There are several fund managers who run extremely concentrated portfolios with the aim of having meaningful stakes in companies allowing them to actively influence and support management.

This strategy is broadly akin to that of a private equity investor putting money into an unlisted firm. The lack of diversification means this approach comes with a different risk profile to funds which spread their money more widely, but in the right hands it can be a successful one.

UK RIPE FOR THIS APPROACH

There is an argument the UK market, particularly at the small- and mid-cap end of the spectrum, is particularly ripe for this kind of gameplan given depressed valuations. A similar dynamic in Japan has enabled specialist trusts like Nippon Active Value Fund (NAVF) and AVI Japan (AJOT) to benefit from being highly-engaged investors in recent years.  

As Ben Mackie, a fund selector at investment manager Hawksmoor, notes, there are two names which fit this bill most closely operating in the UK market: Odyssean Investment Trust (OIT), run by Stuart Widdowson, and Strategic Equity Capital (SEC), steered by Ken Wotton.

‘The real similarity with private equity is they are aiming to effect change. A big part of what they do is try to influence management teams and they can do that because of their [large] stakes’, says Mackie.

‘That’s more important today than it has been in a long while because the UK equity market is in something of a malaise and actually having a manager who’s willing to engage, willing to influence, willing to try and drive self-help and realise value is really important.’

Mackie explains his investment in both funds is heavily predicated on the two men involved and their respective track records. On a five-year view there’s not much to choose between them: Odyssean has achieved an annualised total return of 10.9% while Strategic Equity Capital has chalked up 10.5%.

The more engaged management style comes at a cost, however: Odyssean has an ongoing charge of 1.45% and Strategic Equity Capital’s is 1.22%. Odyssean trades at a slight premium to NAV (net asset value) while Strategic Equity Capital is at an 8.7% discount.

NOT ACTIVIST INVESTORS  

Strategic Equity Capital’s Ken Wotton is keen to stress to Shares there’s a big difference between his approach and that of an activist investor but he is more comfortable with the comparison with private equity, logically given his background.

Wotton spent 12 years at Livingbridge, which he describes as a ‘quality, growth-focused private equity house’ with a ‘hands on’ approach.

Livingbridge was acquired by Gresham House in 2018 and in September 2020 the asset manager took over the running of Strategic Equity Capital with Wotton taking the helm on the trust.

This is now a highly-concentrated portfolio. According to its latest factsheet, Strategic Equity Capital has just 16 holdings.

‘We are looking at businesses as businesses not just as a share,’ says Wotton. ‘So, we have that philosophy, the private equity heritage and crossover of capability in the business as well as a focus on the fundamentals and doing due diligence on the right stuff, and the last bit is we’ve got this very well-developed network built over the last 17 years of people we know.

‘Think of it as the aggregate networks of all the public investment team at Gresham but also the private equity team, the investment committee the management team, all the people they know.

‘Those people come from all sorts of sources they can be advisors, they can be consultants, M&A advisors, people who’ve run businesses we’ve backed, both public and private, chairs, non-execs, specialist subject matter experts.’

Wotton explains this means there is a deep pool of objective expertise which they can tap into. ‘We use that on every investment to try and reference people, understand niche areas better and, importantly, test the critical judgements we’re trying to make on investments to make sure we’ve thought of everything properly.’

Wotton says: ‘We’re trying to find companies where we think it’s a good business, in a good market with a good team and a sensible strategy and we can back them as a constructive, large shareholder.

‘We can have a debate about strategy and we can be provider of capital if they’re going to do acquisitions or other investment activity, we can help support management incentives which are aligned with long-term value creation and introduce people which can help them, potentially as non-executive directors.’

As well as taking large stakes, the trust looks to hold stocks for at least a three-to-five-year time horizon with the aim the company might double its profit over that period, thereby helping to support a re-rating. By having a larger stake, the company is in a position to help fight off takeover interest if it feels a company is in danger of being acquired for a low-ball price.

In terms of carrying out due diligence on investee companies, Wotton says it’s all well and good doing the homework, particularly on the downside risks, but ultimately you have to make a judgement. ‘If you spend too long kicking the tyres in the public markets the opportunity might be gone,’ he says.

The trust avoids sectors like banking, oil and gas and mining. Instead, Wotton likes areas like technology, although only profitable firms not those with blue sky potential, healthcare services and people-based businesses where companies are capital-light and can generate plenty of cash. ‘The single most common thing that blows up an investment thesis is the wrong acquisition for the wrong price, especially if funded with debt,’ Wotton observes.

STRATEGY IN ACTION

Wotton flags teleradiology specialist Medica, which sells access to qualified radiologists to interpret medical imaging to the NHS and Irish health service and into the pharmaceutical sector, as a good case study for the Strategic Equity Capital approach.

Although it was a position he inherited when he took charge of the trust, having done the work on it the position was materially increased. He observes it was a growing business with high margins, high cash conversion, strong balance sheet, strong structural drivers (including an undersupply of radiologists) and good visibility of earnings through contracted revenue. It had a good-quality management team with a chair Wotton had previously backed elsewhere.

The trust bought in at an average EV/EBITDA (enterprise value to earnings before interest, tax, depreciation and amortisation) ratio of eight to 8.5 times while similar private equity transactions for similar businesses were being bought for 14 to 15 times. The company was taken over for £269 million by private equity outfit IK Partners in July 2023.   

Noting the lowly-valued nature of UK stocks, he says: ‘I find this market environment is perfect because, maybe you’re having takeovers but it’s quite easy to redeploy the cash into attractive ideas,’

Wotton also observes that being a closed-end fund, which unlike open-ended funds don’t have to sell investments to meet redemptions, is beneficial as it allows for larger, less liquid equity stakes.

Broadening the geographic horizons, Mirabaud Discovery Europe (BYZXMC7) pursues a pretty similar approach across Europe although within an open-ended structure. It has an ongoing charge of 1.08% and its five-year annualised total return is 6.7%. Manager Hywel Franklin explains the relationship the fund has with companies it holds.

‘We’re quite close to them and their underlying businesses. Sometimes we actively help the businesses, connecting them with other management teams and other businesses we know.

‘We might put them in contact with providers access different markets, there are cases where we suggest customers or suppliers they might want to think about. It’s all from a connection standpoint – helping companies to develop or communicate better.

‘We’re not taking board seats, not being activists, it’s a close relationship and a much warmer relationship.’

Franklin explains the company likes to look at businesses which are a bit below most peoples’ radar, maybe because they don’t have much analyst coverage or they have fallen out of favour. ‘Targeting areas which are less attractive to other people is key to the approach,’ he adds.

RED FLAGS

The fund has a checklist based on the most expensive mistakes made in the past, which are then placed into different ‘families’. This includes things like the robustness or otherwise of the balance sheet, overpaying for the level of cash flow on offer, management teams acting against the interests of external shareholders and turnarounds. ‘If we see any of these clear red flags we move on,’ Franklin says.

The Mirabaud Discovery Europe portfolio currently has 42 holdings, at the top end of its usual range of between 25 and 40 names, out of a potential universe of 2,000 companies.

Most aren’t household names but small- and medium-sized firms and encompass a diverse mix of businesses including isotope technology group Eckert & Ziegler (EUZ:ETR) in Germany and Irish housebuilder Glenvaugh Properties (GLV).

Franklin adds: ‘What is really exciting is we have just seen the longest period of underperformance of small-caps versus large-caps on record and in combination with that investors have forgotten about Europe. There are signs things are turning, which makes it a pretty exciting time to be investing with some of these companies.’

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