After facing several significant headwinds in recent years, optimism has returned to the UK equity market over the past 12 months. Aided by tailwinds such as the Brexit agreement and the early rollout of the Covid-19 vaccine, the UK’s economic recovery has piqued the interest of major market participants, with abundant recent public market and private equity activity.
While the prospects for the UK economy and equity market have clearly improved over the past 18 months, there are signs of overexuberance. Significant challenges still remain for investors– including assessing the ongoing impact of the Delta variant, contradictory and volatile macro-economic indicators, and potential for transitory supply side pressures to translate into a persistent inflationary environment.
In the face of such uncertainties, we believe it is more important than ever for investors to remain disciplined in relation to valuation and selective in terms of quality. This is non-negotiable for us, as our top ten holdings constitute more than 65% of our portfolio. Such a high conviction approach is only possible by taking a private equity mindset in terms of both asset selection and diligence as well stewardship; namely actively supporting management teams in the creation of long-term value.
Investors must also show discipline when considering allocating to overly cyclical areas of the market, which are too exposed to external factors – such as the price of commodities. In our experience, cyclical companies tend to materially underperform over the longer term.
As the UK market moved higher over the past 12 months, we rotated proceeds from names in the strongly performing existing positions, generally in more highly rated stocks at the top end of the small cap space. These proceeds have been invested in a selection of more attractively priced high quality smaller companies – with market caps in the region of £100-300m – which in our view have substantial potential for both growth and rerating over our investment horizon.
Advantages of influential positions
In addition to the valuation discount, by moving down the market cap scale we are able to own a more influential stake in our investee companies, typically between 5-10% of the share capital. This is advantageous for several reasons. Most importantly, large positions enable us to influence strategy, capital allocation and governance decisions through close ties with Boards of Directors, management teams and wider stakeholder groups. This approach, which is more common in the private equity world, can help to unlock hidden long-term value – both organically and opportunistically.
For example, we provided capital to Medica, a teleradiology services provider to hospitals in the UK and Ireland, to support its strategic acquisition of US-based radiology company RadMD. The acquisition enabled the company to further diversify its customer base, enter a new geographical market and access the fast-growing clinical trials market. Similarly, we supported Inspired plc in its acquisition of Ignite Energy, which increased the company’s exposure to the fast growing energy optimisation market and enabled it to cross-sell such services, accelerating organic growth. Additional capital also supported its balance sheet through the pandemic.
Beyond providing capital for expansion, engagement also enables investors to utilise their extensive networks and provide management teams with access to talented individuals. For example, following the pandemic-induced acceleration towards remote learning, we encouraged data and training provider Wilmington to add a non-executive director with strong experience in online education, as such insights are likely to be invaluable in executing the group’s business strategy in the post-Covid environment.
While ensuring the board is composed of the most talented and experienced individuals is paramount, engaging closely with the board to build an alignment of interests between shareholders and top management is equally vital. For example, management remuneration can be divisive, so it requires ongoing engagement with senior executives. It is crucial to ensure management incentives are aligned to long-term value creation – which is something we have worked on collaboratively with our wider investee companies, including both Medica and Inspired plc.
Optimistic outlook
While witnessing solid recent performance, the UK small-cap space remains structurally under-researched and undervalued. We would point to the recent spate of takeovers of UK businesses by private equity and international buyers as stark evidence of this. As these buyers increasingly eye the compelling value on offer in the small-cap space, investors holding a sizeable stake in a firm can ensure that any incoming offer is truly reflective of the long-term prospects of the business. This structural undervaluation, combined with the uncertain and potentially volatile market conditions represents a perfect environment for our strategy; investors will need to be highly selective, engaged and disciplined stewards of capital to succeed.
Adam Khanbhai and Ken Wotton are co-managers of Strategic Equity Capital
