Liontrust UK Smaller Companies Fund

• Speculation around possible fiscal changes in upcoming Autumn Statement has affected sentiment towards UK shares. 
• Positive catalysts could emerge in the form of pension market reform and/or further M&A activity; the Fund’s holding in Learning Technologies and Eckoh were targeted in Q3.
• Among company earnings updates, Cohort gave cause for optimism, but Next 15 Group fell heavily.

The Liontrust UK Smaller Companies Fund returned -4.4%* in Q3. The FTSE Small Cap (excluding investment trusts) Index comparator benchmark returned 6.2% and the average return of funds in the IA UK Smaller Companies sector, also a comparator benchmark, was -0.2%.

A solid quarterly gain for the FTSE All-Share hides a fair amount of volatility during August as investor sentiment first weakened due to softer-than-expected US employment data – undermining confidence in a soft economic landing and reviving recession fears – before swiftly recovering on a clear indication from the US Federal Reserve that it would cut rates in September.

While the delivery of 50 basis point cut in the US and a raft of stimulus measures in China buoyed global markets in September, the UK market was increasingly weighed down by policy uncertainty. The UK general election in July initially prompted enthusiasm at the prospect of greater political stability over the coming years, aided by the Labour government’s explicit agenda of driving economic growth. However, with the Autumn Statement approaching at the end of October and a negative slant to the rhetoric coming from the Treasury, concerns have been rising about the fine balance to be struck between resetting expectations but also avoiding a self-fulfilling spiral of negative sentiment weakening business confidence.

Very little has been trailed by the Chancellor about possible changes to the fiscal landscape ahead of the Autumn Statement, though speculation has been rife. Some, such as an increase to the rate of capital gains tax (CGT) or the removal of inheritance tax (IHT) exempt status on AIM-listed shares, have been met with concern. Without adding to speculation within the scope of this commentary, we maintain our passionate belief in the long-term advantages of investing in companies across the market cap scale with strong barriers to competition and high returns on capital, and that the quality of such businesses will ‘out’ over time. With extreme compression of valuation multiples of listed companies having occurred over the past few years – a dynamic felt most acutely at the small cap end of the size spectrum – our view is that any short-term disruption from the Autumn Statement should present an opportunity.

On the other hand, there is a growing optimism that a powerful positive catalyst to UK markets may emerge in the form of pension market reform. Much has been written about the potential for concrete policy initiatives to reverse decades-long flows out of UK equities from domestic pension funds, and any such move would undoubtedly send a strong signal that the UK recognises the vital importance of its capital markets to economic growth and prosperity.

We have also commented at length in recent reviews on the high prevalence of inbound takeover interest for UK stock market listed companies, given their attractive absolute and relative valuations. While it is frustrating to see long-term Fund holdings targeted in opportunistic fashion at share price premia which fall short of their full valuation potential, M&A may well be a key mechanism through which the significant undervaluation of UK equities is both highlighted and closed out.

On top of the approaches seen so far in 2024 for Mattioli Woods and Smart Metering Systems, Q3 saw Learning Technologies Group and Eckoh targeted.

A very opportunistic conditional approach for Learning Technologies Group (+12%) was tabled at 100p a share by US private equity vehicle General Atlantic during the month. We were amazed and dismayed that the board of LTG indicated they were “minded to recommend unanimously” at that level. Recent trading has undoubtedly been beset by short term headwinds due to the impact of macroeconomic pressures; nevertheless, LTG were keen to emphasise – as recently as in its interim results published just ten days prior to the approach being made public – that “the structural drivers of the learning and talent development market remain intact and support our belief that LTG will return to growth when market conditions improve”.

As an indication of just how uninspiring the mooted 100p price tag appears, an independent research note from Canaccord Genuity Quest – whose cash flow return on capital (CFROC) data is used explicitly within the second stage of the Economic Advantage investment process – indicated a fair value range of between 169p and 199p for the shares, using only modest growth and margin assumptions.

Its seems that Eckoh’s (+11%) board of directors shares our view on the undervaluation of UK equities, going so far as to appoint financial advisers back in March to explore a sale process due to its belief that the share price failed to reflect its prospects. This came to light in August as the provider of secure payment products and customer contact solutions responded to a rally in its share price by confirming that it had received an indicative offer form a private equity group of 54p per share.

