Would you like small, medium, or large?

The old saying goes that ‘small is beautiful’. An increasing number of smaller and mid-sized UK firms are standing out and capturing interest. Simon and Jon discuss what’s driving the growth opportunities among small and mid-caps, where Simon is seeing opportunities in that space, and if he still sees ‘beauty’ in the larger firms in the market, the trust’s usual hunting ground.

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JC: Hello and welcome to A Value View from The Merchants Trust, thanks for joining us. Now at A Value View, we have a simple objective. We aim to bring you insight and views on some of the biggest current investment issues of the day, and we'll do this as we always have by looking at the world through the prism of The Merchants Trust, which boasts a diversified portfolio of well-established and well-known UK listed companies.

So, who better to guide us on this journey than Simon Gergel, Portfolio Manager at The Merchants Trust. Simon, it's good to be with you again.

SG: Hi Jon, it's nice to see you again.

JC: It's great to have you in the studio and I want to take you through an old saying, Simon, and that old saying is that small is beautiful. In terms of the UK market, perhaps a better turn of phrase though, might be small and mid-caps are beautiful. There's an increasing number of these smaller and mid-cap sized UK firms that are standing out and capturing interest and that's a fact, Simon, I know that hasn't passed you by, over recent months. So I'd like to spend a bit of time talking about that on this podcast. Why now? What's driving the opportunities among small and mid-cap businesses?

SG: It's a great question. And the other thing they say is that beauty is in the eye of the beholder.

JC: Yes!

SG: And we get very interested when shares are out of favour and share prices fall, and then that may be an opportunity to make money to buy good companies at cheap levels. And what we've seen in small and mid-caps is they've been significantly underperforming as what you've seen in the UK market so far this year is the large companies performing much better and leaving many of the small and mid-caps behind. Which is a bit unfair because there's some really interesting businesses there. I think what's driven that is a slight concern about the UK economy and what's happening in terms of growth, which is clearly a little subdued and mid and small-caps tend to be a bit more domestically focused. And then the other thing that's been driving that is money coming, flowing out of investment funds, and many investment funds have a lot of money in these types of companies, so there's forced redemptions and forced sales, and that's leading to some pretty erratic behaviour and some sharp moves and creating a lot of opportunities in that part of the market, yeah.

JC: That's interesting. Well, talk to me about those opportunities, Simon. Where are you seeing them in the mid-cap space, the smaller mid-cap space?

SG: In really quite a lot of areas, so everything from some of the smaller mid-cap banks, but also particularly the whole building and construction area around house building, and one of the government policies of the Labour government is to build more houses, and yet, house building shares, companies making building materials, products that go into houses, generally they're quite depressed because volumes have been low, and as we see - and we think we will see volumes pick up - we think those shares will see better profits in the future and the share prices should recover. But it's not just building related, it's also real estate, which has been under pressure as an investment because bond yields have gone up and been higher than expected, and property yields are linked to bond yields as yields go up, valuations come down. And so, what you're finding at the moment is property companies are generally pretty cheap compared to their asset base, and yet the fundamentals of real estate, whether that's demand for offices or demand for prime retail space or demand for GP surgeries, there's a lot of, there's a pretty tight supply-demand balance. You're seeing growing rents in many of these areas, so fundamentals of real estate are actually getting better while the valuations of real estate companies are coming down. So that's just a couple of areas where we're seeing value.

JC: So, like you say, the mood music is there, I guess, for those particular sectors that you're referring to - real estate and for building.

SG: I think the fundamentals should improve over time, and what's definitely true is the valuations are well below where they've historically been. And if those valuations return to normal or to more normal over time, investors should make a good return, yeah.

JC: OK. Of course, I guess one of the challenges here, though, is that there are many more smaller mid-cap businesses. So, what are the risks there as well, you know, if you've got to select those stocks, you've got more to choose from, more potential risk, I guess, as well, and that's, that's where a clear eye and a clear sense of what you're doing and, and choosing is going to be essential, isn't it?

SG: Yes. On average, I would say the mid and small companies tend to be a bit more cyclical, a bit more exposed to economic cycles, so areas like house building rather than say, consumer products and selling toothpaste or something which is more resilient. So, if you compare a big company like Unilever which is making, you know…

JC: It's makes everything, doesn’t it.

SG: Pretty much everything, ice creams and Dove skin, you know, soaps and things like that. That's more resilient, whereas a company building houses or supplying bricks will be a bit more cyclical.

JC: And they'll have a more singular focus perhaps as well, is that part of the risk?

SG: They can do. I mean, some of the mid-caps are pretty diversified and globally diversified. They're not all exposed to the UK economy by any means, but in general, they will be less diversified than typically a big company or less spread geographically. But in terms of what we look for to avoid risk, is we look very closely at the quality of the business and the market position, but also the balance sheet and the financial strength. We want to avoid companies with too much financial risk. So, you take cyclical risks, but you want to make sure that there's a strong balance sheet behind it.

JC: OK, now, where has this slight repositioning of the portfolio led you, in terms of performance over the short term?

