How a private equity mindset can help to spot special situations that deliver

Stuart Widdowson left private market investing for the world of listed companies in the early 2000s because he wanted to run a portfolio rather than just working on one or two transactions every three or four years. But what he learned at private equity group HG Capital plays an important part in his investment approach today.

“One of the things I learned from the senior managing partner was to find an investment methodology, stick to it, and really focus on the companies that are going to meet that criteria,” Widdowson says, noting that the biggest cost you have as an investor is your time. 

He adds that he also compares what he pays for companies against “real world” valuations, meaning what trade or private equity buyers might be prepared to pay for a company rather than other stock market investors, something he thinks stops him from falling into the trap of overpaying for assets. 

Widdowson co-founded Odyssean Capital in 2018 and has co-managed Odyssean Investment Trust (OIT) since it listed on 1 May 2018. Between then and 20 January 2022, its share price rose by 63 per cent, compared with a 28 per cent rise for the Numis Smaller Companies plus Aim (ex investment companies) index over the same period.   

Odyssean is a concentrated portfolio typically owning up to 25 holdings, with its top 10 making up 71 per cent of the net asset value at the end of December. Widdowson says he’s looking for “really good companies that are going through some sort of change”, describing himself as a special situations investor rather than having a traditional growth or value bias. 

To make the strategy a success, he applies his private equity mindset and focuses on trying to minimise losses. Out of 10 investments, he estimates that generally around six should do as he expects, while two will far exceed his expectations and two won’t work in the way that he’d hoped.

Macro headwinds

Two themes likely to dominate the macroeconomic investment landscape this year will be inflation and rising interest rates. Widdowson says it’s important to own companies with pricing power in an inflationary environment, as he thinks its “going to be a real 'separating the wheat from the chaff' year.” 

Widdowson thinks most of his companies should prove resilient if inflation persists, as the portfolio tends to focus on “niche market leaders”. He says: “We don't tend to invest in companies that can't make at least a 10 per cent operating margin, and the ideal company will be making a high teens or low 20 per cent margin, which basically indicates they're in a good position and do something that's difficult to replicate.” 

He gives the example of Elementis (ELM), a speciality chemicals company, which could actually be a beneficiary of inflation because it owns a high proportion of its raw materials. “While it has some raw materials it has to buy in, it actually owns two of its key sources of raw material,” he says. One is high grade industrial talc, which the company has several decades' supply of in Finland and the other is what he believes to be the world’s only hectorite clay mine in California which he thinks has over 50 years of supply. 

In terms of rising interest rates, Widdowson thinks the biggest issue relates to valuations. “Very simply, rising interest rates means growth companies will be worth less because their cash flows are worth less in the future,” he says. Some companies, however, notably banks, benefit from rising interest rates.    

Widdowson built up a position in Curtis Banks (CBP), the specialist self-invested personal pensions provider, last year, which he thinks will benefit from any rate rise owing to the significant amount of cash it holds. However, the main reason for buying the company was because he got in at a very attractive valuation and it is looking to boost margins via an IT project – something he believes is yet to be reflected in the share price.

Investment process

To spot a special situation, Widdowson says he and his team look at a host of metrics. When considering attractiveness to would-be acquires they pay particular attention to enterprise value (EV) to sales multiples. “If a company is able to, with some synergies, make 25 per cent margins for a buyer, it’s reasonable the buyer might pay up to 2.5 times EV/sales for that company,” he says. “If we can buy it at 1.5 times EV/sales, we know we’re getting a big potential upgrade from some sort of corporate activity.” 

He adds that he doesn't buy stocks just because he thinks they’re going to get taken over, and he tends to make sure that he doesn’t buy companies that are on price to earnings ratios above long-term averages. That said, he says “four or five” of the trust's holdings have been bid for over the past nine months which has boosted returns. 

“We felt a lot of investors were focused on Covid recovery stocks, but a lot of other stocks were pretty mis-priced, private and trade buyers have lots of capital, and borrowing costs are low. We wouldn't be surprised if we see more [bids],” he says. 

Widdowson and his team also look closely at changes in management or directors, particularly the chairman. “Small companies are very different to big companies,” he says. “They can go through a change agenda in 18 to 36 months, which is what we get attracted to because often investors won’t price that in until it has started to deliver."

In January 2021, shareholders approved a change in the investment policy of the trust to implement negative screening of certain investments deemed unethical and or involved in activities which were deemed unsustainable. Widdowson thinks this excludes around 17 per cent of Odyssean Investment Trust's investable universe. 

Portfolio positioning

The trust tends to have a net cash position of around 8 per cent, which is higher than that of many of its peers. This is so that they have cash ready to invest when they want to, rather than being forced to sell an existing holding, as they are not looking to enhance returns through gearing.

“In October we quintupled our position in Curtis Banks”, Widdowson says, adding that having the cash available enabled them to get a very good price.    

Odyssean’s portfolio turnover is typically around 25 per cent per year. Widdowson says much of this is down to buying companies the trust already owns. He adds that he tends to make between four and six new investments per year. “We don’t need to find many new investments each year to make it work for us,” he says. 

Widdowson has had significant success with a number of healthcare holdings. When the pandemic struck he sought healthcare stocks that weren’t pandemic beneficiaries, in the belief that no one wanted to own them. He focuses on services, not speculative biotech, and several of the trust’s holdings last year received takeover bids – Spire Healthcare (SPI) (rejected), Vectura (completed) and Clinigen (CLIN) (open). This has helped to boost returns.  

He also likes business to business media companies, with Wilmington (WIL) and Euromoney Institutional Investor (ERM) both in the trust's top 10 holdings. “There’s a recovery situation in those stocks,” he says, as he believes that personal interactions will come back as a means for doing business and that when that happens these stocks will re-rate. They also both have net cash on their balance sheets which gives them options, he says.

Industrials are the trust’s largest exposure. Widdowson says a number of these holdings are going through a process of self help, which should help margins, which he believes are “well below what they could be”. He lists Elementis, Dialight (DIA), and Flowtech Fluidpower (FLO) as stocks which came under some supply chain pressure last year but they were unusual in that they didn’t issue profit warnings. He thinks this is because they have good business models and an element of “self help” allowed them to defend their operations.  

The trust has the potential to have 20 per cent of its net assets in unquoted holdings, but Widdowson says he would only tend to make use of that if a company was taken private and he wished to hold on to the position. When asked if he’s worried about the listed universe shrinking, he says his hunch is that things will go the other way.    

The board of Odyssean Investment Trust recently approached the board of Strategic Equity Capital (SEC), a trust that Widdowson previously managed. While he’s not able to comment on the proposed merger which he describes as a “board to board initiative”, he doesn’t believe that it would require him to change his investment strategy.

Source: Winterflood, 21.01.22

Stuart Widdowson CV

Co-manager of Odyssean Investment Trust, 2018 – present

Lead manager of Strategic Equity Capital, 2009 – 2016

HG Capital, associate director, 2001 – 2006