Fund in Focus Podcast: Marlborough Special Situations April 2023
Fund in Focus: Special Situations Podcast April 2023
[00:00:00] Nick Peters: Hi, welcome to this Marlborough Fund podcast. My name's Nick Peters, and I'll be hosting.
[00:00:07] This week, I'm joined by Eustace Santa Barbara, who's one of the lead managers on three Marlborough UK equity funds, which have a bias to smaller companies, Special Situations, Micro-cap Growth and Nano-cap Growth.
[00:00:20] Today we'll be focusing on Special Sits, which also invests in larger companies. The podcast will be a Q & A session and should last around 15 minutes. Thanks very much for joining Eustace.
[00:00:33] Eustace Santa Barbara: Thank you for having me Nick.
[00:00:35] Nick Peters: Before we start, congratulations on Nano-Cap Fund, making it to the shortlist for the Fund Manager Year Awards this year.
[00:00:43] Okay, so kicking off, perhaps explain to listeners the investment philosophy behind Marlborough Special Situations and why the fund is in the Investment Association's UK All Companies sector rather than the UK Smaller Companies.
[00:00:58] Eustace Santa Barbara: I suppose it's important to start off by just saying we are passionate believers in the long-term growth potential of the UK's smaller companies. Historically, smaller companies have outperformed corporate giants over the long-term, and we see no reason why this should not continue.
[00:01:14] So, reasons we believe small companies can achieve stronger growth would be, for example, highly innovative businesses, their small size means that they can be more agile. And frequently these small companies are niche operators in niche products or niche services.
[00:01:30] So our expertise is in identifying which of these younger, smaller, faster growing companies have the potential to develop into the success stories of tomorrow, and for all of those reasons, the bulk of our portfolio is in companies with a market cap of below £1bn.
[00:01:47] By being in the UK All companies sector, it also gives us greater freedom to run our winners. In addition, we're able to identify exceptional special situations among mid and large cap companies, but we'll probably not be looking at the behemoths of the FTSE 100, the sort of top 10 or top 20. We'll be looking at the more under researched, what I like to call the sort of small-mid-cap companies.
[00:02:10] The companies with a market cap have say, 1, 2, 3, 4, 5 billion pounds. So there's a couple of examples of names that we've run with that we initiated at a substantially smaller market cap than it is today.
[00:02:21] Jet2, the package holiday operator, that's a good example. We bought it when it had a market cap, well under a billion pounds. It now has a market cap of over two and a half billion pounds. We believe there is more room to grow, and so we're sticking with it.
[00:02:35] Another example is the distributor Diploma, this was bought when the market cap was around 330 million pounds, and it's now close to three and a half billion pounds. Again, the prospects for this going forward, we believe are strong, so we continue to hold this name.
[00:02:53] So we're not just complacent or sentimental about our holdings, we continue to believe that names that we hold when the market cap exceeds a certain threshold can continue to merit their place. If they don't, we'll sell them.
[00:03:05] Nick Peters: You've been involved with the fund for 10 years now and the long term performance remains very strong. Last year was perhaps more of a struggle. Can you perhaps give us some colour to that?
[00:03:15] Eustace Santa Barbara: 2022 was not our best year. We do not hold any of the FTSE 100 behemoths, which I mentioned previously, so the oil names BP Shell, the pharmaceutical names, AstraZeneca, GlaxoSmithKline, or the tobacco giants, British American Tobacco and Imperial brands, and those names in particular outperformed very strongly in 2022.
[00:03:39] Meanwhile, the smaller companies had a particularly challenging year. There were a number of reasons for this, multiple headwinds, including but not limited to, spiking inflation, rising interest rates, supply chain constraints, logistics constraints, labour shortages and more subdued consumer demand.
[00:03:59] When one thinks about smaller companies, you have to think that they actually have a less diversified revenue stream, and often, and I think 2022 is a good example, they are more sensitive to a slowdown.
[00:04:10] They are also viewed as riskier, and often investors tend to sell these in more challenging economic conditions. Smaller companies can also be less liquid, and when investors are selling, prices can fall sharp, which is actually what we have seen.
[00:04:26] A further element that I think I should be discussing is that the fund was particularly hit hard by our greater exposure to growth companies and technology stocks.
[00:04:34] This has served us well in the preceding years, but they were hit pretty sharply in 2022.
[00:04:39] However, when one looks at the portfolio today, most of the companies in the portfolio are continuing to trade well, and we do believe that their long-term prospects remain strong. I should also flag that in the past when the fund has experienced negative periods of performance, it has bounced back strongly in subsequent years.
