It was one of Great Britain’s greatest leaders and orators Winston Churchill who famously said: “The pessimist sees difficulty in every opportunity. The optimist sees the opportunity in every difficulty.”
Anyone who invests in UK mid and small-caps will have needed a hefty dose of optimism over the past three years as they’ve seen a divergence in performance between this area of the market and the FTSE 100. However, an optimist would tell you this is one of the few markets where there is genuine value to be had.
“We are now in a situation where the FTSE 250 has a higher dividend yield than the FTSE 100, something we’ve not really seen in the past 25 years. The FTSE 250 is also at record low valuations relative to the FTSE 100. We also forget that this market tends to grow a lot faster than its larger peer.”
That’s the view of Richard Knight, lead manager of the Allianz UK Listed Opportunities fund, a contrarian vehicle which invests in UK businesses of all sizes, but specifically targets cheap companies with good liquidity (a margin of safety) and is not afraid to go against the grain.
You only have to look at the current portfolio to see contrarianism in full flow – the portfolio currently has 75% in UK small and mid-caps, with the manager citing incredible opportunities across both segments.
Mistakes and opportunities
Richard became lead manager in September 2022 and quickly made changes to the portfolio. Although the fund was already overweight mid-caps he has added to the position, cutting from both the large and micro-cap segments.
The mid-cap positioning has clearly been a challenge and Richard notes he has made mistakes – notably interest rate risk, where he felt rates would not be higher for longer and, importantly, that the market would see through it and be more resilient.
“We thought higher rates would not matter as much because of excess savings built up during Covid. But, unlike the US, people have not spent the money in their pocket. Things like repair, maintenance and improvement in your home have taken a back seat,” he says.
While the FTSE 250 is more domestic and cyclical, Richard believes there are unexplained factors facing companies further down the market-cap. He says there are positives for the UK economy, such as relatively good GDP growth and an under levered private sector. Ultimately, he believes the problem comes back to UK government debt, which is the same for every other major developed economy – adding there is lots that can be done to tackle the £20bn deficit.
He says: “The problems are not as big as they are made out to be – we are comfortably on the better side globally when we look at current growth and the forecasted government spending deficit. Inflation is the one negative but that can be easily explained by government choices (water bill hikes, NI increases and other regulatory changes).”
This brings us back to sentiment towards UK equities, which has been in the doghouse for years. Richard says foreign buyers now dominate the market – with no domestic bias. He says we’ve now reached a point where things don’t necessarily need to improve but simply not get any worse for the mid and small-caps.
Bullish on the future
However, Richard does have an optimistic outlook, pointing to recent turnover being down to holdings reaching their full potential and better opportunities appearing elsewhere. He says the fund is now in a very strong position and has been continuing to add to the mid-cap allocation to support his view.
He says the fund’s P/E could creep up as other extremely good businesses come onto his radar due to poor sentiment. Some of these quality businesses could be on 10-12x earnings but were as high as 20-25x previously.
Examples include Victoria Plumbing, which has fallen 15% since he purchased the business. He says it has grown phenomenally over two decades, is debt-free and dominates its position as an online-related bathroom business.
He says: “It is a beautiful structural growth story on 12x earnings. People got upset because the founder announced plans to spend £3m resurrecting the MFI brand and saw it as an earnings downgrade. Earnings momentum is the most important determinant of share price performance at the moment and it is not something we like as a value investor.”
Another is food & beverage travel provider SSP, which is the single largest holding in the portfolio. Richard says this is an uncompetitive industry where the business can maintain its pricing regardless of footfall at airports. He says it is a defensive business that is growing about 25% this year and predicts it to grow at around 20% next year. However, it is on a P/E of 11x, this compares to 20-25x pre-pandemic. Richard says the mistake the management team made a couple of years ago is that they did not focus enough on returns and instead looked at EBITDA – meaning investors got upset as profits did not come through as expected.
“Three months ago SSP listed their Indian business in India (this accounts for 20% of the wider business). The Indian business now trades on five times the valuation of SSP Group. If you just took that value of the Indian business and applied it to the rest of SSP’s business – it is trading on just 6x earnings – a very distressed multiple. The value is there in the business and no one is paying attention to it in the UK,” Richard says.
This fund has undoubtedly had a tough period but, importantly, not only can it be explained but the portfolio also has a history of bouncing back strongly. There does appear to be a crescendo of negative noise around UK small and mid-caps, but there are huge gains to be made if sentiment does show signs of turning – particularly if you invest in the right stocks. We feel this fund is well positioned to take advantage should things start to turn.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Juliet’s views are her own and do not constitute financial advice
Main image: nick-pampoukidis-t-UV1rZqPuY-unsplash
