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Strategic Equity Capital suffers from trickier markets and disappointing newsflow

Strategic Equity Capital, managed by Stuart Widdowson (pictured), has announced its annual results for the year ended 30 June 2016. During the period, the company provided an NAV total return of -8.7% and a share price total return of -22.4%. In comparison, the FTSE Small Cap Index declined by 3.7%. Richard Hills, the trust’s chairman, says that the declining NAV was caused by a combination of trickier markets as well as some disappointing portfolio newsflow. However, he also says that the manager has been active in working with other stakeholders to help stabilise the underperforming companies and some of the benefits of this work have already come through in the period. The additional share price underperformance reflects the fact that the company moved from trading at a significant premium to NAV to a c 10% discount at the end of the period. The chairman says that the discount widened suddenly in June as a result of low trading volumes during the market turmoil following the UK referendum result to leave the EU. The board say that it is continuing to monitor the discount to NAV that the company’s shares trade at and if this is at an unacceptable discount, over a sustained period in the future, it will consider what action to take including, inter alia, the re-introduction of tender offers.

SEC’s board is proposing to maintain a final dividend of 0.78p per Ordinary share for the year ended 30 June 2016 (0.78p in 2015). It says that this will necessitate using some of the Company’s distributable reserves in addition to the current year’s earnings.

In terms of performance, the managers say that the unanticipated result of the UK Referendum caused considerable market volatility and led to a significant depreciation of Sterling. They say that the FTSE 250 Index fell by 5.7% and the FTSE Small Cap Index fell by 3.7% over the period (total returns) and that, with many more domestically exposed companies than the FTSE 100 Index, these indices performed particularly badly in June following the UK Referendum result.

The managers say that their strategy of maintaining of a strong cash position and rebalancing the portfolio away from cyclical companies towards structural growth companies has proven to be well-founded. However, despite this the short-term NAV performance over the last year has been disappointing. They say that, whilst avoiding domestic cyclical companies has been the right decision, particularly in the aftermath of the UK Referendum, negative stock-specific issues at three portfolio companies have more than counterbalanced favourable overall positioning. They believe that the disappointing short-term performances experienced at Goals and Tribal over the period were largely management related and, in the case of Servelec, they believe that the profit warning issued in June was end market and customer related, leading to a delay in new business, rather than any structural weakness in the business or long-term deterioration of market opportunities or competitive position.

The top five contributors to performance were IFG Group, 4imprint Group, IDOX and Clinigen Group. IFG Grouo delivered a total shareholder return of 29% over the year. The managers say that this performance was driven by an earnings recovery in James Hay, its investment platform business. 4imprint Group delivered a total shareholder return of 23.9% over the year. The managers say that the group has continued to deliver organic sales and earnings growth of c.20% in US Dollars. IDOX, the provider of software to public sector organisations, was a new investment made in August 2015. The managers say that they fully exited the position in April 2016 following a re-rating which was faster than anticipated. And that the final tranche of shares were sold at a 40% premium to the purchase price and the investment generated an IRR of in excess of 90%. Vintage, the private equity fund of funds, delivered a positive return, driven by an increase in the valuations of the underlying funds, many of which are invested in overseas companies and have benefitted from the depreciation of Sterling. The managers say that Clinigen Group shares were volatile over the period. The shares began the period performing well as the market continued to react favourably to the complementary acquisition of IDIS. However, the shares de-rated in the second half of the period driven by market concerns over the achievability of the projected results for the year. However, the managers say that they became more comfortable about the company hitting projections and as a result increased the holding materially through the latter part of the financial year. The managers say that, outside of the top five contributors, OMG continued to perform well, with the shares delivering a total return of 12.5% over the period.

