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The Case for Buying Small Caps Now · Merryn Talks Money

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Speaker 1: Bloomberg Audio Studios. Podcasts. Radio. News. So small cap value
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Speaker 1: is the anti-AI trade, you think, Stuart?
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Speaker 2: Quite possibly.
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Speaker 3: I mean, the only certainty is we don't know until
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Speaker 3: it happens. If you look around the world, Meryn, small
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Speaker 3: caps generally, particularly value small caps, are very cheap. UK
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Speaker 3: is an outlier within that. If you believe in reversion
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Speaker 3: to mean they're still upside on rating. If it's purely
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Speaker 3: a rotation rather than economic event or a war or
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Speaker 3: something worse... There's no reason I think that movement of
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Speaker 3: money out of the massive concentration in AI stocks into
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Speaker 3: all the stuff that's been neglected for three years can't
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Speaker 3: happen as well.
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Speaker 4: Welcome to Merrin Talks Money, the podcast in which people
0:54
Speaker 4: who know the markets explain the markets. I am Merrin
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Speaker 4: Somerset Webb, and this week I am speaking with Simon
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Speaker 4: Evan Cook, who is a fund manager at Downing, running
1:02
Speaker 4: a fund of funds. Also, Stuart Widdeson, who is the
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Speaker 4: co-founder and managing partner of Odyssean Capital, who are the
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Speaker 4: managers of the Odyssean Investment Trust. Simon, Stuart, welcome to
1:13
Speaker 4: Merrin Talks Money.
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Speaker 2: Lovely to be here. Nice to be here. Simon, welcome
1:15
Speaker 2: to Merrin Talks Money.
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Speaker 4: You have a history of investing in and talking about
1:21
Speaker 4: investing in not just small companies, but small investment funds.
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Speaker 4: And there's a particular reason why it is interesting you
1:29
Speaker 4: to look at not just small funds, but new funds.
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Speaker 4: And there's a history, isn't there, of new funds outperforming
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Speaker 4: in the first couple of years of their existence. Can
1:39
Speaker 4: we tell us a little bit about that before we
1:41
Speaker 4: move on.
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Speaker 1: To small caps?
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Speaker 2: Yeah, for sure.
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Speaker 3: I mean, There's all sorts of belief out there amongst investors,
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Speaker 3: and I sense it as well, that if you're going
1:51
Speaker 3: to buy a fund, you should buy a nice, big,
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Speaker 3: safe fund because it's got an amazing track record and
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Speaker 3: loads of other people are in it, and therefore that
1:59
Speaker 3: is the thing you want to buy. And occasionally this
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Speaker 3: is true, but really, those big funds only really got
2:06
Speaker 3: big because in their early years, they smashed it out
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Speaker 3: of the park. And there are all sorts of reasons
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Speaker 3: why holding and managing a smaller fund is is considerably
2:16
Speaker 3: easier than managing a large fund. So we're about to
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Speaker 3: talk about small caps later on. That's one of the reasons,
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Speaker 3: for one, that if you're running a smaller fund, you
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Speaker 3: can invest in smaller companies. Over the last few years,
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Speaker 3: that wouldn't have helped you a great deal because of
2:30
Speaker 3: the market dynamics. But generally speaking, we all know that
2:34
Speaker 3: kind of fact that smaller companies will rise more than
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Speaker 3: larger companies over time. And the best managers are able to.
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Speaker 2: Less efficient.
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Speaker 3: So you can make more alpha because you're more likely
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Speaker 3: to find a company that everybody else has ignored. It's
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Speaker 3: only got one analyst covering it rather than the 100
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Speaker 3: that are covering NVIDIA. And so you're able to find
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Speaker 3: a company that is materially undervalued and that can potentially,
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Speaker 3: even if it's not undervalued, still grow by 10, 20,
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Speaker 3: even 50 times. Whereas obviously a company like NVIDIA, amazing
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Speaker 3: as it is, shouldn't be able to grow by 50
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Speaker 3: times from here. I mean, the maths of that must be, yeah,
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Speaker 3: I can't even imagine, but it must be impossible.
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Speaker 1: Okay.
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Speaker 4: So that's part of it, being able to buy smaller companies.
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Speaker 4: A giant fund can't buy into a smaller company, obvious reasons.
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Speaker 1: But that's not all, right? There's got to be more
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Speaker 1: to it than that.
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Speaker 3: No, there's more to it than that. I mean, for starters,
3:30
Speaker 3: if it's an emerging fund, so let's call it a
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Speaker 3: new fund that's just been launched, there are different reasons
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Speaker 3: why it may be that Put them into two camps.
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Speaker 3: One might be that it's a new manager. So that's
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Speaker 3: someone who is younger, maybe getting their first chance at
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Speaker 3: running their own fund, having been an analyst somewhere. And
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Speaker 3: the second one might be that it's a more experienced
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Speaker 3: older fund manager who is leaving a bigger company somewhere
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Speaker 3: because they've got annoyed with the red tape or the
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Speaker 3: amount of extra work they've got to do and is
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Speaker 3: establishing their own boutique and is starting their own fund.
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Speaker 3: So if we take those one by one, starting with
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Speaker 3: the experienced older fund manager and The reason why you'd
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Speaker 3: want to back that particular fund is because now they're
4:09
Speaker 3: finally being let off the lead. You know, whatever was
4:12
Speaker 3: kind of annoying them, holding them back before, it might
4:14
Speaker 3: be that the funder got too big. Might be that
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Speaker 3: they had an overbearing risk department or a CEO who
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Speaker 3: wanted them to hug the benchmark. Now they don't have
4:22
Speaker 3: to do that anymore. And if they are a good
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Speaker 3: fund manager, that should mean that they can create better
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Speaker 3: returns for you for doing that. And at the point
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Speaker 3: when their fund is still small enough for them to
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Speaker 3: be able to maneuver it and buy smaller companies, all
4:34
Speaker 3: of that good stuff, they can still do that. So
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Speaker 3: that's one reason why a smaller fund might be your friend.
