DJ: The market action in the past few weeks has been focused on interest rate cuts. At the same time, there is concern still about a potential recession in the UK. Of these two big, perhaps conflicting, narratives, which is going to have the biggest impact in 2024?
ST: Inflation and interest rate expectations are key. Inflation has continued to fall, and Office for Budget Responsibility (OBR) forecasts are looking for it to average 2.8 per cent in the fourth quarter of 2024. At the same time, UK gilt yields have eased back. If both inflation and bond yields continue to trend down, and I think they will, it eases margin pressure on corporates, and it means real wages rise for employees in what is still a tight labour market characterised by skill shortages in key areas. It also means that the UK housing market and sectors that feed off it are likely to outperform as workers have more cash in their pockets. Of course, the elephant in the room that could derail this narrative is the potential for the Israel conflict or Russia and Ukraine to lead to a spike in energy prices. But as regards the Russia conflict, that just hasn't happened in the past nine months.
DJ: It’s been another difficult year for smaller companies and Aim shares in particular. Has that been due to concerns about the state of the economy? Is it linked to the structural issues with the UK market?
ST: It's not just one issue. There are multiple reasons for the underperformance. The first one being persistent and high inflation, which impacts smaller companies more. Given that London's junior market is more cyclical and has more interest-rate-sensitive companies, there's been a buyers’ strike. Fund flows have been negative since September 2021 into small caps. Pension funds and insurers have been reducing their allocations to UK equity, and that's accentuating outflows and creates a vicious circle. There's been a dearth of IPO activity, so there's been a lack of new listings to tempt buyers into the markets. There’s a lack of flag-bearing top funds; there’s no Warren Buffett in the UK, that's for sure. M&A activity has spiked this year, but what that means is cherry-picking the best companies. So by definition the average rating attributed to the remaining companies will be lower, in the absence of highly-rated new listings replacing the takeover companies.
Investor sentiment, of course, has been dire. It's not been helped by UK government instability. The Liz Truss ‘moron’ premium, as it's known, has impacted flows not just in the UK gilt market, but in the UK equity market too. Greater risk aversion impacts small and micro caps most. And I think we've got to pay some attention to the Bank of England. The forecasts have just been far too pessimistic, which impacts sentiment negatively. In November 2022, to put this into perspective, Andrew Bailey, the governor of the Bank of England, was forecasting the longest recession on record for the UK economy, and a spike in the unemployment rate to 6.4 per cent of the workforce by 2025. Guess what? The recession is yet to materialise and unemployment has only risen from 3.7 to 4.2 per cent. He was wrong, and not for the first time.
Although UK inflation is still above the eurozone’s, analysis by Panmure Gordon highlights the difference in inflation between the UK and the G20 average over the past 25 years has been zero. The implication being that energy price distortions drove parts of the UK inflation numbers. Inflation rates will converge, and this is simply not being communicated by the Bank of England in its forecasting. So the narrative in the media has just been far too negative, and in a risk-averse environment, small caps and micro-cap companies are impacted most.
The final point I'd make is that GDP growth has been understated by the Office for National Statistics. Recent revisions to UK GDP show that real GDP is almost 2 per cent ahead of the start of 2019. That’s higher real growth than in both France and Germany. The reality on the ground is better than the perception.
DJ: What would be the catalyst for an improvement in small-cap fortunes? Do you see some potential for a big shift in sentiment, or will it be on a case-by-case basis?
ST: Personally, I think this is an outstanding buying opportunity. Price/earnings ratios are below 10. Valuations have not been this distressed since the global financial crisis. Discounts on small-cap investment trusts are the widest since 2008, too. If history is any guide then expect a sharp equity market recovery. Post the 2008 crisis, the average small-cap investment trust more or less doubled in value over the next three years, according to research from Kepler. High returns were also enjoyed after other recent troughs in 2003 and 2016. Every time the Numis Smaller Companies index has had a negative year, which it will this year, it has enjoyed positive returns over the next three years. That's well worth noting.
