Flurry of M&A activity highlights valuation opportunity in UK smaller companies

The worst of the economic forecasts for the early part of this year appear to have been avoided, consumer and business demand have held up better than many predicted and most of the companies in our three funds have continued to trade in line with expectations and, in a number of cases, exceeded them.

However, significant challenges remain. Economists at the Federal Reserve are forecasting a recession, albeit a mild one, in the US later this year and we believe there is a good chance turmoil among US regional banks will continue, putting a squeeze on lending. The extent to which these issues will affect economies in the UK, Europe and elsewhere is not yet clear.

More positively though, many of the challenges with which UK companies have been grappling seem to be receding. Inflation, energy bills, rising labour costs, recruitment issues and supply chain difficulties all seem to be easing, and the Federal Reserve appears to have reached, or is reaching, the end of its interest rate hiking cycle.

Among global investors, UK companies, and smaller companies in particular, remain firmly out of favour and valuations are at a substantial discount to comparable businesses in other developed markets.

The value available has not gone unnoticed by private equity houses and trade buyers. In recent weeks we have seen three companies we hold in our funds targeted for acquisition. Veterinary drug maker Dechra Pharmaceuticals received a private equity bid at a 46% premium to its share price, smart meter and housing maintenance company Sureserve has agreed a private equity bid at a 39% premium and restaurant operator Fulham Shore has received a bid at a 35% premium from a Japanese company that plans to expand the business internationally.

We have been deploying cash to add to existing positions in quality companies we believe look significantly undervalued. These include IG Design, which supplies leading global retailers with wrapping paper, and Brickability Group, which is a distributor of bricks and other building materials.

We have a core investment team of five working on the three UK smaller companies funds. This is myself, my Co-Manager Guy Feld and three analysts, Tom Hutchinson, James Workman and Harry Evett. We work closely with the rest of the large UK and European equities team. This level of resource enables us to conduct our own primary research, using analysis of fundamentals to identify the most attractive opportunities among thousands of companies and in almost all cases engaging with management teams through face-to-face or virtual meetings before making the final decision about whether to invest.

The companies we favour have strong long-term growth prospects, high-calibre management and robust balance sheets, with relatively low levels of debt, which means they are well positioned to navigate challenging macroeconomic conditions.

Looking ahead, we believe the long-term case for innovative and agile UK smaller companies, and their ability to outperform slower-moving corporate giants, remains as strong as ever.

UK smaller companies look cheap in absolute terms, in comparison to other developed markets and relative to their historic averages. It is rare to have the opportunity to invest in a carefully selected portfolio of outstanding UK smaller companies at the share prices we are seeing today. For investors with a medium to long-term perspective, we believe current valuations represent an illuminated sign flashing brightly in green the message ‘opportunity’.

Eustace Santa Barbara 09/05/23

Risk Warnings

Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds. Our funds invest for the long-term and may not be appropriate for investors who plan to take money out within five years. The Fund will be exposed to stock markets and market conditions can change rapidly. Prices can move irrationally and be affected unpredictably by diverse factors, including political and economic events. The Fund will be exposed to smaller companies which are typically riskier than larger, more established companies. Difficulty in trading may arise, resulting in a negative impact on your investment. Shares in smaller companies may be harder to sell at a desired price and/or in a timely manner, especially in difficult market conditions. The Fund invests mainly in the UK therefore investments will be vulnerable to sentiment in that market which may strongly affect the value of the Fund. In certain market conditions some assets may be less predictable than usual. This may make it harder to sell at a desired price and/or in a timely manner. In extreme market conditions redemptions in the underlying funds or the Fund itself may be deferred or suspended.

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