[00:04:57] Nick Peters: Okay, thanks. Now, after that selloff, valuations now seem to be much more attractive for many of those smaller companies. How have you responded to that?
[00:05:08] Eustace Santa Barbara: Sure, the sharp selloff in UK smaller companies has what we believe created a rare long-term opportunity. If you look at the price earnings multiple for the Numis Smaller Companies Index, excluding investment companies, this is more than halved in the past year.
[00:05:23] So when you look at the P/E multiple, the price earnings multiple, it's now only slightly higher than what it was in 2009 in the aftermath of the great financial crisis. In addition, UK small caps are at a large discount to the large caps, so the P/E multiple of the Numis Smaller Companies Index is around a 30% discount to the FTSE AllShare.
[00:05:43] That is a rare phenomenon and we don't expect it to last forever.
[00:05:47] Some good quality companies, smaller companies, that is, that previously were trading on P/E multiples of between 20 and 30 x have de-rated to half that level or less.
[00:05:59] So what we've done is we've used this sell-off to add to outstanding companies at significantly lower share prices.
[00:06:05] Again, taking the long-term view, the current valuations among the UK smaller companies represents to us a genuinely exciting opportunity.
[00:06:13] Nick Peters: Okay, great. Before we talk about the investment outlook, let's just talk about the team. So you and the co-manager Guy Feld are supported by a large and very experienced team.
[00:06:26] How many are there of you in total? And maybe explain to listeners how you work together.
[00:06:31] Eustace Santa Barbara: So the core team on the fund is five, me, Guy Feld as you mentioned, and three other analysts, Tom Hutchinson, James Workman, and Harry Everett. We all have different strengths and area of expertise. We do work very closely together, but in addition, we work closely with the . Wider, smaller companies, investment team, that's around 20 of us in total.
[00:06:52] So I would argue we're one of the largest and best resourced small and mid-cap teams in the UK. We're all in the same office, constantly exchanging ideas and analysis. We have a formal investment meeting every Tuesday, but in reality, we're talking all the time.
[00:07:07] As I mentioned, we have lots of experience within the team. Guy Feld has been investing in small and mid-caps for over 30 years. I've been a fund manager and analyst for over 17 years, and also people around me like Richard Hallett and Sid Chand Lall have a great deal of experience.
[00:07:21] I would describe the way we work together as collaborative. We challenge each other's way of thinking, but in a constructive manner.
[00:07:28] Also, the size of the team means that we can conduct our own research to uncover opportunities so we're not just reliant on the sell side for their research. Small and mid-cap companies do tend to be under researched compared to FTSE 100 stocks, so I would say there's a great amount of 'value-add' from doing your own research.
[00:07:48] In addition to the research, we take a lot of face-to-face meetings with management teams of companies, and over the past 12 months, we've probably met with close to 2000 companies, the majority face-to-face, but obviously in this post pandemic world more virtually as well.
[00:08:04] So I would describe our team as large, experienced in that smaller company space and working collaboratively together to identify the most attractive investment opportunities.
[00:08:15] That I believe is how we add value to our investors.
[00:08:18] Nick Peters: Great, thanks, and sort of link to that, the last month or so, you've spent a lot of time immersed in company reports and meetings. Can you perhaps give us some takeaways from that deep-dive exercise?
[00:08:31] Eustace Santa Barbara: Sure. So the month of March is probably the busiest time of the year for us because a lot of December year end companies report in March. They have about three months to finalize their accounts, their annual accounts, and report and post that annual report publication, they come on the road to see us.
[00:08:49] I mean, overall, Nick, I would say most of the companies are trading in-line, there are certain pockets of strength, there are certain pockets of weakness.
[00:08:57] But a lot of the aforementioned mentioned issues that really afflicted the small cap space in 2022, things like inflation, labour shortages, supply chain issues, logistics issues, I think the pressure on those is easing.
[00:09:11] And so actually we're comforted by what we've been hearing from our management teams, and as I said, when the price of these companies has, in some instances fallen quite sharply, we're pretty comfortable with many of our holdings, or indeed, the portfolio as a whole, as we look forward.
[00:09:27] Nick Peters: Okay, that's reassuring, and if you look into your crystal ball, how do you see markets developing from here?
[00:09:33] Eustace Santa Barbara: There are always gonna be risks in investments. The central bank in the United States, the Federal Reserve has stated recently, there are raised prospects of a mild recession, so I think investors should be aware of that.
