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Fund in Focus: Special Situations April 2024


[00:00:00] Nick Peters: Hi, my name's Nick Peters, welcome to this week's podcast and I'm joined by Eustace Santa Barbara, the fund manager for Marlborough's Special Situations Fund. Hi, Eustace.

[00:00:19] Eustace Santa Barbara: Hi, Nick.

[00:00:21] Nick Peters: As usual, we'll get straight down to it, I mean, it feels like smaller companies as a style is coming back into vogue. What are your thoughts?

[00:00:29] Eustace Santa Barbara: It's certainly been a tricky time for smaller companies in the UK in the last just over two years,I'm going to do some comparisons of the AIM market versus the FTSE 100 and the FTSE Small Cap Index. Now the AIM market constitutes about 55% of Special Situations holdings today, and it is the home of some of the UK's strongest growth companies.

[00:00:53] Eustace Santa Barbara: In 2021, the AIM market underperformed the FTSE 100 by 8%. In 2022, the AIM market underperformed the FTSE 100 by 38%, and in 2023, the AIM market underperformed the FTSE 100 by 12%, that is three years of pretty significant relative underperformance.

[00:01:13] Eustace Santa Barbara: There was real potential turning point to your point about the small cap asset class becoming more in vogue. Well, we saw it in the end of 2023 in November and December, where the AIM market actually outperformed the FTSE 100 by 3% in each of November 2023 and December 2023.

[00:01:31] Eustace Santa Barbara: In 2024, year to date, and we're doing this at the end of March, unfortunately, the AIM market has given that performance that we saw in the back end of 2023 back.

[00:01:40] Eustace Santa Barbara: So it's underperforming the FTSE 100 by 5.5%, now, having said that, I would argue that with valuations where they are today, sentiment where it is today, very negative to the UK, very negative to the small cap space, that actually, while you say coming back into vogue, we may not be in a period where there's excessive euphoria in the small cap space, but coming from such negative sentiment today, I don't think it will take a huge amount to change the sentiment to a more positive trajectory, which could lead to very compelling returns in the coming periods.

[00:02:13] Nick Peters: So when listeners hear those numbers, they're probably thinking to themselves, well, why are you invested in the AIM index? So do you want to just give a bit of background as to why you find AIM listed

companies so attractive?

[00:02:27] Eustace Santa Barbara: We've always been passionate believers in the long term success and capital appreciation of UK smaller companies.

[00:02:33] Eustace Santa Barbara: They have historically grown their earnings per share at a greater clip than the large caps and frankly, I don't think there's anything in the environment today, political or economic, that means that that long run trend cannot continue.

[00:02:49] Eustace Santa Barbara: What we've seen primarily in the small cap space is a huge derating. There's no doubt that earnings per shares have not been as stable as some of the more steady sort of GDP type associated mega caps in the FTSE 100.

[00:03:04] Eustace Santa Barbara: I think that with a slightly fairer wind behind them, the small cap earnings per share trajectory can revert to its mean and therefore it's an area we still think is a great place to invest for investors.

[00:03:14] Nick Peters: You mentioned valuations and we'll come back to corporate activity a little later because that has been notable in that space.

[00:03:21] Nick Peters: Maybe just explain to listeners how the fact that perhaps interest rates are peaking are going to start falling, that's led to investors revisiting the smaller company space.

[00:03:31] Nick Peters: It's probably worth explaining why falling interest rates is so much better an environment for smaller companies.

[00:03:38] Eustace Santa Barbara: Well, I mean, leading up to this, and you are right to point to central banks possibly making their next move on the interest rate cycle being down. But leading up to this, we had the most pernicious or the quickest interest rate hiking cycle by the world central banks since the 1980s.

[00:03:55] Eustace Santa Barbara: So when inflation kicked off quite sharply at the back end of 2020, 2021, the Federal Reserve raised interest rates over 500 basis points or 5% and the European Central Bank followed. With inflation data, which comes out monthly in the major economies, showing signs of coming down, it is quite probable that the next move of the Fed, the ECB, and the Bank of England are down.

[00:04:20] Eustace Santa Barbara: Current market projections are for three 25 basis point or 0.25% point reductions in 2024. And it's notable, I would argue, that we've seen a synchronised dovish pivot. So that's when many of the major central banks try to be aligned.

[00:04:36] Eustace Santa Barbara: And I would argue that there's about a 70% chance now that the bank of England cuts its base rate in June.