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Speaker 3: The other one is that it might be a younger
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Speaker 3: fund manager who's getting their first outing. Now, no one
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Speaker 3: ever gives a fund manager an outing when they're 22, 23,
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Speaker 3: literally out of university. This guy seems bright. Let's give
4:53
Speaker 3: them a brand new fund and 10 million quid to
4:55
Speaker 3: go in it. That doesn't happen. They're normally someone who's
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Speaker 3: proved themselves as part of a bigger team, as an
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Speaker 3: analyst and and they're being given their first chance with
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Speaker 3: a new fund. And you might think, well, I don't
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Speaker 3: want to invest with a 28, 29-year-old, 30-year-old. That's too young.
5:12
Speaker 3: I want some grey hair. But you would be surprised
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Speaker 3: at the statistics around that. I mean, if you take
5:19
Speaker 3: possibly the most famous fund manager there's ever been, Peter Lynch,
5:24
Speaker 3: I'm not including Warren Buffett in that because it's not
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Speaker 3: technically a fund, but Peter Lynch... I mean, Peter Lynch
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Speaker 3: is considered to be one of the goats of fund management.
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Speaker 3: Incredible fund manager, stunning track record. And when we see
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Speaker 3: pictures of him today, we see pictures of this grey-haired
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Speaker 3: gent and you think that's what a fund manager should
5:40
Speaker 3: look like. But he retired at 48. So he did
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Speaker 3: all of his fund managering. All of that track record
5:47
Speaker 3: happened between about the ages of 30 and 48. So
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Speaker 3: that's a younger fund manager running what was initially a
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Speaker 3: smaller fund. And I think that comes down to lots
5:57
Speaker 3: of factors, including the hunger of the fund manager. I
6:01
Speaker 3: think the point in life where you're at, where your
6:04
Speaker 3: brain is still at its physical peak, but also you've
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Speaker 3: got enough life experience to be able to use that.
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Speaker 3: So picking that sweet spot ties in quite nicely with
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Speaker 3: picking smaller funds. And then to tie a ribbon on
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Speaker 3: the top of all that, for me as a professional
6:21
Speaker 3: fund buyer, because nobody else is doing what I'm doing
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Speaker 3: currently and nobody else is learnt the art of picking
6:27
Speaker 3: younger funds, we get a nice tasty discount generally for
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Speaker 3: being what's called a founder in that fund.
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Speaker 1: Discount on the fees, you mean?
6:35
Speaker 3: We get lower fees.
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Speaker 4: I mean, it always seems to me that there's something
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Speaker 4: in the fact that when you, you know, say you're
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Speaker 4: reasonably young and you start a new fund, or even
6:41
Speaker 4: if you're older and you're starting a new fund, that's
6:43
Speaker 4: when you're going to be incredibly high conviction, really going
6:46
Speaker 4: with the style that you believe in, etc. So if
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Speaker 4: you're going to outperform, those first three, four years are
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Speaker 4: absolutely going to be it. And you've chosen a style
6:55
Speaker 4: that's going to work in that period anyway. But then,
6:57
Speaker 4: you know, let's say you do that. Let's say you
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Speaker 4: outperform in your 10, 20, 30 percent a year, whatever
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Speaker 4: it is. And you hit year four. People have started
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Speaker 4: to put money into your fund. And that's when the
7:07
Speaker 4: nerves kick in, right? That's when it's like, well, what
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Speaker 4: I've got to do now is I've got to maintain this.
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Speaker 4: So I've got to hang on to the money. So
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Speaker 4: what I want to do now is not take quite
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Speaker 4: so much risk.
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Speaker 1: Maybe not be quite so high conviction. Pull back from
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Speaker 1: the brink a little.
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Speaker 4: And that's why those first three years can be so profitable.
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Speaker 4: And after that, things will kind of slide off. It's
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Speaker 4: just emotion.
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Speaker 1: It's human nature.
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Speaker 2: It is human nature.
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Speaker 3: And it's definitely that one side of it that the
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Speaker 3: fund managers themselves might think, OK, I can throttle back
7:40
Speaker 3: a little bit here. But if you've met some of
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Speaker 3: the individuals I've met, I mean, that is not in
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Speaker 3: their vocabulary to do that.
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Speaker 2: Just as often, if you.
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Speaker 3: Think about the dynamics within a larger fund company, when
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Speaker 3: that younger fund manager starts their fund and it's 10
7:54
Speaker 3: million in size and they're working as part of a
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Speaker 3: hundred billion fund manager, the CEO of that company does
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Speaker 3: not give a damn about that fund. But when that
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Speaker 3: fund becomes a kind of category killing franchise running five
8:07
Speaker 3: billion pounds, then they start to care and then they
8:10
Speaker 3: start to worry about what happens next. If this fund
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Speaker 3: manager underperforms because there's a style change, wouldn't it be
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Speaker 3: more sensible if we pulled it back in a little
8:19
Speaker 3: bit so it looks a bit more like the benchmark?
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Speaker 3: So quite often it's corporate tampering as much as a
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Speaker 3: fund manager losing their willingness to take risk.
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Speaker 1: Okay, so when you talk about an emerging fund, what
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Speaker 1: are you talking about? Up to what sort of size?
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Speaker 3: That's a bit of a how long is a piece
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Speaker 3: of string type of question. But I would say an
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Speaker 3: emerging fund nowadays... It's probably anything south of 250 million.
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Speaker 3: And that in itself was a bit of a sad
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Speaker 3: thing because 250 million used to be enough just to
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Speaker 3: run a fund for it to be a going concern
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Speaker 3: and away you go and that's what you've got. But nowadays,
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Speaker 3: if you're running a fund that's 10, 20, even 50 million,
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Speaker 3: sometimes even up to 100 million, particularly a bigger company,
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Speaker 3: that's seen to be not enough and not viable and
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Speaker 3: you can't attract the bigger fund buyers. So It's not
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Speaker 3: there yet. So you'd put that in the emerging camp.
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Speaker 2: And that's a shame.
