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Is the tide starting to turn for UK smaller companies? · On The Money

• 0:03
  Kyle Caldwell: Hello, and welcome to the latest episode of On The Money. This week, we are focusing on UK smaller companies. So we're gonna be covering the outlook for this part of the market, explain them why UK smaller companies have underperformed UK larger companies over the past three years, and we're also gonna be looking at the reasons why that performance gap has started to narrow of late. Joining me to discuss this topic is Richard Staveley, who is full manager of Rockwood Strategic, which is an investment trust that focuses on The UK smaller companies part of the market. Within the interview, Richard is gonna also outline his investment approach.
• 0:47
  So, Richard, before we get to that, let's start off with what are the reasons why UK smaller companies have underperformed UK large companies over the past three years. Just put some figures on this. At the time of this recording, the FTSE UK small cap index, it's retained 28% over three years, whereas the FTSE one hundred has retained 47%. And the FTSE one hundred, there has been hogging the headlines. You know, it keeps on reaching a new level.
• 1:21
  It surpassed 10,000 points last summer, and it went on to set a new record last month as well. Can you put your finger on the reasons why? I'm assuming it's not just one reason. There's multiple reasons.
• 1:34
  Richard Staveley: Yes, Kyle. It's it's definitely more than one thing. Think the first thing, most probably the most important is the backdrop in the last three years of interest rates. So interest rates started rising in late twenty twenty two and peaks April 2023 at 5% as we as we remember. And the interest rate is such an important factor about driving returns across asset classes, the risk free rates, and essentially small companies are perceived and are a growth asset class.
• 2:02
  And that moves to higher interest rates off for a period a long period of low interest rates has caused a big style change in the market towards value and value investing rather than growth investing. Then when you look at the FTSE one hundred, it at the point that this happened, it was stuffed full of loads of great value. If you then, like, drop into the components within the index, you first you take the bank sector. Now if you look over the last three years, I think there were 28 stocks in the FTSE one hundred that are up at least 75%, and quite a few up a 100% in the last three years. In The UK's FTSE small cap, there's only five stocks up over over 75%.
• 2:42
  Some of the ones that have done that are the banks. So HSBC, Standard Chartered, Barclays, NatWest, Lloyds. These will add up to quite a big driver for the FTSE one hundred. There are only two small banks in the FTSE small in index. Although Rockford does actually own one of them, and we've we've made a good return return out of that.
• 3:01
  I think also, you look at the sector composition and there's the defense businesses that are in the FTSE one hundred. There are no defense businesses in the FTSE Small Index. So there's BAE in large cap. There's Rolls Royce who've also been benefiting from their modular nuclear reactor program, but Babcock as well. Now some people would say, oh, it's about, you know, awful Britain and, you know, all the the headlines about domestic exposure.
• 3:25
  And it is true that small cap overall has more of a domestic exposure than the the FTSE one hundred. But then again, you start looking into the components of FTSE one hundred returns in the last few years. Next, M and S, Tesco's, these are all very much British businesses that have done extremely well. So I do think it's this interest rate effect which has been the main driver.
• 3:47
  Kyle Caldwell: And we have seen over the past year, the performance gap narrow between larger companies and UK smaller companies. Again, just put some figures on this. At the time of the recording, 4,100 index over one year is up just over 22% versus a rise of 18.5% for the FTSE UK small cap index. Is the main reason why that gap is narrows due to the fact that we have seen interest rates cut a couple of times?
• 4:18
  Richard Staveley: I I think it is the one probably the key driver. So we they started falling, I think, August 24. So we're near you know, we're down to 3.75% off that 5% peak. I'm expecting another interest rate cut very soon, probably even in in March, take us down to three and a half. And again, that just that just affects the interest of the risk free rates and allows growth stocks or growth interest to get better.