[00:09:45] We are exiting one of the most rapid interest rate hiking cycles in history and so we've had a prolonged period where interest rates globally were extremely low, post 2009, and essentially in the last 18 months, central banks have rapidly reversed those historically at low interest rates, whether that's the Federal Reserve in the States, the Bank of England and England, European Central Bank, Bank of Japan.
[00:10:10] The reason that's important is that historically there is a lag between interest rate rises and the full impact of those interest rate rises on the real economy. So we are still waiting to see how that plays out.
[00:10:21] There are signs that inflation may have peaked in the UK and the US and that's likely though to mean that weren't close to the top of the interest rate cycle.
[00:10:29] If the economic picture does begin to brighten, we would also expect smaller companies to lead the way in an environment of improving investor confidence.
[00:10:38] So, as I said earlier, in the meantime, we are seeing first class smaller companies on P/E multiples that in some instances are half of what they were little over a year ago, and we believe that for those investors taking a long term view, volatility has created this rare opportunity.
[00:10:52] Nick Peters: Okay, thanks. Uh, perhaps to finish, maybe give us a couple of examples of those first class companies that you mentioned?
[00:10:59] Eustace Santa Barbara: So I'll start with Cranswick, which is a leading UK food producer of fresh pork, sausages, bacon, and in more recent years, it's entered the chicken market.
[00:11:09] Most of its customers are UK grocery retailers, and it has a strong presence as well in the 'food to go' space.
[00:11:17] It's a global business, so it's rapidly growing it's export business serving Europe, the US, and Southeast Asia, although the UK is the predominant end customer.
[00:11:27] So we like the strategy that Cranswick has executed over a number of years of long-term investment in the business, whether that's being deployed on acquisitions or expanding pretty world-class production facilities and as I mentioned, they did also diversify into poultry in recent years.
[00:11:43] Turning to the financials, Cranswick has been a steady compounder. In the five years to March, 2022, the annualised revenue growth rate has been 10%. That's translated to earnings per share growth of 11% and dividend per share growth of 11%.
[00:12:02] So for that revenue and earnings growth, you are paying an attractive P/E on multiple, in my mind, of under 15 times estimated earnings to March 2024, and that is substantially below its historic average.
[00:12:13] The free cashflow yield is over 4% and the dividend yield is approaching 3%. So Cranswick is a story we believe is well positioned to continue its growth trajectory and its current valuation is highly attractive on a long-term view.
[00:12:27] The second example I'd like to give is Coats. This is a world leader in the manufacturer of threads and yarns, and it's used in a range of business sectors, including clothing and footwear, but medical and automotive as well. It has a reputation for innovative, premium quality products, and it supplies over 40,000 businesses globally.
[00:12:48] It is a global leader, it actually has around 24% market share, and it has grown its market share steadily over the last decade, and we believe this can continue. It's targeting currently revenue growth of 6% per year over the medium-term, which compares to a historic growth rate of 4 to 5%.
[00:13:08] It's also targeting increased profitability and it's targeting improving its profit margins to around 17% by 2024 compared to 14% in 2019.
[00:13:20] So what does one pay for this revenue and earnings growth? Trading on a P/E multiple of 11 times an estimated earnings to December 2023, which again, we believe on an absolute level is attractive and on a relative level versus its tenure history, it's about a 25% discount.
[00:13:37] So Coates is a second story that we believe is an interesting long-term opportunity.
[00:13:41] Nick Peters: Excellent. Thanks very much, sounds like some really exciting times ahead for the fund.
[00:13:46] Eustace, thanks very much for joining us and hopefully we'll have you back soon.
[00:13:51] Thank you listeners for joining this Marlborough Fund podcast. You'll find more details of the Marlborough Special Situations Fund on our website.
[00:13:59] Thanks very much and goodbye.
Nick Peters and Eustace Santa Barbara
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. Our funds invest for the long-term and may not be appropriate for investors who plan to take money out within five years. The Fund will be exposed to stock markets and market conditions can change rapidly. Prices can move irrationally and be affected unpredictably by diverse factors, including political and economic events. The Fund will be exposed to smaller companies which are typically riskier than larger, more established companies. Difficulty in trading may arise, resulting in a negative impact on your investment. Shares in smaller companies may be harder to sell at a desired price and/or in a timely manner, especially in difficult market conditions. The Fund invests mainly in the UK therefore investments will be vulnerable to sentiment in that market which may strongly affect the value of the Fund. In certain market conditions some assets may be less predictable than usual. This may make it harder to sell at a desired price and/or in a timely manner. In extreme market conditions redemptions in the underlying funds or the Fund itself may be deferred or suspended.
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