuring to see that performance has predominantly come from stock selection driven alpha, in particular on the long side. The charts below highlight the alpha generation versus the FTSE AIM All Share TR Index, where over 60% of our long book tends to be listed and the FTSE Small Cap ex Investment Trusts TR Index where approximately 15% of our long book tends to be listed.

ALPHA ANALYSIS VERSUS FTSE AIM ALL TR INDEX

ALPHA ANALYSIS VERSUS FTSE SMALL CAP EX INVESTMENT TRUSTS TR INDEX

1798 Volantis alpha analysis is based on gross performance. ‘Other’ includes Cash, FX and Treasury. For illustrative purposes only.

One of the striking features of the last year is the extent to which macro perceptions and the technical structure of the market have compressed returns or the slugging ratio. In an alternative, albeit crude measure of that impact, we have reviewed the returns of the last year on the basis of company operational performance versus share price performance. The objective has been to test our investment process. Are we identifying the right inputs and are companies meeting or exceeding expectations on that basis versus the share price performance? On this basis, of the top 20 Volantis long positions there were six names that performed positively operationally last year yet detracted from returns, totalling -3% gross performance YTD.

There is not a fund manager in the world who does not think their shares are worth more. However, it is unprecedented over the last 20 years for such a large element of a portfolio to outperform operationally and underperform in financial returns. It provides a confidence interval in individual names being ‘pregnant with return’ and that when fundamentals return to the ascendancy over macro perceptions and the technical structure of the market, the prospects for an improving slugging ratio or ‘bang for buck’ increase, especially given significantly depressed UK equity valuations.

There are no silver bullets. But we all know the rules. In Buffett’s language, ‘most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well’. We can say with confidence that UK equities are not popular. We can say with confidence that the UK label belies what many (of course not all) smaller companies are delivering. Such is the gap between stock market perceptions and individual business reality that the risk reward profile looks deeply asymmetric and we can see three keys to unlocking doors to revisiting and rediscovering UK smaller company credentials.

Sources.

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