• 4:44
  I think I'd add further to that though. There's obviously has been a very difficult backdrop in The UK for for investors in the last twelve, eighteen months. Not not no little part due to the initial Rachel Reef budget, which didn't provide enough fiscal head headroom and then thus put this huge elongated period of concern about what further fiscal measures would come out in The UK to affect both investors and business businesses in general. I think in November when we had that second budget, there was a lot a lot more clarity about the outlook. Now she's she's definitely pushed the the problem down the road.
• 5:20
  It looks like there's definitely enough fiscal headroom in my opinion for the next eighteen months before people worry about that. But that window itself is enough for interest in small companies to go, right. We've got a bit more tax clarity now over the next eighteen months. Interest rates are coming down. This seems like a more, you know, more investable asset class.
• 5:39
  I think I'd add one further point in that, in that valuation does play a role. And, obviously, with FTSE one hundred performing so well, the gap between the valuations in small cap and FTSE one hundred widens out to a point where larger cap investors and maybe even overseas investors are going, actually, why don't we reallocate start to reallocate a bit of value to the one of the cheapest asset classes in the world, which is UK small cap.
• 6:03
  Kyle Caldwell: And in terms of valuations, obviously, we've seen a pickup in performance for UK smaller companies over one year. But in your view, is this part part of the market still looking very cheap?
• 6:15
  Richard Staveley: It's definitely still looking good value. And I I mean, I would say the best way of probably describing this is just to think about the American stock market, which obviously has attracted all the attention in recent years. I think that the S and P 500 currently is on an average price to book multiple of about five times. So each company, five times their their asset value. Rockwood's portfolio, half our holdings are on a discount to book value, not five times, a discount to the actual book value.
• 6:44
  If you take the sales, if you take a a market cap weighted s and p and 500 index, it's now on seven times sales. So an American investor or British investor buying American shares, for every pound of sales you buy at the company you're invested in, you're you're we it's seven times the actual pounds of sales. Whereas in for Rockford, for instance, we get you get £1 of sales for every pound of in of investment. So a big a big one. Now I am I have to say there's definitely some there's been a lot of structural change in in markets generally.
• 7:19
  So so for instance, the move to global tracker funds, which I'm sure you'll have seen are interactive. You know, don't global tracker funds, funnily enough, don't buy UK small cap shares. So that's where the flows have been going. I think what we we'd like to see is more help from the government, and I I personally have been a big supporter of further change to the ISA regime. We'd we'd like to see ISAs fully weaponized for UK for The UK stock market.
• 7:46
  It's a tax break afforded to by The UK taxpayer. Why not give it just to UK listed stocks? And I think something like that could create a major major change in markets if it was to come through. Rachel doesn't do it. She's an it's an open goal for the next chancellor, whoever that may be.
• 8:01
  Kyle Caldwell: Do you think then the performance not alone will not dictate a change in investor sentiment towards UK smaller companies? Say, for instance, we have this really good run of performance over the next two or three years for this part of the market. Do you think it's not necessarily that doesn't necessarily mean that investor sentiment will improve and more flows will go in?
• 8:23
  Richard Staveley: I think it will, though. If you look, you know, I think performance breeds flows. It's just it's a it's a virtuous cycle or a vicious cycle. And I think performance does, you know, create flows. We just need to sort of kick start that performance.
• 8:36
  Now it's starting as you've you've noticed. Definitely, money's now relooking at UK overall because the FTSE one hundred performance, you can see that, and it and it feeds. So I do think performance is a key performance, lower interest rates, and it would be helpful to have a bit of a nudge from from the government as well.
• 8:54
  Kyle Caldwell: Because, of course, over the very long term, the history books do indeed show that smaller companies tend to outperform UK larger companies. There's been a fascinating study on this from the London Business School Yeah. And Numis, which looked at the last fifty years of performance compared in UK smaller companies with UK larger companies. And the gap is very significant over that period. Do you think it's known as the small cap effects.
• 9:22
  Do you think this trend has feared the legs in the future, or is it now so well known that it could be overcharged away?
