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Fund in Focus: Global SmallCap May 2024



[00:00:00] Nick Peters: Hi, I'm Nick Peters, Investment Adviser at Marlborough Group, and today I'm joined by Toby Bucks, the Co-Manager of our Marlborough Global Small Cap Fund. Hi, Toby.

[00:00:11] Toby Bucks: Hi, Nick. How are you?

[00:00:13] Nick Peters: Very good, thank you. Thanks for joining us. The fund was launched in September 22 and has achieved very strong performance since then.

The fund's the top Decile performer in the global IA sector and over the past 12 months has delivered a return of 33%, so that's to the end of March. Toby and his co manager Simon Wood have been running an identical domestic strategy for Australia fund manager Ausbil for more than five years. Toby, do you want to start by just reminding us of the fund's approach?

[00:00:46] Toby Bucks: Thanks, Nick. Yeah, sure. So, the fund invests in small cap companies globally in the developed market. So, in the US, in Europe and Japan, and we focus on the smaller companies that we think have got great opportunities to compound value, creating events together, to drive earnings from geographic expansion, as well as vertical integration and horizontal integration in their industries. And delivering earnings upgrades versus consensus, which that we think is really, really key because earnings drive share prices. And that's what Simon and I focus on.

[00:01:25] Nick Peters: Okay. Thanks very much. Ausbil have got a dedicated economist team. Can you perhaps just give us a view on their global backdrop over the coming 12 months and what that could mean for smaller companies?

[00:01:37] Toby Bucks: Yeah, sure. So, we do have a dedicated economist and a team and it really helps the other teams within the firm really cement their top down views and help them identify what regions and sectors are going to be attractive. And we've been very positive on the economy. We've been positive on the equity market for over 18 months now on the basis that the US has got some really strong growth driven by stimulus as well as a strong economy, good employment and great savings. And that we think that the interest rates while they're going up, we think are going to be able to stay at attractive levels for the economy and also potentially maybe come down in some areas where inflation does continue to fall towards central bank targets. That's a very positive outlook and we still continue to be constructive going forward.

What we see is the US has still got a very strong economy and we don't see that faltering in the near term. And also, as interest rates rise back up to sort of more normalised levels we've seen throughout history, that's a much more benevolent environment for global small caps to outperform global mid and large caps.

We've seen in the last 20 years lower bound interest rates. Interest rates are zero in some cases, and that's really helped large caps outperform small caps. But we think the environment right now with a positive economic outlook, a ceiling towards interest rates and higher interest rates and less sticky inflation should provide a very good backdrop for small caps to perform.

[00:03:11] Nick Peters: Thank you. When you were talking about the approach, you mentioned value, valuation as an important part of the process. How do valuations look across the regions?

[00:03:20] Toby Bucks: We think valuations are quite attractive, particularly for small caps. I think what we see in the large cap space, after a strong performance in equity markets over the last sort of 18 months, is valuations have expounded, but we have seen earnings really kick on and we've seen a lot of earnings growth in the developed market economies.

Right now, small caps are trading at the biggest discount on their historical valuation levels to mid and large caps that we've seen before. So, there's a very large relative opportunity in small caps versus large caps right now. And we'd urge people to look at that in their portfolio allocation. We certainly see it as really attractive.

[00:04:01] Nick Peters: And would you say that's across all the regions or just specific to the US?

[00:04:05] Toby Bucks: Globally, we think they're attractive. Certainly, some markets have re rated. Got more expensive on their valuation multiples, but that's owing to some underlying changes and fundamental reasons for the economy. So, whilst the US has got a little bit more expensive than it's been, the growth outlook has improved dramatically.

Europe, which has been in sort of the doldrums in terms of its manufacturing base for a while, has started to improve from cyclical lows, and the market is reasonably attractive if you think that economy can kick on. When we look at Japan, which is now making all time highs in its stock market, having not seen highs for almost 30 years.

Valuations have increased, but yet again in Japan we have seen some fundamental changes in the economy. They're not just legislative changes to help shareholders get the right sort of value out of their investments. But also, we've seen improvements in the demographics in Japan and inflation coming back to that area has helped the central bank achieve their goals.

So we think valuations broadly are attractive, but we'd point out we think in the US, although they're slightly elevated traditionally and right now compared to Europe and Japan, again, US exceptionalism, the US economy and the US stimulus means that those valuations we think are quite attractive here.