[00:04:43] Eustace Santa Barbara: The problem is that no central bank wants to be an outlier, so it's interesting in Western Europe, the ECB is confronted with the weakest demand data, and I would argue that inflation in the UK is probably the most uncertain.

[00:04:56] Eustace Santa Barbara: Neither the ECB nor the Bank of England wants to be too much of an outlier versus the Federal Reserve in the United States, which could lead to increasing exchange rate volatility.

[00:05:05] Eustace Santa Barbara: But I would argue now we have a good probability, not a guarantee, but a good probability that actually all three of those major central banks, the Federal Reserve, the European Central Bank, and the Bank of England, cut their interest rates for the first time in June.

[00:05:19] Eustace Santa Barbara: Why would that be beneficial? We've all noted in the last 12-18 months that our savings rates offered by high street banks, or national savings and investments, or government gilts, have yielded a lot more than what we were getting in 2020when interest rates were essentially nil.

[00:05:37] Eustace Santa Barbara: There is no doubt that there is a competition for capital and if an individual can get, I think the headline was 6.2 or 6.3% from a national savings and investment bond, that's an attractive return with very minimal, if not nil risk.

[00:05:51] Eustace Santa Barbara: As interest rates are cut, the attraction of those other things, whether it be bonds or savings rates does diminish and it really shines the light on the potential for returns from, for example, the UK smaller companies.

[00:06:03] Nick Peters: And I suppose that competition for capital is quite an interesting point because, okay, you say there's a good probability that rates fall. If we don't see that and rates stay where they are, do you think we're going to see that ongoing competition for capital and smaller companies struggling in that environment?

[00:06:22] Nick Peters: Or is it the case that actually those companies have now got used to operating in a higher interest rate environment? Costs have been cut and that earnings growth that you mentioned earlier, we should see that earnings growth coming through?

[00:06:35] Eustace Santa Barbara: I would say it's the latter, and I would say definitely the smaller companies management teams are more accustomed to this higher base rate or interest rates.

[00:06:44] Eustace Santa Barbara: Let's also not forget that one of the reasons that the smaller companies did have a challenging late 2021 and 2022 and even in 2023 is that they saw inflation in a plethora of things, whether that be their energy costs, whether that be their employment costs, whether that be their shipping and logistics, where we saw shipping costs go up 10x post COVID.

[00:07:06] Eustace Santa Barbara: And so what I would say is they've borne the brunt of that, but now those pressures have diminished if not actually been eroded and therefore interest rates are coming down because those inflationary pressures have eased, and so I would argue in an environment where the level of interest rates is maintained, they can still thrive.

[00:07:25] Eustace Santa Barbara: A final point on that is debt surface costs, obviously, if a company has a leveraged balance sheet and the interest rate goes from zero to 5%, the interest costs of that debt are going to be higher.

[00:07:38] Eustace Santa Barbara: But I would just point to the fact that when you look across the portfolio, the average net debt to EBITDA, which is a simple metric to measure a company's leverage, is about 0.4x, which I would argue is quite low and actually shows an extreme sense of prudence from our management teams, many of which would have experienced 2008/2009.

[00:07:59] Eustace Santa Barbara: It was an unwelcome period, banks pulled the plugs on many companies and so I think they learned their lesson quite sharply hence low relative leverage of 0.4x net debt to EBITDA despite very low base rate.

[00:08:12] Nick Peters: And that point about prudent balance sheet management takes us quite nicely onto the next point which is about valuations and the sort of corporate activity we've seen in the smaller company space in the last sort of 12-18 months and Special Sits has been a beneficiary of that takeover interest.

[00:08:33] Nick Peters: What does that tell investors about your style of investing and valuations more generally?

[00:08:39] Eustace Santa Barbara: You're right to point out that we had a lot of takeover interest in 2023 in the fund. We run a diversified portfolio, so we have over 150 names and in 2023, seven of those names received takeover bids.

[00:08:53] Eustace Santa Barbara: What I think is interesting is that they span sectors from logistics and leisure to healthcare and technology and buyers included trade, so we saw, for example, Young's Pubs buying another pub group called City Pub Group, that was at a 46% premium. We also saw private equity engaged in M&A as we saw with the logistics company, DXGroup, and they paid a 33% premium.

[00:09:16] Eustace Santa Barbara: And we also saw founders, so founders who had listed their company in this instance, 15 years ago, they took the company off the market. The example there is Caretech, it's a social care company, and that was acquired for a 28% premium. So we've seen M&A across sectors with different buyers in this case, trade, private equity, and founders.

