Insights

The Sevens – Magnificent vs Munificent

25th Jan 2024

Paul Marriage commentates on a continuing game of sevens between the UK’s niche players and the behemoths of the stock market.

Many investment processes try to find emerging businesses that are growing faster than their peers and exhibiting market leadership in the process. You could argue that global equity markets have been dominated by seven of them for some time and that it has worked handsomely. Our small cap process has this at its core as well – for the past 25 years we have been trying to find niche market leading businesses based and listed in the UK – using the not especially catchy moniker P3M to define them (Product, Market, Margin and Management).

In general, we would expect to pay a premium for this leadership and a global growth opportunity that comes with it. We would hope to make returns for investors by seeing this growth delivered – hopefully overdelivered – and hence the earnings multiple might expand. If you look at what has worked for us in the last twelve months, you will see that some of these businesses feature alongside their less differentiated but seemingly undervalued peers. These Value Opportunities, as we call them at Tellworth, generally play out and once the market has decided to pay a fair multiple for the businesses – maybe the market aggregate one – we should move on. In the case of our growthier leaders, we might reasonably expect an Andrex outcome – stronger for longer. A good example of this last year was Ashtead Technology, a leader in the provision of subsea kit to the builders and dismantlers of Energy infrastructure that was one of the few stars of the 2021 IPO crop.

We believe our portfolio has quite a robust cohort of these type of businesses, but you won’t find many of them in the NE frontier of our attribution charts for 2023. Why? I won’t be any more boring than I need to be on the persistent UK outflow headwinds and higher levels of risk aversion from historic buyers of UK SMIDs, but these are clearly factors. The other, perhaps simpler, explanation is that their attractions are not really being recognised in the general malaise and hence they have been lumped together with their slightly less spectacular peers in a ‘UK? Don’t bother’ basket. The chart below suggests this might be the case – while their leadership attributes have become no less attractive, the multiples they now trade on have steadily compressed. They could even be generously priced into an economic recovery, should it come to pass.

Source: Tellworth, Bloomberg, 24 January 2024

The Magnificent 7 are global leaders in large markets, they are liquid and loved. In short, they are everything that the Munificent 7*, our basket of UK small cap niche leaders, are not. Should the valuation gap be so high between these two groups? The big guys are closer to maturity, where growth will become more difficult, and the eyes of global regulators, if not politicians, are all over them. For the Munificent 7 these are not issues; they can still grow quickly and rerate at the same time. The comparison is a Bramley vs Cox’s apples one rather than a Braeburn vs Conference duke out.

Source: Tellworth, Bloomberg, 24 January 2024

So what is the catalyst? This is a question pretty much every client we meet wants answered and one where we probably leave them wanting. M&A is the most tangible evidence: UK valuations are proving more attractive to non-market participants than to fund managers. Fund managers probably welcome the liquidity, not least the performance boost that a 40-50% premium cash bid delivers. The buyers are paying multiples that are still discounted against long-term averages and, in the case of private equity buyers, smaller 100% equity funded deals appeal in the hope of cheaper refinancing in future years. Trade players can secure a niche market without years of risky investment to challenge the incumbent, or possibly even remove competition that’s just beginning to hurt them. You may not need to be too fussy in your stock selection if the UK becomes more appealing in 2024, but in the second half of the 2020s you might look back and say these were once-in-a-decade buying opportunities in exceptional businesses. The alternative is that the UK remains off the map but you sneak 40% anyway as the M&A Pacman munches its way down the list in short order. Or Ipswich Town/your team of choice (delete as appropriate) wins the Premier League/Rugby Premiership/Caribbean Premier League in 24/25 so you really couldn’t give a fig about the stock market anymore.

*Munificent 7 – our UK small cap niche leaders basket is made up of Gooch & Housego, Oxford Metrics, Volex, Renold, Gresham Technologies, Wilmington, XP Power

Magnificent 7 – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla

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