Strategic Equity Capital has announced its final results for the year ended 30 June 2019, during which it beat its benchmark comfortably. During the year, the company provided positive NAV and share price total returns (2.2% and 4.8% respectively) while its benchmark fell by 8.6%. The chairman, Richard Hills, points out that this has been achieved against a backdrop of challenging financial markets.
Long term record of outperformance
SEC has delivered NAV total return per share of 34.7% over the past three years compared to a total return of 24.8% from its benchmark. The five-year NAV total return per share of 55.0% has exceeded the return from the benchmark by 24.7%. Importantly, all of which has been achieved without the use of gearing (SEC typically maintains a net cash position of around 5%).
Investment manager’s review – commentary on performance
Whilst the market declined over the past year, the NAV per share of the Company increased by 2.2% in total return terms. This builds on the strategy’s strong record of capital preservation. Over the past twelve months, the Company had a Morningstar upside capture ratio of 126.7 and a downside capture ratio of 54.7. This means that the portfolio generally ‘outperformed’ the ‘benchmark’ during periods of positive returns for the benchmark and also that it lost less than the benchmark in down markets.
Portfolio companies performed well demonstrating encouraging operational and strategic progress, with one or two exceptions. This was, in our view, only reflected to an extent in share price performance, and there were broad, often indiscriminate de-ratings across the market over the year. Whilst these have been closed to an extent through some specific re-rating, or by way of transaction, in many cases, ‘price’ hasn’t yet followed the ‘value’ of several portfolio holdings in our view.
Top 5 Contributors to Performance
Valuation at
year end Period attribution
Company £’000 (basis points)
IFG Group 7,695 387
4imprint 10,648 353
Ergomed 9,427 228
EMIS 8,622 192
Clinigen 11,070 102
IFG Group was subject to a takeover approach at a 46% premium by Epiris Private Equity in March 2019. This contributed 387 basis points over the year and benefited from material increases to our position in March 2017 and May 2018 at 132p and 123p, both at significant discounts to the 193p offer price. We have long believed the company to be undervalued as stated in our report last year; ‘Ongoing consolidation and an increasing incidence of listed peers in both the wealth management and platform industries demonstrate considerable valuation upside in our view.’ The investment had been frustrating over recent years owing to external market challenges and internal missteps. As such, it has absorbed considerable time and involved significant engagement with management and various members of the board of directors to achieve a desirable outcome for shareholders.
4imprint performed strongly. Organic growth and cash generation continued to be strong both in their core business and as a result of the investments made in the new marketing strategy. Earnings estimates were upgraded and the shares re-rated. Timely investments increasing our holding in the first half of 2018 amplified returns.
Ergomed was a new investment made in April 2018. As discussed in last year’s report, we anticipated a re-rating following the strategic shift to focus on the services side of the business. This occurred over the period alongside encouraging profit growth and cash generation. Weakness in the share price following delays in on-boarding clients allowed us to increase our holding early in the period at a very attractive share price. The company continues to trade well and has recently strengthened its management and board with some high profile appointments.
EMIS performed strongly in response to the long term strategy outlined by the CEO. The vision remains to integrate healthcare across care settings and to now deliver this over a cloud hosted platform. This should open up more revenue sources (public and private) and over time enable the company to generate higher operating margins. Alongside this, the return to organic growth and the company’s defensive and cash generative qualities drove a re-rating.
Clinigen performed well over the period with good growth in operating cash flow. The company utilised its balance sheet to undertake business and product investments in CSM, iQone and Proleukin. We believe this is sensible capital deployment as it further broadens the platform and increases the diversity of the business which should support future profit growth and cash generation.