[00:09:35] Eustace Santa Barbara: 2024 has seen the continuation of M&A, so, telecoms company Spirant Communications received a bid from, again, a trade buyer, VRV, at a 60% premium, and wealth manager Mattioli Woods received a bid from a private equity house called Pollen Street, they specialise in financial entities, and that premium was 34%.

[00:09:57] Eustace Santa Barbara: In this environment, which we already discussed, where we believe the next interest rate move from central banks will be down, I think M&A can continue to be a feature, especially while valuations remain, in my opinion, suppressed and compelling.

[00:10:12] Eustace Santa Barbara: And finally, on the valuation point, if you look at the UK equity market, in relative terms to other developed market equity indices, and in relative terms versus its own history, it's trading at multi decade lows. I would call that a very attractive market.

[00:10:28] Nick Peters: Okay, thank you. Looking forward, it's very likely to be a general election in the coming months. How do you see that impacting the investment environment in the UK? It's widely thought that Labour will win, do they have any financial headroom to make a significant difference, do you think?

[00:10:47] Eustace Santa Barbara: It's difficult to discuss fiscal rules and adherence to those fiscal rules, given we're talking huge numbers, GDP and debt, numbers that are five years forward and have significant forecast variance.

[00:10:59] Eustace Santa Barbara: Shadow Chancellor Rachel Reeves gave her Mays Lecture on the 19th of March, and I think she gave good insights into her party's thinking. I'll start with the top down key messages she tried to get across, and then I'll go a little lower to the details.

[00:11:13] Eustace Santa Barbara: She talked of building growth on strong and secure foundations, so echoes of Theresa May with her strong and stable, but we shall see, but she talked of active government guided by three imperatives.

[00:11:23] Eustace Santa Barbara: First, guaranteeing stability. Second, stimulating investment through partnership with business.And third, reform to unlock the contribution of working people and the untapped potential throughout our economy.

[00:11:37] Eustace Santa Barbara: I'll just pick up on the second and third points in terms of stimulating investment note through partnership with business. You'll remember Gordon Brown, PPI, Public PrivateInvestments, that was a key feature.

[00:11:48] Eustace Santa Barbara: So it does appear in discussions with our companies, and we talk to them about their discussions with the government, but also with the shadow government, that the Labour Party is willing to engage with a number of our companies across various sectors, where frankly the Conservatives have been criticised in some circles for their maybe lack of engagement with businesses.

[00:12:08] Eustace Santa Barbara: The third point that was mentioned in terms of the contribution of working people, I do think it's worthy of comment around National Living Wage and enhanced legal rights for workers. I mean, we've had a multi year increase in the National Living Wage and it means that the level is moving to almost 75% of median earnings.

[00:12:27] Eustace Santa Barbara: Now, in that environment, employment has been remarkably resilient to these increases up to now. Though it does seem as if both parties, the Conservatives and Labour, are testing the price sensitivity of labour demand.

[00:12:39] Eustace Santa Barbara: For example, we'll have all seen, if we venture into a quick service restaurant, a Burger King or a McDonald's or one of those sort of establishments that the nice men and women behind the till, a lot of them have now been replaced with self service kiosks.

[00:12:51] Eustace Santa Barbara: Well, clearly the payback on that automated machinery is a lot of the people who used to be behind the till are on that national living wage, and therefore, the return or the justification for creating that self service kiosk is that much more magnified. We've seen it in our retail supermarkets, in the Tesco's and Sainsbury's and Waitrose's as well, everyone would have seen it.

[00:13:11] Eustace Santa Barbara: The interesting thing, I think is that it's a very different approach to the United States, which has seen higher income inequality and greater private capital risk appetite, but if you look at labour friendly think tanks, they appear to dismiss these facets of the US economy as not material to invigorate UK growth.

[00:13:27] Eustace Santa Barbara: Now, it's hard to ignore the diversion in US and European GDP growth in the past decade, but you can certainly see on the one side you've got the European with the Social Democrat agenda and on the other side the American, which is pretty much apolar opposite agenda. So a change in government may just be the political reset that stimulates renewed enthusiasm for the UK, to echo, I think it was Tony Blair in 1997, things can only get better.

[00:13:53] Eustace Santa Barbara: Another way of expressing it would be the market hates uncertainty and actually greater political certainty will probably be attained post the UK's general election, which will be at the latest January 2025.

[00:14:06] Nick Peters: Thank you. Listeners will be relieved to hear we won't be asking you to sing things can only get better.