[00:05:23] Nick Peters: Excellent, thanks. So that's a sort of overview from a regional perspective. The team wrote a really good paper recently on some of the themes underpinning stock selection, so areas like decarbonisation, manufacturing renaissance, on shoring data investment and the evolution of AI. Can you perhaps expand on one or two of those themes?

[00:05:44] Toby Bucks: Yeah, I'd love to. I think the electric grid for us is one of the most interesting and important sort of themes for people to think about going forward. Simon and I noticed almost four years ago now when speaking to some suppliers of EV charging equipment, that the biggest headwind to their growth and maybe the risk to the expansive growth expectations they had was the ability of the grid to sort of be there, be ready, to have the connections for all this new type of infrastructure which effectively means more power and lots more power being transferred more quickly between more areas so a different type of energy demand environment.

Over the last four years, Simon and I have done a lot of research on the grid. We've spoken to other people that have focused our attention onto what's going on to see that the electric grid is really at the intersection of quite a lot of people's ideas and themes that they're trying to achieve. So, the world's Net zero ambitions can only be achieved if we rebuild the electric grid, rebuild the highways in the transmission, and then rebuild the distribution to help with data centres and EVs and the electrification of buildings.

So, it's not just net zero, but also areas of the electrification of mobility and decarbonisation of mobility, mobility of cars, but also of industrial freight, etc. That, again, will rely on the rebuild of the electrical grid. And also, the change we're making. in our generation requirements. So, moving away from coal, moving away potentially from gas, more towards renewables, more towards storage.

That again is going to require a rebuilding of the grid. And then probably something that's kicked off a lot in the last year in people's minds is the onset of AI technology to help people improve their efficiencies and potentially who knows what. We are seeing a lot of investment in AI and an AI arms race.

Right now, to deliver a product that can really help businesses and that again that's going to rely on data centers. The chips is yes but it's going to rely on data centers and the data centers need power and the only way they're going to be able to build enough data centers is getting the grid right.

So, it's very interesting that sort of all roads lead to Rome, as it were, at the moment on the electrical grid it's over 40 years old in Europe and the US we're seeing yearly new CAPEX plans come out with increased guidance of how much is going to be spent to improve our transmission and distribution.

And so, what's key for Simon and us is when we look at that is how can we take advantage for our unit trust holders? And we've focused on all the areas where the demand's very large, but because of regulatory and manufacturing requirements, there's very tight capacity. We think areas of bottlenecks and tight capacity, you know, in our experience, we've found in global small caps, that's where you can find great shareholder returns.

Businesses that are niche leaders, that have got fantastic management teams, that are expanding with a solid balance sheet into new markets, new products. and hopefully vertically integrating to drive gross margins. That's what we can see occurring when we do the work on the grid and that's something I think people should really focus on.

[00:09:02] Nick Peters: Thank you and I mentioned the very strong performance since launch of the fund. Are they already benefiting from those themes or do those themes tend to be much sort of longer term?

[00:09:13] Toby Bucks: The performance of the fund has benefited already, I think, from investing in the businesses that people are drawn to.

Based on the the improving financial result profile and looking forward at the end demand. The fund is based from our best bottom up ideas and exposed to a lot of uncorrelated businesses with different end demands. So, although we're very excited about the bottlenecks in the grid, that's only a small portion of the fund.

I would say probably less than 30% of the fund right now. The fund's also exposed to onshoring, it’s exposed to the manufacturing renaissance in the US and the infrastructure build out and also we've got some strong exposure to unique companies have idiosyncratic business models. There were some really strong results over the last year and a bit that this fund has been part of the overall strategy for us.

We've seen a lot of earnings upgrades and that's really benefited and driven performance. Just on the grid theme, I do think it's very attractive. Right now, in Europe, if we look through the capex plans from the transmission system operators, they're not expecting their transmission capex to peak before 2029.

And after that, there's a good 10 to 15 years of distribution capex. So, I think the very strong demand on the tight capacity in sort of the transformer industry, in the switchgear industry, and in other areas of supplying substation equipment will continue for many years, and that gives us great excitement, there's a long runway.

Right now, the market is capitalising an improved growth outlook and an improved return profile for these businesses, as their margins are going up, their order books are going up, and they're investing in new manufacturing facilities, so that's all great. Looking forward, we are expecting that to continue for a number of years, yeah.

