Q&A: Marlborough Special Situations

Trying to anticipate exactly when a rebound will come is notoriously difficult, and attempts at market timing can prove costly. As the chart below illustrates, missing out on the best three months of performance by UK smaller companies over the past more than 35 years would have resulted in significantly lower returns. Those who remained invested went on to reap the benefits over the long term.

Missing market rebounds can seriously impact long-term returns

What is the investment philosophy behind Marlborough Special Situations and why is the fund in the Investment Association’s UK All Companies sector rather than UK Smaller Companies?

“We’re passionate believers in the long-term growth potential of smaller companies and our expertise lies in identifying which of these younger, faster-growing companies have the potential to develop into the success stories of tomorrow. If you look at the historic data, it shows clearly that smaller companies have outperformed larger ones over the long term – and we see no reason why this shouldn’t continue.

“There are a number of reasons quality smaller companies can outperform the corporate giants. They’re often highly innovative businesses, bringing ground-breaking new products and services to market. In addition, their size means they can be more agile, moving swiftly to seize on new business opportunities, and in many cases they’re niche players, with dominant positions in small but growing markets.

“For all these reasons, we’re firmly convinced of the superior growth potential of smaller companies and the bulk of our portfolio is in companies with a market cap below £1 billion. At the same time though, we’re strong believers in running our winners. When you’ve found a great business that’s going from strength to strength, we don’t see any logic in selling out just because it’s reached a specific market cap.

“Positioning our fund in the UK All Companies sector means we have greater freedom to run with these winners, while also enabling us to identify exceptional special situations among mid-cap and large-cap companies.

“One example of a business we’ve held for many years that’s grown into a much bigger company is airline and package holiday operator Jet2. It’s a FTSE 250 stock which now has a market cap of more than £2.5 billion. We believe it’s a great business with plenty more growth to come, so we’re very happy to stick with it.

“Another is Diploma, a supplier of specialised technical products and services to the life sciences sector and other industries. We first invested well over a decade ago when the market cap was
around £330m and today it’s approximately £3.5 billion.

“It’s important to stress though that we don’t become complacent or sentimental about these companies just because we’ve held them for years. We’re constantly reviewing the portfolio and every stock has to earn its place, otherwise we’ll replace it with a fresh opportunity.”

Performance of Numis Smaller Companies Index (excluding investment companies) and FTSE All-Share

Investment Growth 01/09/1992 - 28/02/2023

While long-term performance remains very strong, the fund lagged last year. Why was this?

“We didn’t hold any of the FTSE 100 oil, pharmaceutical or tobacco giants that outperformed in 2022 and inevitably this affected the fund’s relative performance in the IA UK All Companies sector.

“Meanwhile, the smaller companies we favour had a particularly challenging year, as they dealt with multiple headwinds: spiking inflation, rising interest rates, supply chain constraints, labour shortages and more subdued consumer demand.

“Smaller companies often have less diversified revenue streams and can be more sensitive to a slowdown. They’re viewed as riskier and investors tend to sell out of them in more challenging economic conditions. Small-cap shares can also be less liquid, because fewer people are buying and selling them. The effect of this is that when people start selling, share prices can fall pretty sharply
– which is what we’ve seen.

“Our fund was hit particularly hard because we have greater exposure to ‘growth’ companies – which tend to be on higher valuations because of their forecast future profits. Rising interest rates reduce the value of these future earnings, so the shares of many of these growth companies have dropped sharply. We’re also overweight technology companies, which have fallen out of favour.

Calendar year performance

“However, the reality is that the majority of the companies in our portfolio are continuing to trade strongly, and we believe they have very strong long-term growth prospects.

“In the past when the fund has experienced negative periods of performance, it’s bounced back with strong performance in subsequent years. There have been considerably more ‘up’ years than ‘down’ years – as illustrated in the graph above.”

After the market sell-off, UK smaller companies are now on significantly lower valuations. How have you responded to this?

“We believe the sharp sell-off in UK smaller companies has created a rare opportunity to buy outstanding businesses at significantly lower valuations.

“As the chart below shows, the P/E multiple for the Numis Smaller Companies Index excluding investment companies (NSCI XIC) has more than halved in the last year and is now only slightly higher than in 2009 when the world was still experiencing the aftermath of the Great Financial Crisis.

“If we look at small-cap P/E multiples relative to large caps then current valuations are at an even more pronounced discount. The NSCI XIC P/E multiple is at a discount of more than 30% to the FTSE All-Share (excluding investment companies). That’s rare and we don’t expect it to last forever.

“At an individual stock level, we’ve seen several examples of good quality smaller companies that were on P/E multiples of between 20x and 30x de-rate to half that figure.

“We’ve used the sell-off to add to a number of outstanding companies at significantly lower share prices. We believe that for investors taking a long-term view, the current level of valuations among UK smaller companies represents a genuinely exciting opportunity.”