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Speaker 3: And the reason it's become that is because a lot
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Speaker 3: of the fixed costs involved in running funds have become
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Speaker 3: more onerous. And it means you just need more money
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Speaker 3: and it's more of a risk to launch a fund now,
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Speaker 3: which in.
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Speaker 2: Itself is a shame.
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Speaker 3: I have a big gripe about that because like any market,
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Speaker 3: you want lots of things being tried and the fittest
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Speaker 3: things to emerge from that Darwinian soup. Whereas currently what
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Speaker 3: we're doing is limiting the number of people who can
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Speaker 3: start funds, who can run them down to really the
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Speaker 3: people who've got the money or the backing to do that.
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Speaker 3: And that is not many in the current environment.
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Speaker 4: And the other problem, of course, is that there aren't
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Speaker 4: as many active fund buyers around as there used to
9:54
Speaker 4: be because of the rise of passive.
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Speaker 1: Okay, Stuart.
9:57
Speaker 4: So with that in mind, let's move on to the
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Speaker 4: Odyssean Investment Trust. And that, by Simon's definition, only just
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Speaker 4: hits the 250 million below mark, doesn't it?
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Speaker 3: Well, yeah, I think we're about 330 million today. So hopefully,
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Speaker 3: on Simon's analysis, we're about to break out and attract
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Speaker 3: some more people for to look at it.
10:21
Speaker 1: Okay.
10:21
Speaker 4: And everything that he said about why it is that
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Speaker 4: smaller funds can outperform, did that all make sense to you?
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Speaker 2: No, absolutely. We IPO'd with about 85 million.
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Speaker 1: When was that, by the way? When was your IPO?
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Speaker 1: How long have you been on the go?
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Speaker 3: That was in May, 2018. So, and I'd been someone who'd,
10:39
Speaker 3: I think was in the first category that Simon suggested
10:42
Speaker 3: who'd somewhere else before and wanted to go and have
10:46
Speaker 3: a go independently.
10:47
Speaker 4: Okay, so you're self-identifying as the older guy, not the
10:50
Speaker 4: younger guy.
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Speaker 2: Yeah, sadly, yes.
10:54
Speaker 3: And sadly, I'm a bit depressed because I'm a little
10:56
Speaker 3: bit older than Peter Lynch and he'd already retired. But hey,
10:59
Speaker 3: I love what I do.
11:00
Speaker 2: We all feel like that.
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Speaker 1: And I've got.
11:01
Speaker 3: Younger people in the team and that's all good. But no,
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Speaker 3: I think the three things for me is you can
11:06
Speaker 3: be really agile. You know, you start day one with
11:09
Speaker 3: a clean piece of paper, no legacy. How do we
11:12
Speaker 3: do what we did last time, but better, right? And
11:15
Speaker 3: that doesn't just mean actually your fund selection it means
11:19
Speaker 3: how you how you build the people around in your
11:21
Speaker 3: team um number two i think completely agree with what
11:24
Speaker 3: you said um and it is darwinian you know you
11:27
Speaker 3: there is pressure you know very few people launch a
11:31
Speaker 3: fund and a viable day one and we were very
11:33
Speaker 3: lucky with investment trust it was it was a binary
11:36
Speaker 3: outcome either it launches or it doesn't and if we
11:38
Speaker 3: launch it we sort of you know we we wash
11:40
Speaker 3: our face day one but but there is a lot
11:42
Speaker 3: of pressure on you not just to raise the first
11:44
Speaker 3: capital but but really make it work for the first
11:46
Speaker 3: three years. I think we've got a good team. So
11:50
Speaker 3: we haven't sat back on our laurels and we've kept
11:53
Speaker 3: pushing because it's in our nature. But I agree with
11:57
Speaker 3: a lot of what Simon said. I think that the
12:00
Speaker 3: interesting thing for me was when I talked to the
12:02
Speaker 3: clients about it, because we're quite a long-term investor. Our
12:05
Speaker 3: average hold is three to five years. And when you IPO,
12:09
Speaker 3: when you launch a fund, everyone's expecting you to be
12:12
Speaker 3: fully invested as soon as possible. And if you do
12:14
Speaker 3: the maths on that, you're doing three to four times
12:17
Speaker 3: the number of investment decisions in a year than you
12:19
Speaker 3: would normally do. And as we're all human, you always
12:22
Speaker 3: make mistakes. I think the key thing for us actually
12:24
Speaker 3: in the portfolio is getting the first investments right. And
12:27
Speaker 3: if you get the first investments right, actually you'll be
12:30
Speaker 3: viable and you'll grow and you'll create a more sizable
12:34
Speaker 3: vehicle over time.
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Speaker 1: So you are a small cap investor. That's what goes
12:36
Speaker 1: into the investment trust.
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Speaker 4: Your record since your IPO is pretty good, but your
12:41
Speaker 4: record for the last year is excellent. The last six
12:44
Speaker 4: months and the last year are very good. Is something
12:46
Speaker 4: changing in this market?
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Speaker 2: I don't think something's changing.
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Speaker 3: I mean, we've had a particularly good period, but it's
12:54
Speaker 3: come off two years that were quite soft after a
12:56
Speaker 3: fantastic 22.
12:57
Speaker 2: And I think from.