[00:14:12] Nick Peters: Last point, listeners always keen to hear about what's been going on in the fund, can you give us a flavour of what you've been up to recently?

[00:14:21] Eustace Santa Barbara: Yeah, absolutely, Nick, so in terms of names we've added to, we've increased our position in a company called IQE, this is a epitaxial wafer manufacturer. It's heavily geared into the semiconductor cycle, and it appears this cycle is close to bottoming, if not starting to turn positive based on inventory levels and commentary from across the ecosystem.

[00:14:42] Eustace Santa Barbara: There's another holding called Trust Pilot. It's the review platform, many of our listeners will be familiar with. They had a positive trading update that highlighted EBITDA would be ahead of market expectations, and they've also just started a £20m share buyback program.

[00:14:57] Eustace Santa Barbara: I think that's a good segway into something that I wanted to point out to our listeners that we've seen quite a lot of in the UK equity market in the last six months, which is share buybacks.

[00:15:08] Eustace Santa Barbara: When I started about 20years ago, it was pretty uncommon to see many companies on the UK market engaging in substantial share buyback programs. Today, it is almost half of the companies listed on the UK exchange are engaged in share buyback programs.

[00:15:25] Eustace Santa Barbara: I think this is a reflection of a company has capital allocation opportunities, they can invest organically, they can invest via acquisition, and if one thinks of it, not trying to be too academic, but you can acquire your own shares because you think that's a good use of your capital.

[00:15:41] Eustace Santa Barbara: Sometimes companies are criticised for doing share buybacks because in some instances it's viewed as 'the company has nothing else to do with the capital' and therefore they have to buy back their own shares.

[00:15:51] Eustace Santa Barbara: I wholeheartedly disagree with that. I think that if a company management team believes their share prices are undervalued and they have surplus cash on their balance sheet,And they're willing to buy back their own shares because they deem that to be an attractive investment opportunity, I think they should be doing it.

[00:16:07] Eustace Santa Barbara: I think one of the reasons that so many of these companies on the UK market are engaged in share buybacks is that we have seen since pretty much September, 2021 continued outflows from the UK equity market ecosystem, that's the large cap, but especially pronounced in the UK small cap.

[00:16:25] Eustace Santa Barbara: What it's meant is that there haven't been a lot of new buyers, and therefore, if there are sellers, I think share prices can be accentuated down, and so we have seen many instances where we have share prices just sort of trickle down, not on remarkably large volume. So that's another reason I think the UK small and mid cap is really attractive at this juncture.

[00:16:45] Eustace Santa Barbara: I gave a couple of names we've added to in the fund, but let me give a couple of sales just to complete the picture.

[00:16:51] Eustace Santa Barbara: We've taken profits ina company called Cerillion, this is a billing, charging and CRM software provider focused on the telecoms and utilities sector, and we also hold a company called Yellow Cake, which is a proxy to uranium.

[00:17:04] Eustace Santa Barbara: And with all the excitement around oil and energy and energy security globally, uranium has had a very, very strong run in the last 12-24 months, so we've actually just taken, again, partial profits in Yellow Cake. So both of those names we still like, it's just we've taken partial profits.

[00:17:21] Eustace Santa Barbara: I hope that gives you and the listeners an indication of some of the things that's been happening in the fund recently.

[00:17:26] Nick Peters: Excellent, thank you. And just to finish it off, how much cash are you holding in the fund?

[00:17:31] Eustace Santa Barbara: We have a lot of cash that's to be received from takeovers. If you look at current cash, it's around 3%, but if you look at current cash, including cash to be received from proceeds of M&A transactions that have been announced, it's more like 4.5% cash.

[00:17:49] Eustace Santa Barbara: What we're trying to do is balance flows, but also really pick our spots in terms of adding to names that we like.

[00:17:57] Nick Peters: And by the sounds of it, there are lots of names and plenty of potential with the holdings you do have?

[00:18:02] Eustace Santa Barbara: Very much so, I mean, I think that it's been a difficult 30 months, but if I can close with another expression, it's always darkest before dawn.

[00:18:11] Nick Peters: Thank you very much. Really interesting stuff. Thanks very much, Eustace, for joining us.

[00:18:15] Eustace Santa Barbara: Thanks for having me, Nick.

[00:18:17] Nick Peters: That was Eustace Santa Barbara, Fund Manager for Marlborough's Special Situations Fund.

[00:18:22] Nick Peters: If you'd like to find out more about the fund, then please go to our website. Thanks for joining, goodbye.