SG: It's been difficult, the last year or two have been quite challenging for our investment style and our approach, because you've seen this, and the biggest factor of that, I think, has been this very significant money flow out of this part of the market, and many companies languishing really. The big driver of performance in markets has been momentum, and you've seen the biggest case of that has been the Magnificent Seven stocks in America, sucking money into these companies that are seeing, have seen strong earnings growth and from share price performance, and that money has been coming from somewhere else, and it's been coming typically from other markets like the UK. And the companies themselves that don't have strong momentum, i.e. that aren't delivering rising earnings or exceeding earnings expectations, particularly if they're seeing disappointing trading, they tend to be underperforming, and they've fallen. So, we've been buying companies which we thought were very good value in the last year or two, and in our view, many of them would be getting cheaper and cheaper.

And the valuation is pretty compelling now, but along the way, we've clearly suffered some underperformance in that period.

JC: And so it's a, I guess, I guess it's a longer game, is that what you're saying here, Simon?

SG: Yes, it is, and you see in periods when markets tend to be driven by strong momentum, and I've seen this several times in my career. I saw the TMT bubble in the late 90s. You had the financial crisis in 2007-8. in periods like that, the elastic can get really stretched, the valuation anomalies in the market can get really stretched as the momentum pushes in a certain direction, but it does create fantastic opportunities coming out the other end of it.

JC: OK, listen, I just want to have one last thought on this small is beautiful theme, or perhaps, you know, beauty in the eye of the beholder, maybe beauty we're talking about here. What about the large-caps, the firms that The Merchants Trust has traditionally focused on. Are you still seeing, to use your word, ‘beauty’ there?

SG: Yes, I think we've got to be careful not to overdo what we're talking about here, so 60% of the portfolio is still in the FTSE 100 or equivalent international stocks.

JC: And that will remain the same…

SG: I mean we are, we do have a policy of being predominantly large-cap investors, so we are going to remain more than 50% in the large-cap. And actually, many of the FTSE 100 stocks are behaving a bit like the midcaps, so really, I would say there's 20 or 30 super-large companies that are more internationally focused. And then there's a whole raft of companies like Whitbread, which owns Premier Inn or Unite, which is a student accommodation company, which you wouldn't really know whether they're a large or a small company because of the way they're behaving in terms of share prices. So, we're not overly focused on whether something's in the FTSE 100 or outside of it, but we are predominantly, you know, there's still a lot of value in the big companies. We still like some of the big banks like Lloyds Bank and Barclays, we still like many of the other large companies you know Whitbread is still a pretty big business. So, it's not as if - and GSK, WPP - so there's plenty of value in the large-cap part of the market as well. And, and you've got, in the UK market, you've got this great combination of strong governance, international diversification from the businesses and it doesn't really matter whether you're large or small, but at the moment we are finding better opportunities in those mid-cap areas.

JC: And I suppose, you know, despite what anyone might say about the recent budget, there is that air of political stability as well, to add to the overall sense of calm. We've spoken about this on the podcast before, that at least for the next few years, it feels quite predictable.

SG: Yes, I think politics in the UK looks a lot more stable than elsewhere in the world. I think it's a relative game, but if you compare what's happening in the UK to what's going on the continent of Europe or in America, the political environment feels much more secure here, yeah.

JC: Yeah. Simon, just one thought differently opposed to what we've been discussing, over the last 10 minutes or so, and that is another thought around the shape of the market, what and what's happening. We're seeing something of a resurgence of interest in bids for certain firms. That suggests perhaps that, well, more people are seeing more opportunity in the UK market. Surely, that's a good thing. So, what's driving this? And what does it mean for investors, do you think?

SG: Well, actually, these subjects are linked. The reason why you're getting more bids in the UK is because you've got many more companies offering compelling valuations… value. So, if you're a large, you know, if you're a competitor in America, of a UK-listed business, there can be a great opportunity. One of our companies, Dowlais, which makes automotive components, has been bid for by an American peer. In fact, in last financial year we had 3 companies bid for by American peers, so it's not, you'll see more of this as the valuations make these companies really interesting.

JC: Are they making sensible bids?

SG: Not always, I mean, some of the prices bid for these companies are very cheeky, quite low, and some of them have been rebuffed. We had a bid recently for a company called Assura, which is they own GP surgeries - 600 GP surgeries and healthcare facilities - and the board turned that down, and that was, you know, a pretty modest price actually. So, you can't blame the bidders for trying to get companies on the cheap. It's our job to try and decide whether those prices that are being bid are appropriate, but you are seeing a lot of bids coming in because of the value on offer. And the other big buyer you're seeing at the moment is companies themselves are buying back their shares at a huge rate. So, you’re seeing 40 to 45 billion pounds a year on an annual basis, being brought back by companies, which is really enormous.

JC: And that's good news, I guess, for investors, isn’t it.

SG: Well, it should ultimately drive the prices of shares up once the selling pressure stops. So, if there's ever any more enthusiasm for UK shares, and I think there will be for all sorts of reasons, which we can't talk about today, probably in terms of time, but you've got these two buyers in the wings, private equity companies, but also companies themselves buying back their stock and all of that could lead to a much stronger market here.

JC: Well, it's a good point to finish on, Simon. Unfortunately, we're out of time now though, but thank you very much indeed, as ever, for your thoughts and your insight as well.

SG: Thank you, Jon.

JC: And thank you for listening to A Value View from The Merchants Trust. You can find out more about The Merchants Trust and read and watch Simon's latest investor notes by going to merchantstrust.co.uk. Thanks again for listening, and until next time, from all of us here at The Merchants Trust, it's goodbye.