Price/earnings ratio

You and your Co-Manager, Guy Feld, are supported by a large and experienced team. How many of you are there and how do you work together?

“We have a core team of five people working on the fund. That’s myself, Guy and three analysts, Tom Hutchinson, James Workman and Harry Evett. We all have different strengths. Guy, for example, has a huge amount of experience investing in technology companies, while I’m more of a generalist.

“We work very closely with the wider smaller companies investment team, so there are around 20 of us in all. We’re one of the largest and best-resourced small and mid-cap teams in the UK and we’re all in the same office, so there’s a constant exchange of ideas and analysis. We have a formal investment meeting every Tuesday, but the reality is we’re talking all the time.

“There’s a lot of experience within the team. Guy’s been investing in small and mid-caps for more than 30 years and I’ve been working as an analyst and fund manager for more than 17 years. Then you have people like Richard Hallett and Sid Chand Lall who both have a great deal of experience.

“We all have different perspectives and areas of expertise, and we work together collaboratively. The culture in the team is to challenge each other’s thinking in a constructive way, which helps us to avoid complacency or ‘groupthink’.

“The size of the team means we have the resources to conduct our own research to uncover opportunities that other investors haven’t yet identified in small and mid-cap companies, which tend to be under-researched compared with FTSE 100 stocks.

“We’ve calculated that we’ve met – face-to-face or virtually – close to 2,000 companies over the past 12 months. That means we have a pretty good finger on the pulse of UK PLC, from the mid-caps all the way down to the very smallest listed companies. It also means there aren’t many companies where we haven’t, at some stage, had a look under the bonnet.

“So, we have a large team with a wealth of experience investing in smaller companies, all working closely together to identify the most attractive opportunities. That’s how we add value for our investors.”

How would you characterise the investment outlook?

“Clearly, there are risks. We’re in the midst of one of the most rapid interest rate hiking cycles in history, which has come after a prolonged period when rates have been at historic lows. There’ll be a lag before we see the effects of higher rates on the real economy, so we’re still waiting to see how it plays out.

“Having said that, while we’re far from complacent, we are starting to see encouraging signs. Inflation may have peaked in the UK and the US, which is likely to mean we’re close to the top of the rate-hiking cycle. China reopening should also be a strong positive globally, although we’re still waiting to see the full impact of this come through.

“If the economic picture does begin to brighten, we’d expect smaller companies to lead the way in an environment of improving investor confidence. In the meantime, first-class companies are on P/E multiples that, in some instances, are half what they were a little over a year ago. We believe that, for investors taking a long-term view, this volatility has created a rare opportunity.”

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

“Cranswick is a leading UK food producer, supplying fresh pork, sausages, bacon, cooked meats, poultry and gourmet pastry products.

“The company counts most UK grocery retailers as customers and also has a strong presence in the ‘food-to-go’ sector. In addition, it has a rapidly growing export business serving Europe, the US and South-East Asia.

“We like Cranswick’s strategy of long-term reinvestment in the business, with this capital being deployed on acquisitions, expanding production facilities and diversifying into new areas.

“The company has proved itself a steady compounder, achieving annualised revenue growth of 10%, earnings-per-share growth of 11% and dividend growth of 11% (five-year compound annual growth rates to March 2022).

“It’s on a P/E multiple of 14.5x for estimated earnings to March 2024. This represents a 25% to 30% discount to the company’s 10-year median. The free cash flow yield is 4.5% and the dividend yield is 2.7%.

“We believe Cranswick is well positioned to continue its growth trajectory and the current valuation looks highly attractive for those taking a long-term view.”

“Coats is a world leader in the manufacture of threads and yarns used in a range of business sectors including apparel and footwear manufacturing, medical, automotive and other industrial markets.

“The company has earned a reputation for innovative, premium quality products, which it supplies to more than 40,000 businesses worldwide. This reputation has helped the company establish itself as a global market leader, with a market share of around 24%, and we believe it can continue to increase this over time.

“The company is targeting revenue growth of 6% per annum over the mid-term, which compares with historic growth of 4-5%. It is also targeting increased profitability, with a goal of improving EBIT margin to around 17% by 2024, compared to 14% in 2019.

“It’s trading on a P/E multiple of 11x estimated earnings to December 2023. This represents a 25% discount to the company’s 10-year median and we believe it’s a very interesting long-term opportunity.”

Eustace Santa Barbara
March 2023

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 will be exposed to smaller companies which are typically riskier than larger, more established companies. Difficulty in trading may arise, resulting in a negative impact on your investment. Shares in smaller companies may be harder to sell at a desired price and/or in a timely manner, especially in difficult market conditions. 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. In extreme market conditions redemptions in the underlying funds or the Fund itself may be deferred or suspended.

Regulatory Information
This material is for distribution to professional clients only and should not be distributed to or relied upon by any other persons. 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 Fund Manager 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