• 9:31
  Richard Staveley: Yeah. There's so you're absolutely right. This study in fact, for, you know, most UK small company managers should have these numbers etched into their into their bedsteads or but, I mean, it's quite amazing. It it actually the survey volume volume business score actually goes back to 1955. So it's 71 years old now.
• 9:48
  And just think, there's a lot of history in that lot seventy one years. Good periods, bad periods, things happening in Britain and not. So it's it's a good series for saying, over the long term, what really happens. If you'd invested a thousand pounds in 1955 in the FTSE in FTSE 100 in large cap and it compounded, you'd be very happy today. The end of last year, you'd have £1,900,000.
• 10:09
  If you'd invested in the bottom 10% of the market by size, you'd have £11,600,000. If you'd invested in the bottom 2%, which is actually where Rockwood focuses, the bottom the bottom, the smallest 2% of The UK stock market, you'd have 23,900,000 if you invested a thousand in 1955. It's amazing small cap effect. Why is it there? Because of global sorry.
• 10:34
  It's because of growth. So, basically, small companies, just because they're more nimble, they're more agile, they have their capability to take more market share is there or grow their businesses. And and that growth, I don't think is ever gonna change. They're always gonna be able to grow. Now interestingly, if your your your listeners or viewers will will know that just of late, the the phrase elephants don't gallop has been sort of turned on its head because a company like NVIDIA, which is huge, has clearly been galloping, which is why it's been performing well.
• 11:05
  But we all know that overall and over time, the largest companies, they just run out of room keep growing. They may have phases, but in aggregate, the smaller ones can grow faster, grow their profits at a faster pace. Now this so I don't think this effect goes. There is one other aspect to it, is important, is the smaller part of The UK market and any smaller company is more illiquid. And, essentially, the larger flows of money worry about the illiquidity of the asset class.
• 11:31
  And for that, they put a discount on your average small cap. But what happens over time is that as those smaller companies get bigger, obviously, the discount narrows because they've just become bigger and and let and more and more liquid. And that kind of supercharges the return on top of the on top of the growth. Now we could have an arbitrage away of the small cap effect for a period because what people do is they could realize this and then start buying loads of small caps and move them small caps to big premium to large caps in terms of valuation. But I suspect what would happen is you get a phase of excellent returns, and then they'd probably move back to the mean over time.
• 12:09
  So I'm I'm pretty confident the small cap effect will continue to work in the very over the over the long term.
• 12:14
  Kyle Caldwell: Let's now move on to how Rockwood Strategic invests. So you've already touched on a couple of points, but could you firstly summarize your investment approach? So it's a concentrated portfolio, and you have around five to eight core positions.
• 12:30
  Richard Staveley: Yeah. So we've got 25 stocks in the in in the portfolio now, and we're focused on businesses where we think that there's the scope for operational, strategic, or management change. And the the at the same point, we're looking for businesses that that that change is exposed to a business which is cheaply valued to a low valuation stock. And and also one where the profits are are depressed, either depressed relative to the company's own history or to its peer group or to the potential for its business model. So we look for these depressed profits.
• 13:05
  We look for low valuation, and then we we try and work out other initiatives or catalysts that could occur that could unlock shareholder value, create shareholder value, recover shareholder value, and that supercharges our returns for for Rockwood.
• 13:22
  Kyle Caldwell: Could you talk a bit more regarding how you try and unlock value? How involved are you with the companies?
• 13:30
  Richard Staveley: Well, not in every instance. So some of them, we don't have to be either heavy handed or highly involved in the turnaround. Often, we've just spotted because they're small, they're off the radar, things are changing, and no one else has spotted it as as for us, and we're just happy with what what's changed. However, for quite a few of our holdings, we will sort of roll up our sleeves and get stuck in. So of the 25, 10 have people on the board that we've either proposed and and then have joined the board or ourselves if we've taken a board position.
