Q&A: Marlborough Multi Cap Income

Sid Chand Lall, Manager of Marlborough Multi Cap Income, highlights the advantages of a UK equity income strategy focusing on the growth potential of smaller companies and explains why the sell-off in 2022 has created an exceptional long-term opportunity.

While most UK equity income funds focus on the corporate giants of the FTSE 100, your fund favours small and mid-cap companies. Why do you take this approach?

“We have the freedom to invest in companies of all sizes, so we do hold some FTSE 100 stocks, but we retain a bias to smaller companies and this is a key differentiator for our fund.

“There are a number of advantages to our approach. Although smaller companies can be more volatile, they have historically outperformed larger companies over the long term. They are often younger, highly innovative businesses and their size means they can be more agile, moving quickly to seize on new business opportunities. At the same time, they can be generating healthy cash flows and robust profits. Indeed we make it a point to only select companies that can actually afford to pay a dividend.

“Successful smaller companies can grow their earnings faster than the corporate behemoths, and this should, all other things being equal, translate into a rising share price. Higher profits should also translate into sustainable dividend growth, which is another key element in our strategy.

“The other great attraction of smaller companies is in the sheer number of opportunities. If we were focused solely on the FTSE 100, we would only have 90 or so dividend-paying companies to choose from. Our multi-cap approach means we have more than 700 companies from which to select the strongest contenders for our portfolio. This broad range of opportunities across a wide spread of sectors is an important strength of our fund.”

While long-term performance remains strong, shorter-term performance has lagged over the past year. Can you explain why this is?

“Our performance in 2022 lagged the FTSE All-Share Index and the average for the UK Equity Income sector, mainly because we were underweight FTSE 100 stocks. Since launch we have, by design, always been underweight FTSE 100 companies. The FTSE 100 index dominates the FTSE All-Share by weighting and most UK equity income funds have a large number of FTSE 100 stocks in their top 10 positions.

“The FTSE 100 delivered a positive return in 2022, while, by contrast, the smaller companies we favour were very much out of favour. This was partly because they don’t offer the same degree of exposure to commodities. Lower levels of overseas earnings were another factor, at a time when the US dollar was strengthening against the pound.

“Investors tend to reduce exposure to smaller companies during periods of uncertainty, and in 2022 confidence was hit by a succession of events, with the Russian invasion of Ukraine, spiking inflation, interest rate rises and Covid lockdowns in China.

“Small and medium-sized companies also tend to be more domestically focused and share prices were further hit by UK-specific issues including the Liz Truss/Kwasi Kwarteng mini-budget. Meanwhile, the FTSE 100 had a positive year because of its high weighting in sectors such as energy, materials and mining, which performed strongly because of the macroeconomic backdrop.

“While last year’s underperformance has acted as a drag on our three and five-year performance figures, since the launch of the fund we are still comfortably ahead of both the FTSE All-Share Total Return Index and our peers in the UK Equity Income sector. Since launch in July 2011 to the end of 2022, the fund has returned 114.0%, compared with 98.2% for the FTSE All-Share TR and 99.2% for the sector.

“Since launch, our fund’s five-year performance has been better than the UK Equity Income Sector in 59 months out of 78 – 75% of the time. It has been ahead of the FTSE All-Share in 44 months out of 78 – 56% of the time. This strong performance has meant Marlborough Multi Cap Income has been in the top quartile* in 44 months out of 78 – 56% of the time.

“We’re an equity income fund, so it’s also important to look at our track record for dividend payments, and that’s very strong. Our fund has paid a higher dividend yield than the FTSE All-Share in every year since launch.”

*The top 25% of funds in the Investment Association’s UK Equity Income sector.

During a challenging 2022, were you tempted to alter your investment strategy?

“The short answer is no. We have a well-established investment process and we have confidence in it. We’ve had previous periods of short-term underperformance and our fund has always bounced back strongly. That’s what happened in 2016 after the Brexit referendum result, in the 2018 sell-off and more recently in 2020 when markets fell sharply at the beginning of the pandemic.

“We firmly believe that holding, as we’ve always done, a diversified portfolio of more than 100 dividend-paying, mainly smaller companies, carefully selected for their growth prospects and the sustainability of their dividends, will continue to achieve outperformance for our investors over the long term.

“With valuations at their current lows, we’re seeing particularly attractive opportunities among smaller companies. We’ve recently reinvested in Redde Northgate, which is a vehicle hire, insurance and car repair group. The company has an experienced management team, who have reduced debt (a trigger we were waiting for), having already integrated a series of very sensible acquisitions. Profits and dividends have increased significantly since. We believe the company has strong long-term prospects and yet, at the time of writing, it’s still on a single-digit price/earnings multiple*.

“Our investment strategy is focused on identifying outstanding opportunities like this and we believe this approach will continue to deliver for investors who take a long-term view.”

*The price/earnings multiple is the share price divided by earnings per share. This shows investors how highly the company’s shares are priced in relation to its profits. The p/e multiple is one of the most commonly used measures of stock market value.

You’re supported by a large and experienced investment team. How many of you are there and how do you work together?

“We have a core investment team of four people dedicated to our fund. That’s myself and three analysts, each of whom have different strengths. We work very closely with the wider smaller companies investment team, so there’s around 20 of us in all. We’re all in the same office so there are constant opportunities to compare our analysis of companies and share new ideas.

“Each Tuesday we all sit down together for our formal weekly investment meeting, which lasts around an hour and a half, and that’s a very useful forum. But the reality is the exchange of ideas is going on all the time on a daily basis. This sharing of knowledge by experienced investors can be very powerful and it’s a major asset for our fund.

“Depending on the company, several of us may attend a meeting with management and afterwards we’ll compare notes and share insights. That combined analysis from several people with different specialisms and perspectives can provide a real advantage.