12:58
Speaker 3: Our perspective, a lot of the decisions that we made
13:02
Speaker 3: two to three years ago, which didn't seem right in
13:05
Speaker 3: the short term, have actually really come home to roost
13:08
Speaker 3: positively over the last 12 months or so. We've been
13:11
Speaker 3: very bearish about the prospects for domestic UK companies for
13:14
Speaker 3: some time. We're not great fans of what we see
13:17
Speaker 3: around ourselves, not just in the corporate environment, but in
13:20
Speaker 3: our home lives. And we were very focused on finding
13:24
Speaker 3: international companies that happen to have their headquarters here. So
13:30
Speaker 3: we weren't really betting on the UK economy, which has
13:32
Speaker 3: proven to be a good thing. We really have valuation
13:35
Speaker 3: discipline as well, Merrin. So a key part of what
13:37
Speaker 3: we do as well as for decent companies is to
13:39
Speaker 3: not overpay. And then finally, I think the one thing
13:43
Speaker 3: that we have started to benefit on more recently is
13:46
Speaker 3: a lot of our companies go through self-help transformations. Much
13:51
Speaker 3: easier with a small company than if you're trying to
13:52
Speaker 3: turn around Vodafone. Maybe the one thing that has changed
13:55
Speaker 3: in the broader market is when a sector goes out
13:59
Speaker 3: of favor for many years, there's a lot of liquidity
14:03
Speaker 3: problems in funds and people that have open-ended funds become
14:07
Speaker 3: for sellers to meet redemptions. And when those redemptions are
14:12
Speaker 3: quite high and there's no buybacks or there's no M & A,
14:16
Speaker 3: there's selling pressure on a lot of these companies. So
14:18
Speaker 3: illiquidity in small caps works against you. What we're starting
14:22
Speaker 3: to find actually is buybacks and M & A is
14:25
Speaker 3: more than compensating for small outflows. And actually, good news
14:29
Speaker 3: is actually creating positive momentum in share prices. And therefore,
14:33
Speaker 3: liquidity has started to move in your favor. So we've
14:36
Speaker 3: had a couple of stocks this year up 100%, really,
14:40
Speaker 3: because the market started to see, actually, this is a
14:42
Speaker 3: really interesting story. I want to go and buy some shares,
14:44
Speaker 3: and there's no sellers. So I think that it appears like,
14:48
Speaker 3: to us, small cap is towards the end of the
14:50
Speaker 3: clearing phase.
15:09
Speaker 1: So it's an incredibly simple story, really.
15:11
Speaker 4: We've been through a period where everyone loves mega caps,
15:13
Speaker 4: where US tech has been very exciting. AI has been
15:17
Speaker 4: very exciting at the large cap level. People have poured
15:20
Speaker 4: into those. Now they're looking at that going, eh, a
15:23
Speaker 4: bit pricey. I'd quite like to identify, look at all
15:25
Speaker 4: that cheap stuff over there and shifting into small cap.
15:28
Speaker 3: Yeah, I definitely think that's an aspect of it. Divert
15:31
Speaker 3: market small caps are some of the cheapest assets around,
15:35
Speaker 3: quite a small caps, the cheapest assets around in the
15:37
Speaker 3: world today. Simon produced some analysis we talked about a
15:40
Speaker 3: few months ago showing the forward returns from these points
15:44
Speaker 3: post-inflation were potentially very attractive for the next 10 years.
15:47
Speaker 3: And yet the forward returns from the mega caps in
15:49
Speaker 3: the US appear to only potentially just be beating inflation
15:53
Speaker 3: for the next 10 years. So there's going to be
15:55
Speaker 3: some style change. What we see going and talking to
15:57
Speaker 3: our clients, a lot of our clients are wealth managers,
16:01
Speaker 3: small cap is moving from, I know it's cheap, I
16:03
Speaker 3: don't care, to I know it's cheap, I think it's
16:07
Speaker 3: starting to move, which it has. I think I better
16:10
Speaker 3: own some.
16:12
Speaker 2: What am I going to buy?
16:13
Speaker 3: And that's a significant mindset change that we've seen in
16:15
Speaker 3: the last six months.
16:16
Speaker 4: Yeah.
16:16
Speaker 1: Okay. That's interesting. Simon, tell us about that valuation research
16:19
Speaker 1: that you did.
16:20
Speaker 3: Well, I can't claim to have done the research itself.
16:23
Speaker 3: I just put the lipstick on it and.
16:24
Speaker 1: Sent it out into the world. We'll still call that
16:27
Speaker 1: you doing it. I should just claim it.
16:28
Speaker 2: Yeah.
16:28
Speaker 1: So it's by Research Affiliates and they do.
16:29
Speaker 4: A lot of work on.
16:35
Speaker 3: Looking at the same way weather forecasting works, you look
16:39
Speaker 3: at conditions today and you say, right, historically speaking, what
16:42
Speaker 3: could you expect going forward from similar conditions in the past?
16:47
Speaker 3: And a lot of that work is based on the
16:49
Speaker 3: valuations you're paying for different geographical markets, different segments of
16:53
Speaker 3: those markets. And unsurprisingly, the areas that have done the
16:57
Speaker 3: best over the last 10 to 15 years, most obviously
16:59
Speaker 3: the US mega cap growth. have exhausted their potential returns
17:05
Speaker 3: because you're now paying so much for those assets that
17:08
Speaker 3: if they just mean revert to anything like a normal valuation,
17:12
Speaker 3: then that's not much in the way of return. But
17:16
Speaker 3: then when you look at the other side of it,
17:17
Speaker 3: so if you look at European small caps, UK small caps,
17:21
Speaker 3: even within the US, a lot of the small cap
17:23
Speaker 3: markets as well, they really haven't had an incredible 10 years.
17:27
Speaker 3: It's not been a disaster. They've still made you money,
17:30
Speaker 3: but they haven't over-delivered. So it's been sustainable returns they've
17:34
Speaker 3: been delivering. And there's no reason to think that over
17:37
Speaker 3: the next 10 years that they can't keep delivering you
17:41
Speaker 3: inflation plus 5%, 6%, 7%. So let's call that nominal
17:46
Speaker 3: maybe 9%, 10%, 11%. And if you put a great
17:48
Speaker 3: fund manager on top of that, then maybe you can
17:51
Speaker 3: add another one or two. And you start to get
17:53
Speaker 3: up to something that's very respectable looking. At a time
17:57
Speaker 3: when asset allocators on my side of the fence, the
18:00
Speaker 3: multi-asset fund managers, scratching their head and thinking, what do
18:03
Speaker 3: we do? Equity markets look expensive. Bond markets look compromised.
18:08
Speaker 3: There's other stuff out there, but it's unproven. Well, if
18:11
Speaker 3: you can just pick good stocks out of the market,
18:15
Speaker 3: then actually there's not too much of a problem in
18:17
Speaker 3: my view.