• 14:02
  We're currently working on two more. I can't tell them Tuesday, Carl, but we there will be two more short shortly. And secondly, we take large stakes. So of the 25 holdings, 18 of them, we've got at least Harvard have at least 5% of the equity. Now why that's relevant is we try and be constructive with management and boards of these under typically underperforming businesses.
• 14:27
  We go in, we say, look, we we get to know the business, then we say, look, you know, surely this person is being ineffective or you need to adapt the strategy or change in some way. And often, if it makes sense, we may just catalyze that to to happen and then we we all move on with our lives. Sometimes, though, we have to move from a kind of constructive dialogue to writing it more formally to them, rep setting out what we think. And then in some instances, and why the 5% of the shares is relevant is we may have to actually threaten an EGM where all shareholders get to vote on the proposals we we we think would be in the company's best interest. Now that involves a lot of engagement, and we're not sort of aggressive sort of US style active funds.
• 15:15
  We we're we're from the outset, we're speaking to the other shareholders, particularly the larger ones. We're speaking to the board, the management, trying to kind of convince and work out, you know, what needs to happen. But as we know with humans, they're often slow to accept that change is necessary, slow to admit mistakes, don't dislike admitting mistakes. Sometimes board board members become kind of go native. They're meant to be independently sort of pushing the executives to do their best job.
• 15:44
  They but they may get to know them far far too well. So we sort of highlight and these these aspects. And if there is broad shareholder support for the changes and they make sense, typically, they will end up happening without us having to do stuff in the public domain or or noise noisily through sort of aggressive newspaper campaigns or anything like that.
• 16:04
  Kyle Caldwell: And could you give an example or two of companies in the past where you've got heavily involved and it's led to a good outcome?
• 16:12
  Richard Staveley: Yeah. So one there's two, actually, examples that come to mind that would be really good to speak about. The first is one of our leading fintech businesses in The UK called Funding Circle, and they've spent over a £100,000,000 building a technology platform to which facilitates the lending of money to small and medium sized businesses in The UK, something that our high street banks used to do a lot more often than they do these days. So these florists and others, you know, small restaurants and other small businesses, often family owned, need access to credit and fund that's what Funding Circle will allows them to do through their platform. They listed a number of years ago, I think Goldman Sachs did the float at 1 and a half billion pound valuation.
• 16:55
  And you roll forward a few years. This is now we bought the shares about two two years ago. And people had sort of felt that they were still making too many losses, had lost interest in the in the in the narrative from the company, and was trading at a deep discount to the cash the company had on its balance sheet, literally less than the cash that the business had. So we built a stake. We engaged with other shareholders, with the board, the management, and we got them to essentially kick start a buyback policy.
• 17:25
  They've now bought back significant amounts of the equity. We started buying the shares at about thirty p, and all other shareholders, you know, pretty upset when the shares were around thirty p. The finance director was was was changed. They actually sold off their loss making US activities, and they did their first sort of decent cost cutting program, which we'd sort of push them to do to accelerate the move to profitability. So where we are today, we're as we're recording this, funding circles just hit £1.60.
• 17:53
  The shareholders are very pleased with the with the recovery. The the company's in great shape. It's now moved into material profits, and it's now a real really strong position to keep growing as a leading fintech business. Another one would be Centor Media, and this is much smaller much smaller business. I actually, for a period, went on to the board myself to get to know the business really well and make sure they were focused on shareholder value.
• 18:19
  In the end, I chose to come off the board to allow one of the people in the Harwoods network, I call Martin Rollins, to come in as chair of Central Media. And shortly after becoming coming as chair became executive chair, the CEO departed the business. And at that point, the shares were about 22 p. This was about a year and a bit ago. And then Martin has, with huge energy as he always does, and Gusto has sold off the various disparate businesses which were there in Central Media to Better Homes and people that would acquire them, and we should be returning 48 p in cash to everyone in March this in March year.