DJ: What's the mood like out there among management teams, both in terms of their companies' prospects, but also the prospects for their shares after this difficult period?
ST: The mood and narrative are not half as bad as ratings imply. Of course, many executives are cautious and conservative, but this creates potential to overdeliver. I cover 93 companies for the IC: 64 have maintained guidance, 15 have downgraded and 14 have upgraded this year. Of more interest to me is the polarisation of companies that are either outperforming or underperforming. Generally the outperformers are benefiting from structural growth trends of low debt and net cash positions; they generate decent free cash flow and have potential to take market share. This provides them with defensive characteristics. That's not going to change any time soon. Examples of this include Billington (BILN), a structural steel company that is feeding off growth in data centres and NHS infrastructure spend; Journeo (JNEO), a smart transport company that's feeding off UK government funding; Equals Group (EQLS), a technology payment platform for SMEs; Litigation Capital Management (LIT) – litigation funding benefits in periods of economic weakness; Solid State (SOLI), a recent IC Alpha report company, 20 per cent of its revenue comes from defence spending; and Spectra Systems (SPSY), which is focused on banknotes and brand authentication technology that deters fraud.
These are structural themes that these outperformers are actually benefiting from. Of course, I’ve got 15 underperformers that have downgraded guidance, and they've also got common themes: constrained balance sheets, they've been impacted by margin pressure, they’re more exposed to general economic trends. What the management are doing well is they're taking cost out of the businesses, to try to protect margins, and are axing or cutting dividends. But ultimately the profitability of those companies is at the mercy of more subdued markets.
To turn to markets in general, I think that the real risk is deflation, not inflation, and one that central banks are dangerously underestimating right now, which suggests larger and quicker cuts to interest rates than current market expectations. If I'm right, I expect an across-the-board bounce in both general equity markets, but also small caps in particular. Just look at the implosion of credit in China. Deflation is being exported to the west. Then there’s weak and deflationary oil prices, too: Brent crude is off 25 per cent since the summer.
Also, the consensus of the US Federal Reserve, European Central Bank and Bank of England is that the natural rate of interest has jumped to a permanently higher level, so the economy can cope with sharply higher borrowing costs. The groupthink is that we are never going back to zero rates and negative bond yields. However, central banks are being misled by false assumptions about natural rates and so are over-tightening. That's because the natural rate is determined by movements in bank loans and securities, or so-called private credit aggregates. The key is whether they're rising or falling, and they’ve been falling at an alarming rate across the West this year.
Furthermore, real long-term interest rates are simply unsustainable at current levels. The average deficit prior to the Covid-19 pandemic was 2.4 per cent in advanced economies. It's going to be 5.2 per cent this year, according to IMF data. Ultimately, there's only one way out of this, and that's cutting interest rates in response to a combination of slowing economic growth, falling inflation expectations, and the inability of countries to create the growth needed to drive tax receipts to pay for higher interest burdens at current rates. So if I'm right and the move in interest rates is down and far more sharply than the market is actually expecting, this is going to be incredibly good news for small-cap stocks.
DJ: What are analysts saying about companies' prospects in the months ahead? Are we seeing more upgrades, downgrades? How are they feeling?
ST: Well, there's definitely more downgrades because the finance departments are making more conservative assumptions about growth than they were six or 12 months ago. And ultimately, if we're going to be honest, the finance director tells the house broker what the internal budget is, and then the house broker produces a note with those forecasts. By definition, company directors are overly optimistic. It’s a human trait. So it doesn't take much for those assumptions to be downgraded when the economic outlook starts to deteriorate. And that's basically what we're seeing. But that is not across the board. There is polarisation. So the companies with defensive characteristics are outperforming, and those are generally the ones that have got structural growth drivers, some of which I’ve already mentioned. Those that are underperforming are the ones with less pricing power, that may have balance sheet constraints, but are definitely more exposed to the global economy and any downturn in it.