18:17
Speaker 4: I had Jeremy Grantham on the podcast and we were
18:20
Speaker 4: talking about value and the small cap effect, etc. He
18:23
Speaker 4: said he didn't believe in the small cap effect, didn't
18:25
Speaker 4: believe that there were sort of mysterious reasons why small
18:28
Speaker 4: caps outperform long term. It was just a another another
18:31
Speaker 4: part of the value effect that small caps are automatically
18:34
Speaker 4: cheaper than larger companies and so we talk about small
18:38
Speaker 4: caps as over something special but they just outperform over
18:41
Speaker 4: the longer term because they're generally cheaper i.
18:44
Speaker 3: Would never argue with jeremy grantham.
18:47
Speaker 4: I thought that would be really interesting tell someone who
18:49
Speaker 4: say well that grantham he's always wrong.
18:52
Speaker 3: Yeah have you ever met anyone who said that i'm
18:54
Speaker 3: sure there are people who do there are Most of.
18:55
Speaker 4: The people who say that, Grantham, is always wrong because
18:57
Speaker 4: he goes bubbly too early.
18:59
Speaker 3: Well, that's the rub, isn't it? If you think a
19:02
Speaker 3: train is going to crash, you just get off of it.
19:04
Speaker 3: You don't wait five stops and then get off of it.
19:06
Speaker 3: And I suppose that's the trouble with that. But I
19:09
Speaker 3: would take the argument that it's a value effect quite happily.
19:12
Speaker 3: And when you look at some of the Dimson and
19:14
Speaker 3: Marsh data, looking back over the UK, back to 1955,
19:18
Speaker 3: the very best asset class you can be in is
19:21
Speaker 3: small cap value. And I've certainly seen that in my time.
19:24
Speaker 3: Small cap value over long periods smokes everything else. If
19:28
Speaker 3: you find a talented manager there, you just want to
19:31
Speaker 3: hang on to them. Alex Wright, one of the best
19:33
Speaker 3: known managers in the UK today, cut his teeth on
19:35
Speaker 3: the Fidelity UK Smaller Companies Fund. After 10 years of
19:39
Speaker 3: him running that, that was the best fund, full stop,
19:42
Speaker 3: in the UK. It was the best performer because of
19:45
Speaker 3: the inefficiencies of that part of the market and his
19:47
Speaker 3: talent combined with a great style. just stunning returns.
19:51
Speaker 4: And stewart you're a you're a small cap value guy right.
19:56
Speaker 3: Yeah we like to tell you we also like quality
19:59
Speaker 3: as well and i think our key differentiator is we
20:02
Speaker 3: particularly like companies that have the potential to improve themselves
20:06
Speaker 3: through some sort of management action irrespective of what's going
20:09
Speaker 3: on in the market. So we're very greedy. We have
20:11
Speaker 3: a very concentrated portfolio, as you might remember. I think
20:14
Speaker 3: we've got 18 stocks at the moment. We quite like
20:17
Speaker 3: a bit of everything. You know, ideally, I don't know,
20:19
Speaker 3: the value of Aberforth with the growth of something that
20:21
Speaker 3: would attract Lion Trust, but with the self-help that, I
20:25
Speaker 3: don't know, the Melrose management team would love to get
20:29
Speaker 3: their teeth stuck into. You know, when you have a
20:32
Speaker 3: concentrated portfolio, you can afford to be really greedy, right?
20:35
Speaker 3: We want a bit of everything.
20:37
Speaker 4: Simon, you said just now that I'm talking about great
20:41
Speaker 4: managers on top of all these things.
20:42
Speaker 1: What makes a great manager?
20:43
Speaker 3: You've got to have a particular character trait. And that
20:48
Speaker 3: character trait is the willingness to be extremely different as
20:52
Speaker 3: the circumstances require it. That is ever so slightly different
20:55
Speaker 3: from being different all the time, which you might call
20:59
Speaker 3: disagreeability or just being a grumpy bugger.
21:02
Speaker 1: Contrarianism.
21:04
Speaker 2: Exactly.
21:05
Speaker 3: It's believing in what you're doing. And if what you're
21:08
Speaker 3: doing happens to look like the market, fine. But if
21:10
Speaker 3: what you're doing happens to look 100% different to the market,
21:14
Speaker 3: also fine. And the strength of character and ability to
21:18
Speaker 3: ride that out. Because when it's going against you and
21:21
Speaker 3: the world thinks you're the biggest idiot going because you
21:24
Speaker 3: didn't buy Nvidia, you were buying some sort of mid-cap
21:27
Speaker 3: turnaround stories, that's incredible pressure. And to take that on
21:32
Speaker 3: the chin is extremely difficult and not everyone can do that.
21:37
Speaker 3: So there's definitely a character trait. And then there's all
21:40
Speaker 3: the basics. To my mind, you've got to be a
21:42
Speaker 3: bottom-up stock picker. I'm not a big fan of people
21:44
Speaker 3: who are macro investors who are trying to guess what
21:46
Speaker 3: Putin will do next or what Trump's next move will be.
21:50
Speaker 3: I want people who are trying to find 20, 30,
21:54
Speaker 3: 40 individual stock situations where the quality of the company
21:57
Speaker 3: is good, the valuation of the company is low, And
22:01
Speaker 3: it's diversified enough that if you've got 20 of them,
22:03
Speaker 3: then they're not all pointing the same way.
22:06
Speaker 4: So tell us about some of the stocks you do
22:08
Speaker 4: hold in the trust. As you say, super concentrated, 18.
22:13
Speaker 4: What's the most interesting one you've added recently?
22:16
Speaker 2: Well, we don't add very many new ones a year.
22:18
Speaker 3: I think the one that stood out for us this
22:20
Speaker 3: year was a company called Zote Foams, which has been
22:23
Speaker 3: around for a very long time. It has a unique
22:27
Speaker 3: process of creating foam using Nitrogen being forced into it,
22:32
Speaker 3: which means it's inert. This was our halo asset.
22:38
Speaker 2: Investment.
22:38
Speaker 3: So heavy asset, low obsolescence. We really like this company.
