It is unusual to see the amount of stocks with “double-upside potential” that are currently on display in the UK small-cap market, according to Stuart Widdowson, manager of the Odyssean Investment Trust.
Widdowson aims to deliver a 15 per cent annualised return for investors, equivalent to doubling their money every five years.
Yet he said lowly valuations mean that in many cases, investors in UK small caps will not have to wait this long to see a 100 per cent gain.
“Ed [Wielechowski, co-manager] and I made four new investments in this quarter, which is pretty unprecedented,” he said.
“And those are typically companies with what we describe as double upside: their business models should benefit from normalisation post-Covid, but on top of that, they have self-help opportunities and they should be better rated by the market.
“It’s very unusual to have this many double-upside stocks around. That’s why Ed and I are pretty optimistic over the medium to long term.”
Despite his optimistic outlook, Widdowson warned that investors need to take a selective approach to UK small caps. For example, while valuations on fully listed stocks look attractive, it is a different story on AIM, which trades on an average P/E (price-to-earnings) premium of 90 per cent to the main market.
“And it’s been very much exacerbated over the last few weeks and months,” the manager said. “We highlighted the premium rating on AIM as an anomaly at the IPO in May 2018 and indicated there was value to be found in non-AIM names, or those not favoured by IHT [inheritance tax] funds. We believe the same is true today, and in some cases doubly so.
Source: Peel Hunt & Odyssean. Only includes positive earning companies
“Moreover, we see many AIM names trading at a material premium to their take-out multiples. And in contrast, we see numerous full-list small companies trading at discounts to M&A valuations.
“We think this is an excellent hunting ground for our investment style at the moment.”
Widdowson said the differing fortunes of AIM and the fully listed market is not the only anomaly in small caps, pointing out there has also been a wide divergence between sectors. For example, he said that while forward P/E ratios on tech and telecommunications on the Numis Smaller Companies and AIM indices have re-rated from the high teens to the high 20s since the start of 2019, they have barely budged in healthcare and industrials.
“A lot of the sectors that have seen the most resilient earnings performance since the Covid crisis are on the highest ratings and, in some cases, materially higher than two years ago,” the manager continued.
“In contrast, some of the sectors that were hit harder by Covid haven't really seen any material re-rating at all and yet their earnings have been depressed.
“And we think that’s where there's going to be some pretty interesting investment opportunities.
“We don’t have a crystal ball and we never make predictions, but our suspicion is that the non-tech and non-telco companies are going to see much more interesting returns over the next 18 to 36 months than they have done over this year. And we’re finding some very interesting special situations in those sectors.”
When Widdowson analyses a potential holding, he typically looks for one of five ways he can make money from it: organic sales growth, margin improvement, a re-rating, improved free cash flow and adding value through M&A – either by disposing of assets at a premium to the current rating or acquiring assets at a discount to the core group and creating synergies.
However, he prefers businesses that exhibit potential in more than one of these areas, “because as we all know, not everything works to plan”.
“If you’ve got lots of ways to make money, you’ll probably make a positive return,” he added. “As a result of that, the loss ratio tends to be quite low.
“It’s not just about valuation, we’re looking to invest in above-average companies. Ideally great companies priced as average companies.”
Widdowson comes from a private equity background and tries to use his experience from this industry in helping push portfolio holdings to the next level.
As a result, he aims to ensure he has identified something a business could be doing better before investing in it. After investing, he will engage with the management, which he does for three reasons: first, to help crystallise value; second, to stop companies making mistakes that destroy value; and third, to recover value if a company has taken a wrong turn.
“We’ve been doing it for quite a long time,” he said. “We’ve seen many things that have worked and many things that haven’t worked, and we think we've got a good balance of being engaged without being obstructive or difficult.
“We’re not messianic. The analogy I’ll give is our investment approach is a bit like golf. Ultimately, if we make a good stock selection at the beginning, it’s like a tee shot, and the engagement is there to help get as close to par as possible. And if you get it really right with a good stock selection, you get a birdie or an eagle. But the big picture is, when we exit the company, we want it to be in a better shape than when we first invested.”
Data from FE Analytics shows Odyssean Investment Trust has made 1.48 per cent since launch in May 2018, compared with losses of 7.28 per cent from the IT UK Smaller Companies sector.
Performance of trust vs sector since launch
Source: FE Analytics
The trust is trading at a discount of 6.31 per cent to net asset value (NAV) compared with 5.73 per cent for its one-year average. It is not geared. It has ongoing charges of 1.66 per cent, plus a performance fee.