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Jo Groves
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Updated 15 Dec 2023
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Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by Rockwood Strategic. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.

Investing guru Jim Slater’s oft-repeated mantra that “elephants don’t gallop” captures the benefit of investing in small-caps better than most, alluding to their superior growth potential relative to larger-cap peers. However, small-cap investors may feel somewhat flattened by the stampede of the mega-cap herd of late, with the ‘magnificent seven’ bouncing back from their nadir last year to deliver some stellar gains in 2023.

In contrast, it’s fair to say that UK equities, and small-caps in particular, have borne the brunt of a challenging macroeconomic environment. Stubborn inflation, soaring interest rates and recessionary fears have weighed on valuations, leaving the UK small-cap sector trading at a significant discount to its long-term average. The MSCI UK Small Cap Index is currently trading on a forward price-earnings valuation of 11.0x, significantly below the 16.8x of the MSCI World Index (as at 30/11/2023).

Despite depressed valuations, small-cap aficionados highlight the outperformance of small-caps relative to large-caps over time, particularly after a cyclical low. Our recent research indicates that, since 1955, the Numis Smaller Companies Index has averaged a return of 84% in the three subsequent years following a negative calendar year (with a 16% fall in 2022). While it’s hard to call the bottom of the market, an improving outlook for the UK economy over the next few months could prove the turning point for the fortunes of UK small-caps.

Sustained takeover activity

M&A activity is a good litmus test of attractive company valuations and, as the chart below shows, demand for UK companies remains robust.  In addition, interest from overseas buyers continues to rise, fuelled (in part) by the strength of the greenback against the pound.

UK small-cap specialist Rockwood Strategic (RKW) actively considers a company’s strategic and financial appeal to potential acquirers as part of its initial investment thesis. This continues to prove a successful approach, with takeover bids for Smoove, OnTheMarket, Finsbury Foods and The City Pub Group in the last four months alone.

Manager Richard Staveley holds a concentrated portfolio of around 20 companies, considerably below the 50 to 100 companies held by many small-cap funds. As a result, acquisition premiums can provide a significant boost to returns and Richard believes that 80% of RKW’s holdings will ultimately be acquired by a trade or private equity buyer.

Looking at returns in more detail, the £99m offer for property portal OnTheMarket was at a 56% premium (to the closing share price prior to announcement), generating an impressive (unrealised) IRR for Rockwood of 107% (as at 17/11/2023). The City Pub Group and Finsbury Foods are also forecast to deliver IRRs of 52% and 33% respectively on completion. In addition, Rockwood has a realised IRR of 30% for industrial manufacturer Crestchic, which was acquired by Aggreko earlier this year on a money multiple of 4.8x.

These acquisitions have contributed to RKW topping the small-cap investment trust sector for one, three and five-year share price returns, delivering an impressive one-year return of 17.2%, compared to a fall of 0.6% for the sector (as at 12/12/2023).

Taking an active approach

Another benefit of RKW’s concentrated portfolio is the ability to spend more time on portfolio companies which is more akin to a private equity approach. RKW looks to take a minimum stake of 5% to influence strategy and unlock shareholder value. In contrast to other small-cap trusts, this allows Richard to target the smaller end of the small-cap spectrum, with a sweet spot of sub-£100m. He views this as the least efficient area of the market, with limited analyst coverage but a large investable universe.

Another differentiating factor is the trust’s value bias and focus on recovery situations, or as Richard puts it, the potential to ‘move off the naughty step’. RKW recently increased its stake in Trifast, an international manufacturer and distributor of industrial fastenings. The company has instigated a restructuring process, with changes to the board, significant investment in a new ERP system and expansion plans in the US market. Richard believes that improved cash generation and returns should prompt a re-rating in valuation over time.

Resilience in challenging times

Despite the difficult macroeconomic backdrop, the turnaround potential of Rockwood’s portfolio companies is more about self-improvement than a broader cyclical recovery. As a result, the trust has delivered positive share price returns in every calendar year since 2017 despite negative returns in the Morningstar UK Small Cap Index in three of these six years.

RKW carries out extensive due diligence on target companies before deciding whether to invest, with particular focus on proven businesses with strong cash generation. The RKW team works with management to identify catalysts for improving profitability and strengthening the balance sheet. RKW has a time horizon of three to five years and develops an exit thesis to mitigate potential liquidity issues.

One such recovery story is education solutions provider RM plc, whose share price slumped to 26 pence last year after an unsuccessful ERP system roll-out. RKW took its first stake in the company at this point and has subsequently overseen senior management and operational changes. Although the share price has dipped after hitting more than 90 pence earlier this year, Richard believes the company could be worth as much as 180 pence per share.

RKW is well-positioned to benefit from a recovery in small-cap valuations if macroeconomic headwinds start to ease next year and, without forgetting the risks associated with investing in small businesses, investors who are bullish on the outlook for smaller companies may see this as an attractive entry point.

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