22:42
Speaker 3: There's a management improvement story going on. It has a
22:45
Speaker 3: very high market share in the UK for what it does,
22:47
Speaker 3: about 85%, which is great. But the key thing is,
22:50
Speaker 3: it's very well invested. And the use for life of
22:54
Speaker 3: the assets is, we think, until 2060. And they're virtually
22:57
Speaker 3: fully depreciated. And in our view, this is a great
23:00
Speaker 3: place to be in a company that's growing, that can
23:02
Speaker 3: pass on inflation and doesn't need to reinvest very much
23:06
Speaker 3: in the future. So it was very much an asset play.
23:10
Speaker 3: There's also an interesting growth play. They are putting some
23:12
Speaker 3: more capacity in at the moment. And one of the
23:16
Speaker 3: customers they have is Nike, for example, where they do
23:19
Speaker 3: a lot of the specialist mid-layers for Nike shoes. And
23:22
Speaker 3: they're actually putting some capacity in close to the Nike
23:25
Speaker 3: shoe factories in Vietnam, which will allow them to free
23:27
Speaker 3: up some capacity in the UK. So we think it's
23:31
Speaker 3: a very rare, super, super asset-backed business. We think we've
23:36
Speaker 3: probably got in at around 60% of the real asset value.
23:41
Speaker 2: It's a growth story. We bought in very cheap.
23:43
Speaker 1: And valuations, how do you look at the valuations on
23:45
Speaker 1: a stock like that?
23:47
Speaker 3: Well, the current PE ratio is about 11 times. It's
23:51
Speaker 3: got a tiny bit of debt. So I think the
23:53
Speaker 3: EVU bit's about somewhere between eight and nine, which is
23:57
Speaker 3: not really expensive. On an asset basis, the net asset value,
24:02
Speaker 3: as I mentioned, I think we paid slightly above book
24:05
Speaker 3: value as stated, but the book value is materially understated
24:08
Speaker 3: in our view. I think from, to give you an idea, Meryn,
24:11
Speaker 3: I think the site in Croydon, the insured value and
24:15
Speaker 3: replacement value in the site is a multiple of what
24:18
Speaker 3: it is in the books. So it's quite a nice
24:21
Speaker 3: mix of like an old style deep value investment asset
24:25
Speaker 3: backed with a growth story, but also a management change
24:27
Speaker 3: story as well, relatively new chief exec, relatively new finance director,
24:31
Speaker 3: who are also very incentivized to perform.
24:33
Speaker 2: Okay.
24:34
Speaker 1: You said earlier that you tend to hold things for
24:36
Speaker 1: a couple of years. What would make you sell this?
24:39
Speaker 2: Three reasons something would leave the portfolio.
24:41
Speaker 3: One, it's taken over and we've had a lot of
24:43
Speaker 3: our Because the way we select stocks, a lot of
24:45
Speaker 3: our companies have been taken over over time, typically overseas
24:49
Speaker 3: trade buyers. The second thing is before we invest, we
24:53
Speaker 3: write a very detailed investment thesis. We all discuss as
24:56
Speaker 3: a team. And that provides the guidebook for what we
25:01
Speaker 3: think is going to happen. And periodically we review this,
25:04
Speaker 3: typically no more than every 12 months. And if a
25:07
Speaker 3: stock isn't doing what we thought it was going to
25:09
Speaker 3: or the management team aren't doing what we thought it
25:11
Speaker 3: would do, it's a trigger to say, actually, have we
25:13
Speaker 3: just got this one wrong? And the important thing for
25:15
Speaker 3: the team is it depersonalizes the decision that we've got
25:19
Speaker 3: this one wrong. So, you know, second thing is thesis
25:22
Speaker 3: goes wrong. The third thing, absolutely right, is around returns.
25:25
Speaker 3: So we set a target price for all our stocks
25:28
Speaker 3: three to four.
25:28
Speaker 2: Years in advance. You compare that to day share price.
25:31
Speaker 3: That gives you a potential forecast annualized return. Now, if
25:35
Speaker 3: that annualized return goes below 15% or isn't as good
25:38
Speaker 3: as other things in the portfolio or other things we
25:41
Speaker 3: want to buy, we reduce or move it on. So
25:44
Speaker 3: we have quite a disciplined way of thinking about returns
25:49
Speaker 3: in the portfolio. And I think that's a big differentiator
25:52
Speaker 3: compared with some that has 100 stocks. If you have
25:54
Speaker 3: 100 stocks, it's a bit like the magpie. You collect
25:57
Speaker 3: interesting things and leave them in the nest. For us,
26:00
Speaker 3: every single stock has to work.
26:19
Speaker 1: You mentioned M & A and private equity, etc.
26:22
Speaker 4: Do you worry that the market is shrinking and there
26:24
Speaker 4: will come a point when the interesting stuff is not
26:26
Speaker 4: available to you? And we always say when we talk
26:28
Speaker 4: about small caps, John and I, when we're doing podcasts
26:31
Speaker 4: and when we're writing, we always say, if you don't
26:32
Speaker 4: buy them, somebody else will, and then it will be
26:34
Speaker 4: too late and there'll be nothing left, nothing left for
26:37
Speaker 4: the domestic retail investor to buy in small caps.
26:40
Speaker 3: Yeah, look, it's a really live debate. I mean, we're
26:43
Speaker 3: very fortunate because we don't have to own many stocks
26:45
Speaker 3: and we can put up to 20% of.
26:47
Speaker 2: The portfolio overseas.
26:48
Speaker 3: So I would be more concerned if I was used
26:52
Speaker 3: to running 100, 150 stock portfolio and my job was
26:55
Speaker 3: to try and beat the index by 1% a year.
26:58
Speaker 3: Because as your index shrinks, you're going to end up
27:01
Speaker 3: with more volatility against the index, which as Simon knows
27:04
Speaker 3: for big asset management company is risk, right? So I
27:07
Speaker 3: think it's a much bigger concern for the bigger players
27:10
Speaker 3: than us. I mean, I'm more optimistic. I used to
27:14
Speaker 3: work in private tech many years ago. I looked at
27:16
Speaker 3: taking lots of companies private. It has been a bit
27:19
Speaker 3: like shooting fish in a barrel in the UK for
27:21
Speaker 3: private equity for many years when the cost of debt
27:24
Speaker 3: was very low. I think where the cost of debt
27:27
Speaker 3: is now, it's much harder to justify taking companies private.
