This week’s Investment Soundbite Q&A from FundCalibre is with Guido Dacie-Lombardo, the Elite Rated manager of the LF Montanaro UK Income fund, who talks to us about the UK equity income sector, notably the small and medium end of the market, covering a variety of topics from M&A activity to dividends and net zero targets.
(Recorded 31 May 2023)
The fund invests predominantly in small and mid-cap stocks. Are these companies still out of favour?
Small and mid-cap companies – particularly in the UK – have really been out of favour against their large cap peers for some time now. If you look at the 18-month period to the end of April 2023, the Numis small cap index underperformed the Numis large cap index by a full 26%. You’ve got to go back 25 years all the way to 1998 to see a similar level of relative underperformance of small caps. It has really been a ‘once in a generation’ type period that we’ve lived through.
Small caps have underperformed because, as longer duration assets, they tend to be growing faster than large caps. So when inflation spikes and when interest rates spike, you get a valuation-led sell-off of these longer duration assets.
Also, with the war in Ukraine, the oil price increasing has helped the oil and gas companies, and interest rates going up has helped the banks, and you get more oil and gas and banks companies in the large cap sector than in small caps. We have had a macro period that has certainly favoured the large cap sector in the last 18 months or so.
Long-term, the small cap effect, where smaller companies have outperformed large cap, remains in place in the UK. If you go back to 1954, since then, small caps have outperformed large caps by 3.1% per annum. If you compound that over time, actually going back to 1954, small caps have given a return almost seven times greater than large caps. We think, despite this recent period that we’ve had, that small cap continues to be a good place for the long-term investor. Our CEO has recently written a blog on this particular topic.
Why don’t you invest in larger companies or AIM-listed companies?
First let me explain what we do invest in, and then I’ll say what we don’t invest in: so, we invest in small and mid-cap companies in the UK. It’s roughly 50% small, 50% mid, and we define small cap as stocks that are capitalised from a hundred million to one and half billion which is roughly where the Numis small cap index cuts off. And then mid-cap, from one and a half billion up to 10 billion. With about 550 companies in this range, it gives us a huge choice as active managers.
We don’t invest in large caps as we’re just not convinced we can add value there. Firstly, as I mentioned earlier, there are many oil and gas and banking stocks in large-cap land and an important part of the value driver for those companies is what the oil price is doing, what the interest rates are doing and frankly, we’re not macro specialists.
Secondly, if you think about the amount of sell-side coverage that there is, our companies tend to have a low single digit number of sell-side analysts covering them. We have a very large team of analysts and portfolio managers here, about 16 of us in total, really kicking the tyres on these small and medium-sized companies, and because of that lack of focus from the sell-side, we think that gives rise to some pricing inefficiencies that we can take advantage of.
As to why don’t we invest in AIM-listed companies, it just comes down to liquidity. We’ve been known to say in the past that AIM is almost like a lobster pot market – you can get in, but you can’t get out! And given the lack of liquidity, we don’t think it’s an appropriate place for an open-ended strategy like ours to be investing in.
Have many of your companies received takeover offers, and are you expecting more in the future?
In short, yes. As we touched on earlier, UK’s small cap market has had a very tough 18-24 months, certainly relative to the large cap. It’s trading towards the bottom of its historic P/E range and, of course, the pound is currently still relatively cheap compared to history. It’s a well-known fact that private equity is sitting on a lot of dry powder, so I think all the ingredients are there to make this – or the UK specifically – an attractive market for bidders looking to buy companies.
In terms of our fund, we invest in high quality companies, cash-generative companies, companies with strong balance sheets – actually 40% of the companies in the portfolio have got net cash. These are the kind of companies that can be very attractive to a private equity company or a house to come in, lever up the balance sheet, service the debt using those strong cash flows and make a decent return.
Last year we saw two takeovers in the fund, Brewin Dolphin Ltd and Biffa Waste Services Limited. So far this year, Dechra Pharmaceuticals PLC, the vet pharmaceutical company, has announced they’re in discussions with Swedish private equity firm EQT AB about a possible takeover, although nothing has been formalized yet.
As an income fund, can you tell us how dividends are holding up?
