Speaking at a recent Merian Global Investors media event, BMO Gam co-head of multi-manager Gary Potter said investors should look at the quantity of private, less liquid assets they have in a portfolio because some private equity investors are fishing in the bottom end of the public markets where there is better value in terms of stock prices.
He explains: “Multi-asset guys are perhaps saying, ‘We must have 20% in private equity markets’ but that is increasingly being sourced through acquisitions at the bottom end of the public markets because the share prices have not performed well, particularly more domestically-focused businesses.
“Perhaps it is time to re-engage with the bottom end of the public markets rather than private, less liquid portfolios, as they would appear to offer better value. And/or their share prices have just been ignored because everyone is interested in Nick Train’s portfolio – with respect to Nick Train – and therefore the real value is in the bottom end of the public markets as well as the private markets?”
Lots of money, less liquidity, fewer analysts
Oliver Brown, manager of the MFM UK Primary Opportunities fund, agrees the “unloved” public small cap sector has seen cheaper valuations over the past decade. He says this is down to a combination of high volumes of money flowing into private equity, fewer banks backing smaller listed companies making liquidity scarce, and fewer analysts covering the sector.
“There is just more money in the private equity arena than there used to be, so companies have been able to tap those resources when they needed to,” he says. “The other reason is businesses are less capital intensive; a lot of tech companies that have grown over the past decade are not like old companies that had to buy a lot of equipment. So you haven’t had the necessity to raise as much money.”
Ken Wotton, managing director of quoted investments at Gresham House, notes the only time public markets might value certain business as higher than private equity firms is when the stock offers access to a new or scarce sector as was the case with fashion ecommerce.
He says: “Public markets will pay prices for certain areas because they are scarce. You saw that with ecommerce businesses where there just weren’t many ways to play that massive structural change in public markets. So a business like ASOS would trade at a big premium multiple because it was the only way people could play fashion ecommerce until Boohoo and others floated.”
Merlin prompts debate on public versus private
Potter also queries whether there are some very interesting companies in the public small or micro-cap world that should have perhaps never gone public because of this phenomenon.
In May, investment manager Value Act wrote to its biggest holding, Merlin Entertainment, urging it to return to being a private company over concerns the share price does not reflect the underlying value of the company.
The letter said: “The company’s share price is down 2.7% since the 2013 IPO despite a 35.5% increase in earnings per share. Simply put: Merlin has struggled as a public company.”
Merian head of UK equities Richard Buxton (pictured), who has owned Merlin Entertainment in the Merian UK Alpha fund for “several years”, says this is because “private equity is prepared to take a longer-term view than the quoted stock market”.
He adds: “The unholy trinity of the accountant, the actuary and the regulator have destroyed the ability for long-term savings institutions to invest in public equity, so you have this bizarre phenomenon.”
Buxton says Merlin is a stock “you tuck away today, shut your eyes, come back in five or 10 years”.
“It [Merlin] is going to be a massive cash generative machine, but the public market is not prepared to look beyond the next earnings upgrade or downgrade, so the value is absolutely in the quoted arena, but it is not going to realise that value any time soon.”
Small caps also losing out to bond proxies
Richard Watts, co-manager on the Merian Chrysalis Investment Trust, which invests in later stage private UK companies, says value is particularly scarce the top end of public markets, noting the “bond proxies” which trade on inflated multiples.
He says the UK stock market is becoming increasingly dysfunctional due to the increasing prevalence of ETFs, passive strategies, algorithmic trading and AI models which fuel a short-term investment horizon. “I get grief from clients on one bad month of performance,” he adds.
In the private markets, by contrast, everything is much longer term because these assets don’t trade on a daily basis, he says.
Watts noted FTSE 100 technology company Halma which used to trade on a PE of 12x earnings but is now on 33-35x earnings. He said such bond proxies – including Unilever, Diageo and Experian – have re-rated over time owing to them being perceived as quality companies that deliver consistently.
“The point is they are probably growing organically at 3, 4, 5% per annum and yet on an earnings basis they are 3%. I think it is very odd. It is simply a function of monetary policy and where we are with central bank policy. It encourages people to try to identify these stocks that perform well in a low economic growth, low bond yield, loose monetary policy environment, but until something changes it could carry on. I’m just not convinced it will be any time soon.”