27:31
Speaker 3: So I don't see so much risk from private equity.
27:34
Speaker 3: It's not said there's none. But I think the bigger
27:37
Speaker 3: issue more is the really interesting companies, particularly those global
27:41
Speaker 3: niche market leaders, if they're not recognized properly.
27:45
Speaker 2: By the UK stock market, the obvious trade buyers are.
27:48
Speaker 3: Can come in and if you look at some of
27:49
Speaker 3: the m & a we've had this year that that
27:51
Speaker 3: appears to be what's happening on the other hand i
27:54
Speaker 3: think rationally what should happen is if flows have stabilized
27:57
Speaker 3: what's left should re-rate and actually it will probably re-rate
28:01
Speaker 3: to a point where ipos make sense again and there's
28:03
Speaker 3: so many assets that private needs to sell again the
28:07
Speaker 3: quaternary or septunary buyout or whatever it's going to be
28:10
Speaker 3: this time you know it ain't going to work and
28:13
Speaker 3: maybe ipo becomes a good exit again so i'm i'm
28:17
Speaker 3: I'm short-term concerned, medium to long-term. I think these things
28:22
Speaker 3: do go in cycles.
28:23
Speaker 4: And rising rates should make it make sense for growth
28:27
Speaker 4: companies to come to an IPO rather than just keep
28:30
Speaker 4: borrowing money at 6%, 7%, 8%, right? So changing interest
28:34
Speaker 4: rates should really change the dynamic between the choice of
28:38
Speaker 4: private or public.
28:39
Speaker 2: I think that's right.
28:42
Speaker 3: We meet many management teams who have done public and
28:44
Speaker 3: private and their pros and cons are both. I think
28:47
Speaker 3: The really nice thing is if you treat the public
28:49
Speaker 3: market right and you get the right shoulder base, it
28:51
Speaker 3: is semi-permanent capital. Whereas if you're going through private equity,
28:56
Speaker 3: quite often the second day the private equity house buys you,
29:00
Speaker 3: they're thinking about how they're going to sell you in
29:01
Speaker 3: two and a half to three years' time.
29:03
Speaker 2: And decisions are.
29:04
Speaker 3: Maybe made to optimize that point rather than what's right
29:07
Speaker 3: for the next five to 10 years. And if you've
29:11
Speaker 3: got a very, very good long-term growth story in a
29:13
Speaker 3: decent company, why wouldn't you want permanent capital? I do
29:17
Speaker 3: think these things go in cycles. We've had a very
29:19
Speaker 3: weird period during zero interest rates. It wouldn't surprise me
29:22
Speaker 3: if we have a boomy IPO market in three or
29:24
Speaker 3: four years' time.
29:25
Speaker 1: Wouldn't that be great?
29:27
Speaker 4: We've been complaining about the lack of IPOs for so long. Simon,
29:30
Speaker 4: do you think that's possible as well?
29:33
Speaker 2: I hope it is. Yeah, I'm an optimist.
29:36
Speaker 3: I'm not as close to the market as Stuart is,
29:39
Speaker 3: but I do speak to a lot of small cap investors.
29:41
Speaker 3: They've been a fairly depressed bunch for the last three
29:44
Speaker 3: or four years, so it hasn't been a lot of
29:45
Speaker 3: fun talking to them. But yeah, I am also a
29:49
Speaker 3: great believer in cycles and it does feel like we've
29:51
Speaker 3: come out of a very long, very weird cycle. The
29:54
Speaker 3: weird thing this time is that you're starting to see
29:57
Speaker 3: these M & A activity happen and the market is
29:59
Speaker 3: still downtrodden. And that's because of the peers on my
30:03
Speaker 3: side of the fence who have been busy selling their
30:05
Speaker 3: UK equity, active UK equity funds that hold the small caps.
30:10
Speaker 3: And at some point, the last one of those will
30:13
Speaker 3: have left. And as Stuart mentioned earlier, at that point,
30:16
Speaker 3: then suddenly it's not going to take very much to
30:19
Speaker 3: get things moving the other way, I believe anyway.
30:21
Speaker 4: Well, let's go back to the beginning of our conversation
30:25
Speaker 4: to emerging funds. And As you said, you can't buy
30:29
Speaker 4: investment trusts. But in the open-ended area, what's interesting? What
30:34
Speaker 4: funds have you been looking at?
30:35
Speaker 1: What do you like?
30:35
Speaker 2: Are you looking at UK specifically?
30:37
Speaker 1: Well, across the board.
30:39
Speaker 4: What are you seeing that's interesting in newish funds that
30:41
Speaker 4: fit the criteria that we discussed at the very beginning
30:44
Speaker 4: of this conversation?
30:45
Speaker 3: So the easiest place for us to pick a fund
30:47
Speaker 3: currently is in the global value space because there's been
30:51
Speaker 3: such a Darwinian cull of value managers over the last
30:54
Speaker 3: 10 years that the only ones left who are actually
30:56
Speaker 3: very good So we've got the likes of Aram Moore there.
30:59
Speaker 3: That's Sean Pesce you've met.
31:01
Speaker 1: We've had him on the podcast.
31:02
Speaker 4: Yeah. Yeah.
31:03
Speaker 3: Red Wheel are very, very good there. We've got a
31:05
Speaker 3: Dutch manager called Kempen. Havelock are a very good smaller
31:09
Speaker 3: firm in London. We've had to leave a few on
31:12
Speaker 3: the bench as well. So there's good funds at Jupiter.
31:15
Speaker 3: There's good funds at Brickwood and a new manager just
31:19
Speaker 3: having left Schroders. A lot of fund managers have left
31:22
Speaker 3: the Schroder value team and he's gone over to start
31:26
Speaker 3: at Brown Advisory.
31:27
Speaker 2: So there are a lot of.
