Meet the Fund Managers: Small companies, large gains
In this series, investment reporter Elliot Gulliver-Needham sits down with a fund manager for a Q&A. This week, we’re hearing from Ken Wotton, manager of investment trust Strategic Equity Capital.
How does your fund stand out from others in the same market?
Strategic Equity Capital plc is a listed investment trust that sits in the UK Smaller Companies sector. It stands out because it takes a highly concentrated and high conviction approach to investing in smaller companies. Unlike many of the other funds in its sector, which are very diversified and have similar open ended equivalent funds managed by the same manager, SEC is doing something different, uncorrelated and we think more effective in this space.
SEC takes larger equity stakes in a very selective portfolio of high quality small cap companies where we believe that constructive and active engagement with the management teams and boards of those companies can support and drive value creation for all shareholders. We try to leverage our private equity network to spot opportunities and to make introductions to high quality individuals and organisations that can help our portfolio companies in whatever way adds most value.
Which of your holdings are you most excited about?
We have a conviction weighted portfolio where the largest holdings are those we believe are the most exciting opportunities. Our largest holding is XPS Group, a specialist consultancy focused on the pensions sector. It has all the characteristics we really like: structural market growth; attractive margins; a strong market position; an experienced and high quality management team; a solid balance sheet and strong cash generation.
These stand-out financial and operational characteristics are combined with a valuation which sits at a material discount to the multiples for M&A transactions for similar businesses. We believe the stock market will rate this business appropriately in due course but if not, then it is likely to be an attractive target in a market where UK smaller companies seem to be in the sights of private equity and corporate buyers.
What is the biggest mistake you’ve ever made in the fund?
R&Q Insurance is our worst mistake for this fund. We saw a compelling opportunity to back a business going through a transformation from a capital intensive specialist insurance business to a faster growth and more cash generative services business model.
Our thesis was broadly correct in terms of the transition but unfortunately the legacy business turned out to have balance sheet issues we hadn’t foreseen, which undermined the whole company. When we worked with other shareholders and the board to mitigate the problems it was too little too late and we lost a lot of money. Lesson learned that opaque balance sheets, even if a diminishing proportion of the whole story, can be just too risky.
What’s one change you made in the fund recently? Why didn’t you make it sooner?
We recently sold out of a business called Wilmington. It had been a long standing holding that went through an extended turnaround. The current management team did a fantastic job of stabilising, right-sizing and then ultimately growing the business and we made a great return.
We were patient and sold out progressively as the share price started to reflect the strong operational progress of the business after a number of years of underperformance. Why didn’t we make the change sooner? Largely because we believed in the team and the strategy and we waited patiently until the market recognised the value of the business too.
What’s the biggest change you’ve seen happen during your time in the industry?
Over the course of my time in fund management, the biggest changes have been the consolidation of the fund management and wealth management industries as well as the rise of private markets.
This has led to a fundamental change to the focus of institutional and wealth investors toward larger, more liquid parts of the capital markets. This, together with the increasing prominence of private equity, has reduced mainstream allocations to smaller companies in the UK and globally due to liquidity constraints.
On the one hand, it has created problems for the smaller company ecosystem by reducing the pool of natural buyers small cap stocks. On the other hand, the reduced competition and attention have created a wealth of opportunities for specialist dedicated small cap active managers like us. It’s not all doom and gloom for smaller companies though.
The venture capital and private growth capital market in the UK has matured. Now we are past the era of zero interest rates I expect the public markets, and AIM in particular, to benefit from a greater flow of exciting growth companies seeking flexible access to capital and VCs seeking exits to recycle their profits into new ventures over the coming years.