[00:11:17] Nick Peters: Okay, great. That gives us an idea of the longevity of some of these themes that you're, you're playing. So, can you give us a flavour of what's been going on in the Fund recently? Perhaps give us an example of a recent purchase and sale?

[00:11:30] Toby Bucks: So, one of the stocks that we've invested in for a number of years and provided a great return for the fund exited the portfolio recently.

BE Semiconductor is a Dutch based business that is a world leader in the semiconductor capital equipment that you need to make very advanced chips specifically the AI chips. As I said, it's provided a great return for the strategy over a number of years since this fund's inception it's been a top performer.

The business had grown. It was a, it was a small cap when we first invested in it and it's grown so much it's become a mid cap and it's also become much more of a flavour of the month amongst fund managers and the investment markets. So, we decided that on its forward valuation it was getting to a point where there wasn't so much unrecognised growth going forward.

And, you know, Simon and I focus on unrecognised growth and positive earnings revisions in niche leaders. And we thought the market was capitalizing sort of too much growth, that's valuation, so it, it exited the fund. And that's it, that's how we like these things to do, that's a sign of a healthy investment, you buy it, it grows, and at one point, you know, it gets too expensive, because the mid cap guys come into it.

A stock that's just come into the portfolio, would be Knife River Corporations, a leader in the US in aggregates and cement. They've got a very strong ESG profile after their recent spin out a year and a half ago, and a strong management team. The fund also owns Eagle Materials, which is a leader in aggregates and cement in the US, and we see very tight capacity in certain areas of the aggregates and cement market. It's an area that's often overlooked by a lot of investors who want to focus on IT, healthcare and industrials, but we're core investors here in this product. We invest in every single sector and industry where we can see unrecognised growth, strong management teams at attractive valuations.

You know, we've seen over three years now of double digit price increases in aggregates. And we don't really see that much price increases in this there's tight capacity and huge demand. We've got very strong US government stimulus coming in to support infrastructure. Onshoring is a very strong driver of non residential construction in the US and we're seeing that really expand at the moment because every single new manufacturing site needs a massive concrete slab.

So, there's a huge opportunity here to benefit, particularly in the southern states like Florida and Texas and South Carolina. Where we're seeing a lot of growth and we're very excited about that area and that company's ability to drive earnings.

[00:13:59] Nick Peters: You mentioned unrecognised growth, what sort of valuation is Knife River on?

[00:14:03] Toby Bucks: Well, it's trading on a discount to the index, currently a 30% discount to the index for the premium growth profile over the next few years.

I think all the assets there are reasonably undervalued in the near term as we see a large demand growth continue. So, just to put that in context, some of the revenue growth in Texas for the aggregate was up 30% and that's for asphalt up 40%. So there's a huge amount of spend going on in the US to help with on shoring and the grids investment and other areas that they're trying to stimulate.

The amount of money that's being poured into fixed asset investment on a relative basis, this hasn't been seen since after the Second World War. So, it's a whole new territory really for anyone alive. And I think the market's really undercooking US exceptionalism and what they can deliver with their manufacturing renaissance, particularly with the themes of the grid decarbonisation, data center investments and AI.

[00:14:58] Nick Peters: Excellent. Thanks very much. And then lastly, there are obviously a lot of global small cap funds out there that investors can choose from. What do you see as the competitive advantages of your strategy?

[00:15:10] Toby Bucks: Well, I think one of the most important things is performance and consistency to style and philosophy.

One of our advantages is that we focus on growth. And we've got a demonstrated history of picking great positive earnings growth stories that the market's underestimated. We've got a long term track record. We're a very experienced team that have worked together for a long time. And this is one of the best asset classes for an active manager to go out and deliver alpha for you.

There's key opportunities in Global Small Caps at all times. By being core managers, Simon and I can always try and be in what area of Global Small Caps is going through a bull market at any particular time. And there's always a bull market somewhere in Global Small Caps.

[00:15:59] Nick Peters: Great. Toby, thanks very much for joining us.

[00:16:03] Toby Bucks: Thank you very much.

[00:16:05] Nick Peters: That was Toby Bucks, co manager of the Marlborough Global SmallCap Fund. And if you'd like to find out more about the fund, please go to our website, Thanks very much. Bye.

Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.