31:28
Speaker 1: Good global values. And who is that who's gone to
31:29
Speaker 1: Brown Advisory?
31:31
Speaker 3: It is Nick Kirridge who's gone across. Yeah, great track record,
31:36
Speaker 3: great heritage. Yeah, and there is disprover that has come
31:42
Speaker 3: out of that Schroeder Value team. We've just bought some
31:46
Speaker 3: of their emerging market, ex-emerging market managers over at Neuberger Berman,
31:50
Speaker 3: Juan Torres and Vera German, who are, exceptional emerging market
31:54
Speaker 3: value fund managers. We were lucky enough to get into
31:58
Speaker 3: their fund in July when they were one of a
32:00
Speaker 3: handful of funds that went up when the market was
32:03
Speaker 3: being dragged down by the AI sell-off that happened in
32:08
Speaker 3: that period. And that's been one of the most encouraging
32:11
Speaker 3: things for us is that the funds we have picked
32:14
Speaker 3: by and large have.
32:15
Speaker 2: Delivered in the.
32:19
Speaker 3: Which is when you've seen that wobbling AI, as you've
32:21
Speaker 3: seen over the last six weeks. We've had funds, we've
32:25
Speaker 3: had lots of active funds that have not just outperformed
32:28
Speaker 3: that falling market, but actually risen in that falling market.
32:31
Speaker 3: And to the point where our own Downing Fox funds
32:33
Speaker 3: have actually risen as well because of the underlying stock pickers.
32:38
Speaker 1: Essentially, because you would have thought that the AI fallout
32:40
Speaker 1: would hit everything. Everything.
32:43
Speaker 4: Everything is now connected to AI one way or another.
32:46
Speaker 4: Are you going to be more productive because of AI?
32:48
Speaker 4: Are you in any commodity market is now connected to AI?
32:51
Speaker 4: Any infrastructure market is connected to AI? Any consumption market
32:55
Speaker 4: is connected to AI, etc. So when it really happens,
32:59
Speaker 4: when the AI bubble really crashes, everything will go with it, surely. Absolutely.
33:04
Speaker 3: I'd be brave to argue that it definitely won't be
33:06
Speaker 3: the case. But if you look at the experience in 2000,
33:10
Speaker 3: when we had similar conditions, similar concentration, then it wasn't
33:14
Speaker 3: the case at all. We've mentioned Aberforth, UK smaller companies,
33:18
Speaker 3: that fund went up in that bear market. I had
33:21
Speaker 3: a look at the data the other day, because I'm
33:22
Speaker 3: the sort of boring person who does that. There were
33:25
Speaker 3: 50 UK funds, mostly UK equity income funds, who boringly
33:29
Speaker 3: had to stick to their valuation disciplines and buy boring
33:33
Speaker 3: companies whose price went up as the tech market sold off,
33:38
Speaker 3: as did Warren Buffett, of course, who was doing that
33:41
Speaker 3: same old thing of buying boring companies at a cheap price.
33:44
Speaker 3: So if it's purely a rotation rather than an economic
33:47
Speaker 3: event or a war or something worse, there's no reason
33:50
Speaker 3: I think that movement of money out of the massive
33:53
Speaker 3: concentration in AI stocks into all the stuff that's been
33:56
Speaker 3: neglected for three years can't.
33:59
Speaker 2: Happen as well.
34:00
Speaker 1: So small cap value is the anti-AI trade, you think, Stuart?
34:03
Speaker 2: Quite possibly.
34:04
Speaker 3: I mean, the only certainty is we don't know until
34:06
Speaker 3: it happens. I mean, look, if you look around the world, Meryn,
34:12
Speaker 3: small caps generally, particularly value small caps, are very cheap.
34:15
Speaker 3: UK is an outlier within that. If you believe in
34:18
Speaker 3: reversion to mean they're still upside on rating. As Simon said,
34:21
Speaker 3: every circumstance is different. I think, you know, our view
34:24
Speaker 3: is you pick a style and you stick with it and...
34:27
Speaker 3: You don't get greedy.
34:28
Speaker 1: How many funds in a funder fund portfolio?
34:30
Speaker 3: In ours, there's 35. Yeah, very diversified. But then when
34:34
Speaker 3: you think about any given market, and we don't pick
34:38
Speaker 3: a particular style. We're not one of those fund managers
34:40
Speaker 3: who are going to be all in value because we
34:41
Speaker 3: think value does well.
34:43
Speaker 1: Yeah.
34:44
Speaker 3: You imagine the Japan market, for example. It's not crazy
34:47
Speaker 3: to imagine buying a large cap growth, a mid cap growth,
34:51
Speaker 3: and a small cap growth and doing the same for
34:52
Speaker 3: value as well.
34:53
Speaker 1: Mm-hmm.
34:54
Speaker 3: And you wouldn't have a single stock crossover. And before
34:56
Speaker 3: you know it, that's just six funds in one market.
35:00
Speaker 3: And you can do the same for most markets across
35:02
Speaker 3: the world. And very quickly, you get up to well
35:05
Speaker 3: into double figures and you're not, you know, they're not
35:08
Speaker 3: treading on each other's toes. Yeah.
35:10
Speaker 1: And thank you both so much for joining us today.
35:13
Speaker 1: We really, really appreciate it. My pleasure.
35:16
Speaker 2: Pleasure.
35:19
Speaker 1: Thanks for listening to this week's Merrin Talks Money.
35:21
Speaker 4: If you like our show, rate, review, and subscribe wherever
35:24
Speaker 4: you listen to your podcasts. And keep sending your questions
35:26
Speaker 4: or comments to merrinmoney at bloomberg.net. You can also follow
35:29
Speaker 4: me and John on Twitter or X. I'm at MerrinSW
35:32
Speaker 4: and John is John underscore Stepak. This episode was hosted
35:35
Speaker 4: by me, Merrin Somerset Webb. It was produced by Sam
35:37
Speaker 4: Asadi and Moses Andam. Sound design by Blake Maples. And
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Speaker 4: special thanks, of course, to Simon Evan Cook and to
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Speaker 4: Stuart Whitteson.