DJ: What are the lessons we can take from the past two years in terms of company analysis? When you look back on this period – a very different environment – what do you find yourself thinking?
ST: Firstly, free cash flow generation is critical: companies that comfortably service their debts and operating costs are attributed higher valuations. I've mentioned Journeo, Equals, Solid State and Spectra. All four have fantastic free cash flow generation. I can also add Fonix Mobile (FNX), the mobile payment platform. Those companies are not only generating absolute performance but also relative outperformance to the declining Aim market. That's not going to change. Secondly, watch out for companies with short-term debt maturities that may or are very likely to have to refinance at significantly higher interest rates. That explains why I look for long-duration debt profiles for companies to mitigate that risk. Keep an eye on stock levels, too. When interest rates were 0.1 per cent in the UK, the financial cost of tying up capital in inventories was relatively low. That's no longer the case, with some small-caps being forced to borrow at rates of 8 or even 9 per cent a year. Tying up capital in stock is a drag on financial performance and means that sweating the balance sheet is required to maintain levels of profitability. So keep a really close eye on company stock levels. I'm paying close attention to debt covenant ratios as well, for the simple fact that in the current risk-averse market environment, any company that warns of a breach of covenant is going to see its share price absolutely hammered. This market is taking no prisoners.
DJ: Considering the takeovers and the relative lack of IPOs we’ve seen, do you find your opportunity set is narrower now? Or do low valuations mean there's more businesses to look at?
ST: Relatively speaking, there’s more, because valuations are so low. You've also got to look at the market environment. M&A activity has spiked this year: by the start of October, 32 Aim companies had been bid for or were closing out takeovers. Four of these were ones that I covered and had buy recommendations on. Gresham House (GHE), the fund manager, Crestchic, a producer of load banks, K3 Capital Management, a corporate finance boutique, and cyber security firm Kape Technologies. Those four companies have one thing in common: the bid premium and the return you actually made on these investments was eye-wateringly good. The average bid premium in the first three quarters of this year for those 32 Aim companies was 47 per cent. So there are opportunities even in this dire market environment to make decent returns.
The other point worth noting is that trading volumes haven fallen off a cliff. Go back two years and the average trading volume was £8.3bn of shares a day. The average so far this year has been £4.3bn. What this means is that because there's less investor interest in Aim, it's creating under-the-radar investment opportunities to exploit. Also, there's a lack of or even less broker coverage for certain small micro-cap companies. And that gives me an edge because I do my own research. To give you a recent example, AssetCo (ASTO), an asset manager and my November report for IC Alpha, was trading in the middle of last month on a 60 per cent discount to sum of the parts valuations, despite the fact that a third of the market cap was in cash. It owns a stake in a tech platform that's been independently valued at 150 per cent of its market cap. On top of that, it's got a fund management business with £3bn assets under management, most of which is equity funds, that could actually turn profitable in 2024, with a positive tailwind behind the market. Those are the types of opportunities that I've been spotting. So yes, the number of companies listed on Aim is shrinking. But in terms of the investment opportunities, there's even more because of the valuations.
DJ: What are the sectors that look particularly interesting – the areas of the market that are throwing up more individual opportunities?
ST: I'd be overweight renewable energy. I put readers into a stock called Triple Point Energy Transition (TENT) a couple of months ago; it’s currently trading on a 40 per cent discount to net asset value. It's hardly got any debt. It pays a 10 per cent dividend yield, which is fully covered by operational earnings. It invests in hydro plants, battery farms, solar parks. The rule of 72 tells you in seven years’ time you’ll double your money just by recycling the dividends back into the shares. And you’re probably going to double your money far sooner because I can’t see it still trading on a 10 per cent yield in seven years’ time. [The trust has since announced plans to wind down and return cash to shareholders, though at the time of writing it still traded at a 30 per cent discount to NAV].
