Go big or go home…

We are in a period of market transition, complex and elongated like the extended cycle that it follows but still a transition. Inflation will return, more meaningfully and for a more protracted period than consensus currently suggests, initially as the product of an inevitable post-pandemic mean reversion in economic activity, but I anticipate it will become more ingrained and insidious on fundamental grounds in the ensuing period. The initial phase will be ambiguous as we navigate the annualising of a pandemic characterised by stop-start economic activity. Then we will need to mind the “output” gap; once we have burned through this headroom in latent economic capacity, higher prices will be a factor of the real economy again – not an asset market dynamic only. In turn, central monetary policy will reverse engines; a move up in rates will be the catalyst for a change in investor orientation not the quantum of the move.

“A ship’s strength is not in its size, but in its ability to sail against the tide.”

Matshona Dhliwayo, author

 

A further transition the investment landscape will require in the achievement of acceptable returns will be a migration from ownership of the highly rated, predictable, global bond proxy to its smaller and more nimble listed alternatives – the UK being a market particularly rich in discounted opportunities of this kind. We can debate the drivers for the extreme UK underperformance and the current discount valuation, but general Brexit fatigue and specific Woodford-related damage to smaller, less liquid quoted names are two of the reasonably debate-free culprits. The title of this piece does not refer to the merits of absolute size but to the growth mindset. It is the smaller, more agile and growth-focused listed firms that will be at the vanguard of returns in the post-pandemic world, as was seen in the post-global financial crisis period. Given the onerous direct financial and general resource costs of maintaining a listing, the deployment of a growth strategy should be a given. As the following quote suggests, being in the right smaller company allows exposure to materially greater capital growth potential.

“Elephants don’t gallop.”

Jim Slater, author of The Zulu Principle (1992)

 

The lower floors of the UK stock market by size are now generally performing as the economy emerges from the pandemic, many constituents making new highs, and so commentators are beginning to suggest a reduction, if not an exit, from these investments. This in my view would be wrong; greater value remains here than elsewhere and the virtues will become clearer as economic activity gains momentum. There is the allure of double leverage through the delivery of growth in profit metrics and in turn the application of a higher valuation multiple to those profits. The greater opportunity in the small and less well researched company for this to be achieved endures. This is more the case now than for some time, as we enter year four of the impact of the implementation of the MiFID II directive, making the following historic quote from Jim Slater appear ever more applicable.

“Investment is essentially the arbitrage of ignorance.”

Jim Slater, author of The Zulu Principle (1992)

 

I make the point above that the direction in rates rather than their nominal value is key in the first instance, but it is worth noting the absolute levels in historical context, given their very depressed levels. This in turn should be considered with reference to the unprecedented liquidity picture and how long these conditions have prevailed. There will continue to be economic and interest rate cycles; it is dangerous to confuse a “longer cycle with the notion that there are no longer cycles”.  Without labouring the point, note the prevailing 17% rate in the 70s, as wage and energy inflation was rife, and the 5% rate in 2006, some 15 years ago. Q4 2017 saw the first upward revision in a decade BUT to a level of just a tenth of that of more than a decade earlier, a lowly 0.5% – and here we hover at a token, cosmetic 0.1% today.

What constitutes a “normalised” level in the current world has likely fallen a long way, but one imagines it will be a quantum higher than what we are subject to now. It should also not be forgotten that there remains an active debate about the requirement to deploy negative rates in the short term to combat the current economic malaise. Unlikely in my view, but it indicates the deep chasm between divergent views. I mention this to underscore how material an event a change in the path in rates would be, and in turn how material a reaction it might generate from investors.  

The importance of globalisation as a long duration factor in driving valuation metrics in global larger index constituents to elevated levels must be considered. Many beneficiaries are now industry leaders with influence on the global stage equivalent to that of nation states, further enhancing their valuation through complex and beneficial fiscal structures. These firms will be pressured in the scenario I suggest is unfolding, as the benefits of globalisation are tempered and, in some instances, reversed. As discount rates applied to these predictable long-dated profit streams increase, investor appetite to focus elsewhere will grow.

 

“I think there are some cases in the UK, particularly outside the largest companies in the UK, in some small-and mid-sized companies where the valuations are absolutely stunningly low.”

Gervais Williams, Premier Miton Fund Manager, December 2020

 

Brexit and the ongoing scrutiny of China as the currently accepted ground zero for Covid-19 are examples of a wider thematic, one of creeping regionalisation and greater national perspective. This change in focus is likely to be ever truer as technological disruption and speed of change magnify the need for flexibility. Smaller scale firms that implement timely and meaningful changes to their structure and orientation will be at a growing advantage, as the law of large numbers dictates. A dynamic approach to the short lead-time provision of new products, services and entry to new geographies will be most visible in meaningful accretion in the financial delivery of such a company. This is in stark contrast to global entities operating in saturated markets and trading on premium ratings. These are, as a group, facing greater fiscal scrutiny (US tabled legislation for tax harmonisation amongst other imminent risks) where many smaller companies will be benefiting from fiscal stimulus amongst broader support packages from their national and regional governments and agencies.

 Beyond the planning and execution of a business strategy to deliver the appropriate financial growth metrics, management need to marshal both their internal and external capital markets facing resource efficiently. They must ensure delivery of an investment message that is clear, consistent and efficiently directed to the right recipients. Investors seeking listed companies fitting specific criteria in an area of the market lacking in analytical coverage will need management to help them in their search by clearly demonstrating their credentials and suitability for consideration. Many managements are currently juggling with their inadvertent “self-exclusion” from the wider investable universe due to inappropriate or simply having no coherent and valid ESG policy, as an example. DP Advisory will facilitate this process, aiding in the formulation of a capital markets strategy, investment case and assisting engagement with targeted investors through the execution of an effective custom solution in a resource-efficient manner.  

 

Rich McGlashan

Director

DP Advisory

www.dpadvisory.co.uk

April 2021