This bonus Investment Q&A is with Scott McKenzie, co-manager of the WS Amati UK Listed Smaller Companies fund, discussing recent trends in UK smaller companies. He covers challenges such as undervaluation, lack of investor interest, high inflation and liquidity concerns for smaller companies. Scott finishes on a high note and expresses hope for a more stable investing environment in 2024, with opportunities for smaller companies to recover and improve their valuations.
Why you should listen to the interview: Scott’s speciality for the last 20 years has been UK equity portfolios so he is well-qualified to discuss the current challenges facing the UK smaller companies sector. It’s interesting that Scott picks up on corporate frustration at low valuations in the UK market as one factor behind an increase in M&A – how many other companies are feeling this? – but also identifies a lack of enthusiasm in the domestic market as a contributory factor too. Also find out more about Amati’s investment sweet spot and why the only way is up.
Moments worth highlighting:
Undervalued by UK investors and the UK stock market – is M&A picking up?
“In early 2022, there was quite a lot of takeover activity and we saw three or four takeovers within our own fund companies such as HomeServe, the specialist home services, utilities business which was taken over in early 2022, as were companies such as CareTech, which was a specialist nursing home provider. That then all dried up in the second half of 2022 and we really saw a pretty steep decline in takeover activity. If you recall, we had the whole kind of Liz Truss/Kwasi Kwarteng debacle in September-October of last year and obviously, as a consequence of that, we then saw interest rates begin to escalate fairly dramatically as well. So I would say we’ve had quite a big hiatus in meaningful takeover activity between mid 2022 and mid 2023. We’re only just beginning to see that improve now.
“Over the summer we had two takeover bids in our main smaller companies fund; Ergomed, which is a specialist healthcare services provider and Gresham House, the specialist alternative asset manager. And interestingly, in both cases they were acquired by private equity. In many ways we were sorry to see them go because they were companies that we thought would have a lot of future growth potential, but I guess what’s similar in both companies is that they perceived themselves as being undervalued by UK investors and by the UK stock market. And they became frustrated by that.
“So, I think we are beginning to see the signs of M&A activity pick up. At the moment, they’re relatively small companies. But given where valuations are, we do believe that we should expect to see more, particularly if interest rates are perceived to have peaked and the cost of funding is perceived to have become more settled.”
The market remains cheap as ever
“Yes, we do believe the sector is exceptionally cheap and yes, it’d be hard to find an asset class less loved than UK smaller companies at the moment!
“I mean, there are lots of things to address here. The valuation discount is related to the unloved aspect of your question. We’ve seen fairly relentless selling of UK equities in general over the past 6-7 years and, in the last couple of years, of smaller companies in particular which has been a very significant headwind for investors in small cap. And there have been very significant disposals of UK equities, not just from retail fund investors, but also from pension funds. That’s been happening for many, many years, pension funds have been selling out of UK equities for almost 20 years now.
“And we’re seeing it in some of our client base; wealth managers and advisors are changing their asset allocation for clients, and that’s involved less UK. So, wherever we look, there have been lots of selling pressures and therefore liquidity pressures, and in the smaller company asset class, that’s magnified because illiquidity leads to some fairly significant downward shifts in valuation.
“So, how do we change this? This is the million dollar question.
“I think there’s now an awareness that we’re in something of a crisis for the funding of smaller companies here in the UK. And between Jeremy Hunt and his Mansion House reforms, we have the FCA looking at this; we have both the opposition and the government looking at this. And clearly we’re going to have a change of government potentially in a year’s time. So, I think there are a lot of people looking at this problem now, and it’s more urgent than it was a year ago.
“It’s hard for me to predict exactly what will happen, but there are some very simple things that that can be done. For example, we could change the rules regarding SIPPS and ISAs and make investing in domestic companies more attractive and more incentivised. There are a number of things that could be done but it’s hard to say at this moment in time exactly how that will transpire, but ultimately, we need to hope that those that have been selling UK smaller companies stop doing that, and hopefully the valuations will be a trigger for that to end.”
Liquidity concerns?
“I think it’s been very, very difficult for the smallest companies in our market and it’s also been particularly difficult for early stage companies by which I mean typically businesses which are not yet in profit, which require funding for the future growth.
“If one goes back to 2020/2021, there was a lot of almost free money around then; a lot of IPOs and new companies were being funded and the vast majority of those, I’m afraid to say, have not ended well. So it has been quite a brutal environment for those early stage businesses, many of which have now collapsed in value. I don’t see that changing quickly, particularly with regard to the cost of funding. We’ve gone from a situation where the cost of funding was virtually 0% to a much more punitive interest rate. If you’re an early stage company now, you’re probably paying north of 10%, on new money, or you’re having to raise equity at a very discounted price.
“Unfortunately, for that part of the market, it’s going to remain difficult and you have to be super selective, and some bubbles have clearly burst in certain sectors, like clean energy, for example.
“In terms of what we do at Amati, we’re really not focusing on much below a £100m of market value. Now, there are some very good businesses below that level which may well turn out to be great businesses, but for us, we don’t feel that we’re paid to take that liquidity risk at the moment. So, in terms of our new investments, our sweet spot really is probably north of £250m to about £1bn. Those are where we see the majority of our new fresh investments originating from.”
Conclusion: It feels like the UK smaller companies sector needs a three-pronged approach to help it out of the doldrums: the return of the domestic investor; a more stable inflationary environment; and finally, recognising how close to the bottom of the cycle we now may be. As Scott nicely summed up: “ It doesn’t take much improvement for things to get better.”
Link: This bonus Investment Q&A was part of a wider video interview aimed at professional investors. To access the full interview, you will first need to register for a free FundCalibre account. Sign up here