Bottom 5 Contributors to Performance
Valuation at
year end Period attribution
Company £’000 (basis points)
Proactis 1,801 (464)
Tyman 11,211 (180)
Wilmington 10,793 (132)
Tribal 10,983 (109)
Equiniti 20,668 (100)
Proactis was the major disappointment. Ongoing growth and retention issues with the acquired Perfect Commerce business led to the company warning on profit expectations in February. Downgrades, combined with concerns over the balance sheet and institutional shareholder selling led to a very large de-rating. The developments were exceptionally disappointing given the apparent progress the business had made in other areas and the long term strategic opportunities we envisioned. We remain engaged with management, the board and other shareholders to determine the best route to value recovery. The company commenced a formal sales process post period end.
Tyman shares were weak largely, reflecting concerns over the company’s end markets. Along with other companies in the building products sector, Tyman was severely de-rated by c.25% from the same point a year ago (which accounted for the majority of the share price fall). Unlike many other companies with either material North American exposure or involved in similar industries, which have since re-rated, Tyman remains on a depressed valuation. We believe this is partially owing to new management being in place and the expectation of some downgrades at the interim results (which turned out to be modest and somewhat ‘priced in’). Furthermore additional concerns around leverage which is forecast to be slightly below 2x net debt to EBITDA are unfounded. Given the company’s cash generation, leading market position with a 40% share in North America and ability to extract value from consolidating a fragmented market, we believe Tyman has many of the characteristics private equity look for in an investment. We expect the valuation anomaly to close over time.
Wilmington saw its share price fall following a re-setting in expectations at its full year results. For a long time, the company has disappointed on organic growth and its go to market strategy. This, alongside questions around independence, was behind our recommendation to the company to find a new chairman and our introduction of Martin Morgan from DMGT. Alongside the chairman, a high quality CFO has been in place for a little over a year and a new CEO with relevant digital and business information experience has recently started. Despite challenging end markets, we believe the company has strong positions in attractive industries such as business risk and compliance and better operational and sales execution should improve the company’s growth profile. The very low valuation, c.11% GVQIM Cashflow Yield (see below) provides scope for significant re-rating.
Tribal underwent a de-rating which accounted for the majority of the share price fall. Whilst top line growth was, and is likely to remain modest, profitability and cash generation were strong. The well-liked CEO very sadly and suddenly passed away last summer. The company, along with others, has been subject to a potential legal claim from a software partner. The company will contest this as it believes it is unjustified. The company has a strong net cash position and is undertaking development to further enhance its leading position as a software provider to education institutions globally. We believe this will further improve its attractiveness as a strategic asset.
Shares in Equiniti remained out of favour. Trading has been positive. Full year results showed above market organic growth of c.7%, strong client retention, new customer wins and very good cash generation. Furthermore, the company has fully separated from Wells Fargo and we expect the significant growth opportunity in North America to materialise over the coming years. Negative sentiment remains around the support services sector, companies which have leverage and those which have undertaken large M&A and have a degree of exceptional costs in their accounts. We believe these concerns should subside over time as features of the business model and its defensive qualities come to the forefront. The company, previously owned by private equity (with far higher leverage) is trading at a significant discount to transactions of similar businesses which have occurred over recent years and is far too lowly rated in our view.
The average cash balance held by the Company was 7.5% of net assets over the period. The approach of the Investment Manager is one of no gearing and to retain sufficient cash to enable the ability to participate in liquidity events without being a forced seller of existing holdings. Peak to trough, the FTSE Small Cap ex Investment Trust Total Return Index moved by almost 17% (FTSE AIM All-Share Total Return Index by almost 24%) over the past twelve months illustrating the extreme volatility in equity markets. With markets likely to remain volatile, driven by low liquidity and a focus on short termism, we retain a cash balance to take advantage as opportunities arise. Our approach is patient. The ending net cash balance was 8.4% of net assets in line with historical average cash held.
Investment manager’s review – commentary on dealing activity
“Turnover was low also in line with our investment philosophy. Disposals netted £35.8m (excluding distributions from unquoted investments) representing 22% of the weighted average NAV. In addition, £0.3m of net distributions were received from unquoted investments. Purchases of £28.5m were made, representing 17% of the weighted average NAV.
