Paul Marriage Fund manager of the Tellworth UK Smaller Companies Fund discusses the recent wave in M&A among UK small caps and the strong message this sends about the sector.
Catalystics
While I was no great shakes at the sciences at school, I am always amused when scientific terms are used freely by non-experts to add some perceived gravity to their chat. Catalyst is a great example – in the last year or so, many people have asked us ‘What is the catalyst for buying UK smaller companies?’
Let’s start with what they are actually asking – are they asking us to identify the substance that increases the rate of a chemical reaction without undergoing any permanent chemical change? If they are, we can’t help, not least as we don’t invest in the mining sector. Or are they asking us to identify the signal that will precipitate a small cap rally? The Deutsche Numis UK Smaller Companies Index, which represents the bottom 10% of the market by capitalisation, troughed in November 2023. If the case for saying you have missed the trough in UK small caps is gaining strength, why bother looking for the catalyst?
So far, those investors who told us last year that they were prepared to sit out the first 20% until they knew the market had legs, have yet to act. Unstable UK politics, and lower interest rates not coming as soon as hoped, have been very valid ‘not now thanks’ positions to take. A majority government with an ostensibly pro capital markets mindset and the passage of time means both arguments are losing credibility as this year progresses.
Unlike those stable-for-now MPs, I’m not dodging the question here. There has been one very significant and well documented catalyst which has only gathered momentum in the last year, incoming M&A. If you are a small cap fund manager who wants to stay somewhere near the peloton this year, you will have had a few bids. While there is no typical transaction, cash premiums of +30-50% have not been uncommon, and while Private Equity has been prominent, trade buyers and a combination of trade, private equity, and family investors, have also been seen.
UK small cap acquisitions reflect breadth of sectors & acquirers
Source: Premier Miton, as at 24.07.2024.
Past performance is not a reliable indicator of future returns.
Why now?
The exodus from UK equities by both domestic and international investors over the last decade has left a lot of unloved shares languishing in portfolios. In most cases, this derating has not coincided with particularly weak financials or a spate of management missteps. The UK has a disproportionately large smaller companies market. The aforementioned Deutsche Numis Smaller Cos index has over 1,000 constituents, which creates a big pool to fish in. We have a very open capital market. Most listed companies have broad shareholder bases including institutions, founder families and retail holders.
After a long period of investor redemptions, institutional fund managers see the cash injections from M&A as a welcome alternative to salami slicing the portfolio. You may be losing the odd ruby from the crown, but the jewels are still shining. The M&A wave sends a strong message about UK Small Caps – suitors are saying ‘if you don’t value these businesses as highly as we do, then we’ll take them off your hands and pay you a nice premium for the trouble’. The buyers also evidently think they are getting a good deal over the medium and longer term too. We are now perhaps seeing a little evidence in the flow data that allocation to the sector is beginning to pick up.
Small-cap flows remain positive
Smaller companies have also found themselves more readily in the crosshairs of PE funds who might have shunned sub £500m deals in the past as higher interest rates have made the maths hard work on larger leveraged deals. They can now use more equity and less debt to acquire 100% today and will probably seek to refinance at lower rates in the future. We believe a broad portfolio of long term growth businesses with niche market leadership, and fundamentally decent businesses with the wrong share prices, should fare very well in this environment.
Horses bolted
Is this a fin de siècle rally that will soon fizzle out? Funnily enough we don’t think so. The Tokyo carry trade wobble that shook markets in early August would have been a good opportunity for investors to shun the sector on risk grounds. While we did see one bid approach disappear, with a Lebanese trade buyer for Wood Group pulling out of their extended due diligence due to market volatility, smaller companies have rallied back with global indices and M&A looks set to carry on where it left off. In the meantime the UK macro picture has probably improved relative to other developed markets. Indeed we have seen a few companies cut numbers on a weaker global outlook, those that are UK facing have thus far been more resilient. The smaller end of the market generally behaves as if it is interest rate sensitive and domestic even if many of the strongest businesses are niche market world leaders with a very modest slice of UK revenue. The re-opening of the IPO and primary equity market this year started very well with UK tech champion Raspberry Pi, and this should encourage others. While the day one win of a good IPO is never to be sniffed at, the introduction of new companies that can replace those leaving via M&A has been the missing link in a vibrant capital market. To go back to where we started with repurposing scientific terms, perhaps the M&A phase is the flywheel – starting to release a store of value in the UK small cap market that can run far beyond this wake-up phase.