• 18:59
  Kyle Caldwell: I wanted to end by asking you about one of your biggest holdings, which has been in the news recently. So that is a Capita. So it was reported that the Capita's in a a bit of a spot above there following the civil service pension scheme that it took over the management of. I think it was towards the end of last year it took over. Your latest results, some point last year, suggest that the company was getting back on track.
• 19:26
  So what is your view now in light of recent developments?
• 19:31
  Richard Staveley: Yep. So the the company is definitely getting back on track. And I think since I said that a year ago, we're you know, Capita's now up 90% in in terms of shares. We bought it when it was about 225,000,000 market cap. It's now about 400 and so odd million market cap.
• 19:46
  For those that don't know, our our view is that the business is gonna be eventually valued at over £1,000,000,000. So we still think there's at least a 100% upside in in capital. If we take the the civil service pension scheme, obviously, it's a contract that they relatively recent recently won. I I think it was they they clearly have taken it over in a when it was in a bit of a mess from the prior guys. So I think I think it's something like there were 16,000 unread emails and a backlog of 84,000 cases, and they took it over the contract on the December 1.
• 20:20
  So the transition phase, I think, is through to March, and it's clearly in a bit more of a mess maybe than they they had hoped or expected it to be in. I think they've allocated what they call a surge of additional employees in to try and deal with the backlog and get that going. But but as usual, because they have got good relationships with government agents, they put out a joint statement with the I think it's it's either the cabinet I think it's the end with the cabinet office or the yeah. Cabinet office saying that it's being addressed and that, you know, they're both they're both working on it. I think capital, I've always felt, you know, if you own the shares, you've got a it touches so many parts of British public's life.
• 21:00
  It's sort of inevitable that they're gonna be in the news a bit trying to do their very best that they can. They they run the student loan company. They do the congestion charge, the ULEZ zone. They do the TV license, GP surgeries. And where I'm really excited about it, which I think people haven't really fully recognized, is that they are going to be the tip of the spear for AI.
• 21:23
  I actually think Capita is this hidden AI stock in The UK market because Adolfo Hernandez, the new CEO, we've obviously backed us, as you've explained from this before, a and the new board, new CEO, new finance director, new heads of ops, all the rest of it. And they've they've been selling off businesses to pay down the debt, which is now under control. They had a huge pension deficit, and he he they've paid that all off. So there's no more money going into the pension. They took on some horrific contracts, not the civil one.
• 21:49
  They they want the civil service contract. They took took some loss making contracts, which they've now exited. And Adolfo used to run Amazon Web Services, AWS Europe. And what he's done since he's joined is he's announced a a series of strategic partnerships with Microsoft, AWS, ServiceNow, Salesforce to embed AI not only into how capital works as a business, but how they deliver on these government contracts. If you think if we all sort of sit back for a moment and think, what's the biggest opportunity in Britain now?
• 22:23
  It's probably to get the costs of government bureaucracy in the public sector down as much as possible without cutting. If you see what's in that's the more political question. But in terms of making them more efficient, that's gotta be a massive goal, hasn't it? And AI is gonna play a huge role, and Capita have the relationships and the trust and the contracts with government to really lead huge improvements, we we hope, to the provision of government services. Just just to remind for those listeners who are interested in kind of multiples and things, Capita's currently on a PE of seven times, very low single digit PE.
• 22:58
  And, again, we we think as they continue to deliver improved free cash flow generation over the next couple of years, that we should see a further rerate.
• 23:08
  Kyle Caldwell: Richard, thank you very much for your time today.
• 23:10
  Richard Staveley: Thank you so much too.
• 23:12
  Kyle Caldwell: So that's it for the latest episode of our On The Money podcast. We love to hear from listeners, and the best way to get in touch is by emailing us, otm@ii.co.uk. In the meantime, you can find lots of practical insights related to investments, personal finance, and pensions on the Interact Investor website, which is ii.co.uk, and I'll hopefully see it again next week.