The top five detractors from performance were Goals Soccer Centres, Tribal Group, E2V Technologies, Servelec group and Tyman. Goals Soccer Centres released two disappointing trading updates in the first half of the period. as detailed in the half-yearly report. The managers say that the shares continued to de-rate materially between January and the end of March, despite trading being in line with revised expectations and they believe that this de-rating was driven by market concerns over the level of the company’s gearing. In early June, the company announced a well-supported placing of shares at close to the then prevailing share price. At the same time, the recently appointed executive chairman announced the results of his initial review of the business. The proceeds of the cash raised are being used for three purposes: to reduce gearing; accelerate a refresh of older pitches at some of the UK centres and modernise club houses; and fund the development of an additional site in the USA. The managers say that, since the beginning of 2016, the incoming chairman has overseen a wholesale refresh of the company’s board, with the appointment of a new CEO and new non-executive directors. The new executive chairman has set out a detailed strategic plan for the company to re-invigorate its customer proposition and its long-term financial performance.

Tribal Group was a considerable detractor to performance in the first part of the period, as detailed in the half-yearly report. However, there has been a significant improvement in performance in the second half of the period. The managers say that the new chairman and senior non-executive directors, appointed in November 2015, acted swiftly and decisively to stabilise the business.

The managers say that, after its stellar run in the previous year, E2V Technologies gave back some of its performance due to a de-rating of the shares. The managers believe that the market de-rated the shares relative to its broader peer group due to concerns (unwarranted in their view) about the working capital absorption during the year. However, the managers believe that this is temporary and should unwind during the current financial year. The managers say that, at the end of the period, the company’s shares appeared considerably undervalued relative to its peers and what they believe to be its intrinsic value.

In the middle of June, Servelec Group released a profit warning driven by a combination of unrelated bad news across all three of its trading divisions. The health and social care software business had been anticipating winning new business through the year and during 2017 and 2018 through the “North Refresh. However, in mid-June, the company was informed by the health authorities that this reprocurement would be delayed. At the same time, the company was informed by its major oil and gas client that it wished to delay the start of automating control and safety systems for two offshore production platforms. Although the company was told by both parties that the delays were timing issues, the directors decided to inform the market and profit guidance was reduced to remove all revenues from these activities from the forecasts, which led to a significant fall in forecasts and a further de-rating of the shares. SEC’s managers had been taking profits from March through to June, the fall in the share price had a significant negative impact on the NAV. The managers believe that the profit guidance has been reduced to an extremely conservative level and the medium to long-term balance of risk appears skewed to the upside. Tyman’s key North American residential market failed to grow at the pace of industry expectations during 2015, leading to lower than anticipated profits in the year. However, 2016 has started well. In addition, the company announced the acquisitions of Giesse and Bilco, to strengthen its product lines in the European and US commercial markets respectively. The managers say that, although the company’s earnings have benefitted from the translation of overseas earnings of late, as well as the enhancement from acquisitions, the shares have not performed well over the year.

In terms of outlook, the managers say that they continue to believe that the next year will see mixed trading from quoted companies. In their view, with many companies operating at close to peak margins, combined with a low growth macro environment, companies that cannot benefit from structural growth or significant margin improvement initiatives, are likely to find material, organic, constant currency earnings growth challenging. Alongside this, there are many macro and geopolitical factors for these companies to navigate.

However, the managers say that, whilst these factors influence broader market conditions, the financial and operational performance of portfolio companies and potential investments we consider are more likely to be influenced by decisions taken by their management teams and demand conditions in their individual markets. Within their target investment universe, the managers say that returns will be driven by three factors: earnings growth; rating changes (which will be impacted by the broader market as well as company specific factors); and M&A. They believe that the prospects for earnings growth of smaller companies are likely to vary considerably. Companies with low growth prospects, challenged business models and little scope to improve margins are likely to struggle to make headway. In comparison, smaller companies operating in niches which are growing and/or where their financial performance is relatively unaffected by the geopolitical and macro economic gyrations of the global economy, are likely to continue to perform well. The managers say that there are competing influences on ratings in our investment universe but that the prospects for M&A look better than for some time. The fall in Sterling has made UK assets much “cheaper” for overseas investors, particularly where those UK companies have significant overseas earnings and that trophy assets may attract suitors.

Strategic Equity Capital suffers from trickier markets and disappointing newsflow : SEC

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