The takeover of Mattioli Woods by private equity group Pollen Street Capital completed in September, so the position exited the portfolio.

Turning to company updates on trading, Next 15 Group (-42%) was a standout disappointment during the month, as it issued a shock September profit warning which was triggered by the loss of a significant contract and a softening of client spending from its technology sector customers in particular. As a result, it expects profits for the financial year to 31 January 2025 to be significantly below its prior expectations. The data-driven growth consultancy’s Mach49 agency lost its largest customer, which unexpectedly terminated a contract that had been expected to continue for a further two years. We have since engaged at length with the company to form a better understanding of the factors at play, as well as steps that will be taken to return the company to a solid trading footing.

Cohort (+28%) led the way among the Fund’s risers. News of a £135+ million contract with the Royal Navy (for supply of a trainable decoy launcher system) lifted shares in earlier this year. This strength has been maintained on the back of a number of smaller contract wins, a strong set of results – released in July – for the year to 30 April 2024, and a bullish AGM update in September.

A Q3 trading update from AJ Bell (+18%) revealed that customer numbers rose 5% over the quarter and 13% annually to 528,000. Assets under administration have risen 4% in the quarter and 20% over a year to £83.7 billion, following new inflows of £1.7 billion in Q3. Its direct customer business saw particularly strong customer growth of 7% in the quarter. AJ Bell attributed this rising investor confidence in light of good recent stock market performance, a trend which has also driven higher levels of dealing activity, especially for international securities. 

Focusrite (-31%) is a global music and audio products group that develops and markets proprietary hardware and software products used by audio professionals and amateur musicians. Its shares have been under some pressure recently due to some client destocking and other post-Covid headwinds. A trading update outlined that, while revenues for the year to 31 July will be in line with expectations at around £157 million, higher shipping and logistics costs (due to the Red Sea crisis and congestion in ports) have constrained EBITDA to £25 million, below expectations. Focusrite now expects higher shipping costs to persist into the new financial year.

A Q2 trading update from Robert Walters (-23%) showed a 12% constant currency fall in net fee income year- on-year, as the recruitment market continues to rebase following the post-pandemic spike in activity. The company commented that this dip in conditions is longer than it had expected, as macroeconomic turbulence and political uncertainty weighted on client and candidate confidence. Robert Walters now doesn’t expect a recovery until at least 2025.

Mortgage Advice Bureau (-22%) also slid over the quarter due to a combination of weaker investor sentiment and specific concerns over how the business might be impacted by the FCA’s proposed market study into the sale of protection products.  However, a half-year results release in late September prompted a partial recovery. Since August’s rate cut from the Bank of England, activity and adviser numbers have begun to pick up. The company expects significant refinancing activity in the second half of the year as well as a recovery in housing transaction. As a result, it has maintained its full-year financial guidance. Despite continuing volatility in the backdrop, we have been consistently impressed with the business’ ability to continue taking market share, with its share of new mortgage lending up to 8.2% at the half year.

The position in Franchise Brands was exited during the period. A combination of management team turnover and a levered balance sheet informed the decision to sell the holding.

We feel that there is currently a compelling opportunity for investors in UK shares. The UK is at a clear valuation discount to historic averages and measures of intrinsic value but there is the potential for government policy intervention (focused on pension fund domestic equity allocations in particular) to help turn the tide of investor sentiment and capital flows, which would be of particular benefit to smaller company valuations.

Whilst the re-rating potential of UK equities, small caps in particular, is significant, the timing and magnitude of the catalysts remains uncertain. In the meantime, we are optimistic about the portfolio’s ability to continue to deliver attractive compounding longer term investment returns supported by an attractive combination of earnings growth and increasingly shareholder yield (both dividend and share buybacks).

Positive contributors included:

Cohort (+28%), FRP Advisory (+20%), AJ Bell (+18%), Foresight Group (+14%), and Learning Technologies Group (+12%).

Negative contributors included:

Next 15 Group (-42%), Focusrite (-31%), Robert Walters (-23%), Fevertree Drinks (-23%) and Mortgage Advice Bureau (-22%).

Discrete years' performance** (%) to previous quarter-end:

*Source: Financial Express, as at 30.09.24, total return (net of fees and income reinvested), bid-to-bid, institutional class. **Source: Financial Express, as at 30.09.24, total return (net of fees and income reinvested), bid-to-bid, primary class.