The other one that really stands out is the insurance sector. The sector is benefiting from a positive rate premium cycle and one that seems to have further legs across the global insurance industry. Premium rates rose 3 per cent in the last quarter. That was the 23rd consecutive quarter of rate rises, and they've been relatively consistent as well across regions. One company I follow that is benefiting is BP Marsh & Partners (BPM), which on 7 December announced a disposal of one of its investments for a 33 per cent premium to book value, potentially a 100 per cent premium if an earn-out is paid. When that transaction completes, the company will hold 44 per cent of its net asset value in cash. Strip out the cash from its £156mn market cap, and you’re getting £120mn-worth of investments across the rest of its portfolio in the price for half the carrying value. It's not as if this company's underperformed over the years. I first put readers into it in January 2012 at 90p. The share price today is £4.33 and it's paid out 38p-worth of dividends. I can see that company overdelivering from its own portfolio, and it’s feeding off a very positive insurance market as well.
I'm looking at technology too. It's a little known fact that the Vix index fear gauge fell for eight consecutive days at the start of November. That's only happened 13 times since 1990, and 12 months later, every time the S&P 500 has been higher: not just a little bit, an average of 14.4 per cent higher. The S&P is currently about 3.5 per cent higher than it was on 8 November. What that's telling me is that, if history is any guide, there was a turning point in market sentiment at the end of October or early November, driven by an easing of inflation and interest rate expectations, and investors positioning themselves for a continued bull market in the US. And that to me also means better sentiment in Europe and the UK markets.
I'm looking at technology stocks. I've got several on my list, but one that stands out as ridiculously valued is Augmentum Fintech (AUGM); 30 per cent of the fund is in cash; it trades 38 per cent below net asset value. The valuation of three holdings – challenger banks Zopa and Tide in the UK, both of which are profitable, and a German tech platform, Grover – and the cash back up all the share price. That means you're getting a portfolio of 21 other companies in the price for free.
DJ: There's likely to be a UK general election next year. Do you have any early thoughts on how that might affect smaller companies?
ST: The latest polls show that the incumbent party is going to get wiped out. You’ll have the Labour Party, if not with a majority, then in a position to form a coalition very easily with either the Liberal Democrats or one other. So you will have a dominant force post-election, or at least it looks that way. What you have to bear in mind is that the UK economy is in a very different place now than it was in 1997 when Tony Blair and New Labour took power. The UK economy was actually doing very well in 1997 under the Major government. The problem was that the Conservatives lost their way with infighting. This time round, debt ratios are completely different. UK debt is at around 100 per cent of GDP. As we learned in October 2022, the bond market vigilantes take no prisoners. If you announce unfunded tax cuts, UK bond yields will spike. That limits the ability of the next government to spend, spend, spend.
The spending I think they will focus on is infrastructure spending, where they can actually generate returns and growth from tax receipts that will actually cover the cost of actual spending over the long term. And I think that will be acceptable to markets. Specifically, I can see certain construction companies doing quite well out of it. The ones that I follow that should do quite well are mechanical engineer TClarke (CTO), which has exposure to NHS and education projects and Henry Boot (BOOT), which has got property development and a construction arm too. I also think, assuming I’m right in terms of the rate cycle, that the housing market could do a lot better than the pessimists are predicting next year. And a positive housing market is good for the economy, so it's good for economic growth forecasts too. To summarise, I can't see the markets falling out of bed if the Labour Party win.
DJ: It’s not long now before the 2024 edition of Bargain Shares. What kind of things are you looking at through that lens?
ST: I think it could be a vintage year given the discounts on offer in the small-cap market. As I've said before, ratings have not been this low since the global financial crisis. And if I look at the returns from my Bargain Shares in 2009 and 2010, the portfolios delivered a 12-month return of 53 and 46 per cent respectively. I feel that history is about to repeat itself. 2024 could be a golden year for small-cap investing.
