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The 12 April 2024 marked the three-year anniversary of my tenure as the lead manager of the VT Downing Small & Mid-Cap Income Fund. Much has changed over that period, from the name of the fund* to lockdowns being a thing of the past, and UK base rates moving from 0.1% to 5.25%. However, what hasn’t changed is our view that UK smaller companies continue to present a compelling total return potential that is still overlooked. We strongly believe that many of these companies are positioned to perform well in the current environment. Moving forward, our commitment is to consistently apply this investment strategy to achieve the best possible outcomes for investors.
The good
Market volatility – perhaps not the most obvious positive point that springs to mind, but before my time at Downing we were always told as junior analysts we knew nothing of the grinding bear markets and huge, volatile swings that decorated the memories of more senior colleagues. They were right!
“Re-opening winners”, “new normal for working”, “Covid over-earning”, “commodity supercycle”, “peace dividend”, “higher-for-longer”, “supply chain constraints”, “reshoring”, “overstocking”, “cost of living crisis”, “unfunded tax cuts”, “LDI scandal”, “peak rates”, “sticky inflation”.
These are just a few of the agendas that were responsible for market volatility over the last few years, and interestingly all of them were virtually non-existent in the previous decade. Whilst it may have been more comforting to get to grips with leading a mandate in a more benign market, doing so over the last three years certainly did more to test one’s process and investment philosophy and must ultimately be more beneficial in the long run.
There were many days, weeks and even months that were spent questioning if the investment process was fit for purpose. We stuck to the view of investing in companies offering total return potential – those businesses that astutely deploy their excess returns on capital into both reinvestment to fuel growth and shareholder distributions. We believe this was correct and rewarding, as evidenced by the fund outperforming the IA UK smaller companies by over 21% over the three-year period.
The bad
Performance relative to other UK smaller companies mandates was pleasing, but there is no hiding the fact that this is a UK equity income fund so sits in the UK equity income sector. The fund delivered a return of 6.13% compared to the sector’s 17.81%. This was less pleasing.
After what seemed like a lost decade, UK large caps, or specifically the FTSE 100, finally got its mojo back. Unfortunately, this is the one part of the UK market that this fund doesn’t invest in. The FTSE 100 has continued to find new all-time highs as recently as 2024 and is the area of the market that dominates the UK equity income sector. But this is also one of the main rationales for this strategy – to do something different. This means there will often be periods when performance looks different to the pack. Unfortunately, the last three years have been the sort of different we don’t wish to see.
Whilst a disappointing and rather frustrating headwind, this isn’t the only reason the fund’s performance has been held back. Of course I have made mistakes, I made decisions that I wish I hadn’t, and didn’t make decisions I wish I had. This is the beauty of hindsight and a careful reminder that you are always learning when participating in financial markets. I won’t go into specifics here but would be happy to discuss further with anyone who wants to know more. But one example is when things develop gradually, then suddenly. A lesson learned the hard way thanks to the shortest reigning UK PM.
The ugly
Put simply – the UK small & mid-cap market has been ugly. Most small & mid-cap indices peaked in September 2021 and have largely been on a downward trajectory since. To answer my old colleagues, it appears we have now seen volatility and a bear market. Yes, there have been worse, longer, and more broad-based bear markets. But lasting over 2.5 years and peak-to-trough falls of 30% for the FTSE 250 and nearly 50% for the AIM market, it feels like this one can hold its own with some of the worst we’ve seen in history.
Despite these depressing figures, there have been plenty of companies within UK small & mid-caps that have continued to operate well, with shrewd operators delivering good results. However, headline figures and poor sentiment have continually weighed on flows out of UK equities over the last three years, resulting in even the best UK companies sitting on discounted valuations to their own historical levels and overseas counterparts. This hasn’t gone unnoticed by strategic and trade buyers who have splashed out over £105bn on UK acquisitions over the last three years. Most of these have been acquired not as distressed assets but as sound companies trading at steep discounts.
A very recent example is Inchcape – a UK motor dealer and international distributor that announced the sale of its UK motor dealerships division. The motor dealership division has been regarded as the lower quality side of the business; 1.5% EBIT margins and 20% ROCE vs 7% EBIT margins and 30% ROCE for the distribution division. The UK motor dealerships have been sold to a US trade buyer on a 7x EV/EBIT valuation. Before the announcement, the entire group traded on 6x EV/EBIT. So, a trade buyer is willing to pay a premium valuation for the lowest quality part of a business.
Looking forward
Despite some of the doom and gloom around the UK market, we believe it is presenting a generational buying opportunity, with still plenty of high-quality UK-listed businesses to invest in. Especially those with the greatest total return potential, i.e. can continue to carve out organic growth which generates high returns on capital that can be invested in further growth and shareholder distributions. Acquisitions are less palatable at current valuations and cost of capital. Therefore, we believe an organic growth focus in conjunction with shorter-term returns (dividends and buybacks)within a small & mid-cap mandate are set up to outperform. We understand this isn’t the traditional approach to investing in small caps with much more focus on capital growth. But times have changed, and investors can get attractive yields from other asset classes so potentially equities, even small caps, need to offer something. Currently, the fund’s holdings are on average net cash, offering an ROE of greater than 24%, three-year forward earnings growth of greater than 12% compounded, and a greater than 4.5% yield. If the forecasts are correct this should deliver a compelling future return.
We can’t control market multiples but if the market decides to resemble anything close to the “easy markets” I was continually told that I was fortunate enough to start my career in, the future really is bright. With the fund currently trading on 12x earnings, we believe that the next three years will be far more rewarding for our investors.
Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Important notice: this document has been prepared for professional investors and has been approved as a financial promotion in line with Section 21 of the FSMA by Downing LLP (“Downing”). Capital is at risk and investors should note that their investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a reliable indicator of future performance. Any subscription to the fund should be made on the basis of the relevant product literature available from Downing or from the ACD, Valu-Trac; and your attention is drawn to the charges and risk factors contained therein. Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is a trading name of Downing LLP. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England and Wales (No. OC341575). Registered Office: 6th Floor, St Magnus House, 3 Lower Thames Street, London EC3R 6HD.