Dividends are holding up well. If you look to last year, and you think about it between the ordinary dividends and the special dividends, the ordinary dividends, which were distributed by the fund, they actually grew by 22%. And this is despite of what was happening with the share prices, those ordinary dividends grew 22%. The specials did reverse slightly, but that’s because in 2021 there were a lot of special dividends, which were making up for the skipped dividends in 2020.
We’ve seen some very nice ordinary dividends from Games Workshop Group PLC, which is one of our larger holdings. 4imprint Group, Plc has announced a special dividend which was very large. And just generally across the board, dividends have just been a bit better than I was expecting and the fund today is yielding about 3.8% or so. And I think it’s also important to remember the growth. So, the fund has grown its dividend at a compound annual growth rate since 2014 of almost 6%. And that actually compares to 0%, actually moderately negative for the FTSE All Share.
The fund is known to be pretty ESG friendly; you exclude certain companies from the portfolio and the company is looking to be net zero by 2030. Tell us more.
Yes, the fund has been structured to be an ESG-friendly fund; actually, many of our clients use the fund in their ethical portfolios for their clients. We have some ethical exclusions, such as no oil and gas production, no tobacco, no alcohol, no controversial weapons, no gambling, no high-interest rate lending, and a few other areas.
From an ESG perspective, we also spend a lot of time actually engaging with our companies, again, with that big team of analysts I talked about. And one real focus over the last 18 -24 months has been to encourage our companies to put net zero targets in place, which are verified by the Science Based Targets initiative to give some real credence to those targets and the pathway to achieve them. Pleasingly, about two thirds of the companies in the portfolio have now put these SBTi-verified net zero targets in place.
And moving to Montanaro Asset Management itself and our ambitions as a company; firstly, we’re a B corporation and we renewed that status for a further three years recently, with a higher score than previously. A B corporation is essentially a company that has gone through a process and been verified to be at the highest standards of ESG throughout the whole organisation. As an example, we have even had to change our articles of association to make sure that we comply with the rigorous standards to be a B corporation. Some of the most forward-looking and ethical brands in the UK and around the world are B Corporations, including, for example, Patagonia, Inc. We were one of the first asset managers to become a B corporation.
In terms of our ambitions as a company, aside from being a B corporation, in March this year we announced that we want to be carbon negative by 2030, so basically, we want to remove 100% of all of our historical emissions since the company was founded in 1991. We’ve partnered with a Danish carbon removal platform called Klimate ApS will be funding some carbon sequestration products to take carbon out of the atmosphere. It’s an ambitious target, but hopefully one that we can achieve and also hopefully one that will inspire others to follow suit.
Tell us a little bit about your largest holding, Games Workshop.
Games Workshop is the largest hobby miniatures company in the world with a strong brand in War Hammer. They’ve got a very diversified, and importantly a loyal customer base, which gives them some element of repeating revenue. They’ve got a good manufacturing base, which they use to produce the figurines, which they then sell unpainted but then they also sell their proprietary paint alongside it which is very high margin – that’s quite a nice little business model.
But their key asset is their very rich IP. They have created fantasy worlds, fantasy storylines, fantasy characters, which gives them an unlimited pipeline of new characters, new storylines and essentially an unlimited pipeline of new products. Over time, we think that’s going to continue to drive growth. In terms of adoption around the world, this is a global business, but the US is certainly underpenetrated and we think that could be a very big driver of growth in the coming years.
One further key aspect of their IP is that they can actually license that out and in return receive a royalty fee. And royalty fees basically drop straight through to profit. They’re obviously very high margin and transformational for the economics of a business. Historically Games Workshop has been licensing their IP to video game manufacturers who’ve been making War Hammer games, for example. But there was an exciting piece of news towards the end of last year, when they announced that they were in discussions with Amazon about Amazon potentially creating a TV series and maybe a film based on War Hammer, and then also additional merchandising. If that does get signed and if it takes off, that could be a very material royalty fee for Games Workshop.
And this would additionally have a virtuous cycle effect of encouraging existing players, but also attracting new players to play the core game as well. So overall, this is a business with net cash on the balance sheet, strong return on capital, and it’s delivered a five-year historic earnings growth and compound average growth of 33%. We think it’s a high quality, structurally growing company.
Listen to the full interview here:
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