David Kimberley
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Updated 28 Oct 2022
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Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by Downing Strategic Micro-Cap. 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.

Even prior to the start of 2022, UK equities were trading at lower valuations than almost all of their major peers. Given the cloud of gloom that’s hanging over the country at the moment, it probably won’t surprise readers that there hasn’t been much of a change to that dynamic over the course of the year.

According to data published by Yardeni Research at the start of October, the UK stock market is trading at an average forward price-to-earnings ratio of 9.0. This is almost 50% lower than the US market, about 25% below Japan, and almost 15% below the emerging market average.

This isn’t a new trend and a litany of reasons have been given to justify it over the years. One is that pension funds and other institutions have lowered their allocations to UK stocks. There is also the fallout from Brexit and other political uncertainty. Lastly, the UK has large weightings to financials, commodities, energy, and mining. These are not the sort of growth businesses that have performed well over the past decade and it is hard to imagine investors wanting to pay large premiums for their shares moving forward.

Compounding this has been the increase in value of the dollar relative to the pound, and indeed almost all other currencies. In the year to 13/10/2022, the pound had lost almost 20% of its value against the greenback. If UK stocks were already looking comparatively cheap for dollar buyers previously, they are now looking even cheaper.

And it wouldn’t be new if we did start to see more merger and acquisition (M&A) activity as a result. Over the past couple of years we’ve seen buyers develop something of a penchant for UK firms. M&A activity hit record levels last year according to Reuters, with 55 London-listed companies receiving takeover bids, up from 40 in 2020.

Bids for takeover targets averaged a 47% premium to their share price last year. That was lower than 2021 where the equivalent figure was just over 60%. However, it’s worth keeping in mind a couple of factors here.

One is that much M&A is typically debt driven, and if rates rise then acquirers may be less willing to pay such high premiums. On the other hand, the private equity market has grown significantly over the past few years. Even though the amount of cash private equity funds have at their disposal is down relative to its 2020 peak, private capital levels still stood at $3.2trn globally at the end of Q3 of this year, according to data provider PitchBook. More funds sitting on dry powder means more interest in the same companies, something that’s likely to drive bids higher.

If some of this capital does end up being deployed in the UK public markets, then Downing Strategic Microcap (DSM) may stand to benefit. The trust’s managers, Judith MacKenzie and Nick Hawthorn, take a unique approach to investments, looking for firms at the smaller end of the UK stock market, where they look for pricing inefficiencies that are driven, in part, by a lack of research coverage.

Predicting takeover bids is notoriously difficult but the companies in the DSM portfolio have some characteristics that may make them appealing to buyers. One is that the managers take a more value driven approach to markets. This is part of the reason the portfolio has delivered relative outperformance this year. It also means they look for good companies that have potential but which the market is undervaluing – the same sort of businesses that M&A buyers have shown an interest in as well.

As a result of this, companies in the portfolio possess traits that may potentially make them more likely to be subject to takeover bids. Firstly, DSM’s holdings derive a larger proportion of their earnings from outside the country than the average of trusts in its peer group, the AIC’s UK Smaller Companies sector. Given some of the concerns around the UK economy’s prospects, this shouldn’t be overlooked.

The bulk of the trust’s holdings also refinanced their debt last year, prior to interest rate hikes coming into play. As a result, they may be less susceptible to increasing interest costs. There are also plenty of companies in the portfolio, like digital publisher Digitalbox, that are sitting on a net cash position, meaning they should be better able to ride out a period of economic instability.

If any holdings are subject to M&A activity, then DSM should be better positioned compared to some of its peers. DSM’s managers have long held a highly concentrated portfolio. Since its launch in 2017, the trust has typically held only 12 – 18 companies. The result is that if any takeover bids for portfolio companies do come, this should have a meaningful impact on returns for shareholders, unlike other funds that may hold 4x or 5x as many companies. A highly concentrated portfolio does work both ways, and so if any holdings disappoint, then investors are more exposed to the impact than they might be in a more diversified fund or trust.

If a takeover of a portfolio company were to occur then DSM could find itself with a significantly higher cash balance, which already stands at 10% of NAV. This might prompt the board to revisit the idea of buybacks, which at the current level of c. 26% would further boost the NAV, and potentially help to narrow the discount.

Again, it’s worth remembering that there are no guarantees that companies in the DSM portfolio are going to be subject to takeover bids. But if they do, then the trust should be able to benefit from them more meaningfully than some of its peers.

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