“There are some companies we’ll hold in several different funds, for example the tabletop wargaming business Games Workshop, which has just signed a potentially very lucrative film and TV series deal with Amazon. In this situation, you have several people vetting the company independently and assessing its prospects – so the business is being very intensively researched. It serves as a useful reconfirmation for us.

“In other cases, there may be a company held in Marlborough UK Micro-Cap Growth that’s just starting to pay dividends, which could present an opportunity for our fund. In that scenario, we’ll initially draw on the knowledge of the Micro-Cap team to complement our own subsequent analysis.

“So, we have a large team with a huge amount of experience investing in smaller companies and we’re all working closely together to identify the strongest opportunities. That gives us a real edge in small and mid-cap companies, which tend to be under-researched compared with FTSE 100 stocks.”

How would you describe the outlook for 2023 and beyond?

“There’s still considerable economic uncertainty. We have the conflict in Ukraine, slowing global growth, higher interest rates, semiconductor shortages and the Covid situation in China. However, we’re bottom-up investors and there will always be companies that are winners, managing to take market share from competitors or benefiting from effective self-help strategies. These are the companies we’re looking for.

“After a turbulent 2022, I also think it’s true to say that the prospects for high-quality dividend-paying companies are now looking significantly more positive. The vast majority of the companies in our portfolio are continuing to trade well. They have high-calibre management; pricing power, so they can pass on rising costs; and robust order books, providing good earnings visibility.

“Looking at valuations, we’ve seen quality smaller companies that were on P/E multiples of 20x derated to 10x or, in some cases, even single-digit P/E ratios. These are well-managed businesses that have strong long-term growth prospects and are paying attractive and often growing dividends, and in our view they now look substantially undervalued.

“With valuations at these levels, we believe there’s an exceptional long-term opportunity for investors. In the meantime, the dividend income from these companies means we’re being well paid to wait.”

Can you highlight two companies you hold in the fund that you believe have strong long-term growth prospects and currently look significantly undervalued?

Ricardo

“Ricardo has been at the forefront of engine design for more than 100 years, but as the world moves away from the internal combustion engine it is repositioning itself as a global environmental and engineering consultancy. The new focus is on the transition to clean energy and a greener environment and we believe this is an attractive market.

“The company employs around 3,000 people and works with clients around the world including transport operators, manufacturers, energy companies, financial institutions and government agencies.

“CEO Graham Ritchie is targeting a doubling of profits within five years and dividends per share are forecast to grow at an annualised rate of 14% over the next three years. So, we’re expecting the dividend yield to show healthy growth from its current level of just over 2%. At the time of writing, the company is on a relatively undemanding P/E multiple of 12.9x estimated earnings for the year ending in June.

“Ricardo has a bold vision and is growing strongly. We believe the company has very attractive long-term prospects and there’s scope for considerable upside from here.”

Drax

“Power station operator Drax is another business undergoing significant change. In 2021, it ceased commercial operations at its last two remaining coal-powered sites, although these can be reactivated if needed in an emergency.

“Drax has transformed itself to become the UK’s largest generator of power from renewable sources including biomass and hydro. It has submitted plans to build a multi-billion-pound facility in North Yorkshire combining biomass power generation with carbon capture and storage. Drax plans to use this technology to achieve carbon-negative status by 2030.

“The company is highly cash generative, supporting an attractive dividend yield of 3-4% and earnings are forecast to grow at an annualised rate of 18% between now and 2025. Dividends per share have grown at an annualised rate of 10% over the past five years and that’s expected to rise to 12% this year. The company is on a P/E multiple of 9.4x estimated earnings for the current financial year.

“Drax is in the process of ambitious change and trading robustly. In our view this is a company with strong long-term growth potential that’s not reflected in its current valuation.”

Data source: Morningstar and Canaccord.

Sid Chand Lall 28/12/22

Risk Warnings
Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds. Our funds invest for the long-term and may not be appropriate for investors who plan to take money out within five years. The fund will be exposed to stock markets and market conditions can change rapidly. Prices can move irrationally and be affected unpredictably by diverse factors, including political and economic events. The fund invests in smaller companies which are typically riskier than larger, more established companies. Difficulty in trading may arise, resulting in a negative impact on your investment. The fund invests mainly in the UK therefore investments will be vulnerable to sentiment in that market which may strongly affect the value of the fund. In certain market conditions some assets may be less predictable than usual. This may make it harder to sell at a desired price and/or in a timely manner. All or part of the fees and expenses may be charged to the capital of the fund rather than being deducted from income. Future capital growth may be constrained as a result of this. Dividends paid by companies are not guaranteed and can be cancelled, which may impact the fund’s ability to deliver an income to investors.

Regulatory Information
This material is for distribution to professional and retail clients. It’s provided for general information purposes only and is not personal advice to anyone to invest in any fund or product. Information taken from trade and other sources is believed to be reliable, although we don’t represent this as accurate or complete and it shouldn’t be relied upon as such. Calls will be recorded for training and monitoring purposes.

Issued by Marlborough Investment Management Limited, authorised and regulated by the Financial Conduct Authority (reference number 115231). Registered office: PO BOX 1852 Lichfield, Staffordshire, England, WS13 8XU. Registered in England No. 01947598. Investment Fund Services Limited (IFSL) is the Authorised Corporate Director of the Fund. IFSL is registered in England No. 06110770 and is authorised and regulated by the Financial Conduct Authority. Registered office: Marlborough House, 59 Chorley New Road, Bolton, BL1 4QP. Copies of the Prospectus and Key Investor Information Documents are available from www.ifslfunds.com or can be requested as a paper copy by calling 0808 178 9321 or writing to IFSL at the registered office above. Source: FTSE www.ftserussell.com/legal/legal-disclaimer.