Partial realisations were made in IFG Group (£12.1m) at a discount of less than 2% to the takeover bid price. Following the approach, the position accounted for over 12% of the NAV and we sought to book some of the consideration ahead of completion.
Positions in 4imprint (£6.8m) and EMIS (£6.4m) were trimmed. Whilst both companies are very high quality with good momentum in their businesses, a strong combination of growth and cash flow, given the re-ratings over the period, we took advantage of the liquidity available in both. We also sold shares in Tribal (£2.7m) on share price strength early in the period.
Investments were made both in new holdings and the existing portfolio. In terms of new holdings, an investment was made in Strix (£2.6m). Strix is the global market leader in the design and manufacture of safety controls used in kettles and other water heating devices. In addition, the company has a growing water filtration business. The company is highly cash generative making healthy margins based on their intellectual property and superior manufacturing techniques. The end markets are stable and growing modestly. Cash generation from its core markets can be redeployed into new product development with greater scope for market share gains. Since listing two years ago the company has halved its net debt position whilst paying a well covered mid single digit yielding dividend.
We initiated an investment in Eckoh (£1.3m). Eckoh is a provider of secure payment and customer contact solutions large corporate contact centres. It is IP rich, offering patented PCI compliant solutions enabling card payments to be taken securely over the phone, reducing potential for card fraud or theft of customer data. This niche is growing with regulatory drivers like GDPR increasing the burden of firms to ensure systems compliance. The company is a UK market leader, with a significant opportunity in an unpenetrated North American market and has made encouraging progress in this new market. The financial characteristics are attractive with a high degree of recurring revenue and excellent cash generation. Changes in IFRS15 had a short term impact and put the shares under pressure, although effectively result in a highly conservative recognition of revenues relative to cash flows received. This provided an opportunity to initiate a holding.
We invested in JTC (£1.3m), a global provider of administration services to trust, corporate and private clients. Growth in profitability and cash flow is driven by an increase in outsourcing of specialist administration services to external providers and a proliferation of the formation of alternative, multi-jurisdictional fund structures. Solid growth, visibility and cash generation has seen private equity activity in this sector at attractive ratings.
Among existing holdings, significant capital was redeployed into Equiniti (£7.8m). For a stable, ‘boring’ business, the share price can be extremely volatile. This presented opportunities to acquire, what we believe, is a far improved company at a discounted valuation. Furthermore, following a material realisation in Alliance Pharma last year, we bought some shares back (£3.2m) following a de-rating over the summer. The fall in the price resulted from the company announcing additional investment in infrastructure addressing regulatory requirements and also some lumpiness in sales. At an elevated rating, this caused a steep fall in the share price. Additionally, we built up our position in Ergomed (£1.6m) following some delays in client on-boarding.”
Investment manager’s review – commentary on outlook
The broader market view is one of nervousness; global political and economic (trade) relations remain fractious and macro-economic data is softening. This is filtering through into weakening business sentiment and reflected in companies warning on profits. This has, in part, contributed to a period of underperformance for smaller companies recently, as they are generally viewed as riskier, more domestically focussed and, with the changes brought around by MiFID II, less well researched and more illiquid.
“Liquidity has been very poor in smaller companies with over £400m cumulatively withdrawn from UK Smaller Companies open-ended funds in the last three months according to the Investment Association. This is significant at around three percent of total assets in the space. This is further depressing smaller company share prices and favours a closed-ended strategy with a long-term investment approach.
Further, we don’t believe the above generalisation of small caps is apt for the portfolio. In our view, much of the portfolio is characterised by quality features, such as high recurring revenue (e.g. Equiniti, EMIS and Ergomed), limited exposure to economic cycles (e.g. Alliance Pharma, Medica, Tribal) and financial security (almost half of investee companies have net cash balance sheets).
This trepidation has created opportunities. Conditions are ripe for Private Equity activity. Valuations are low, financing is generationally cheap and there is significant dry powder; $2.5 trillion globally according to Preqin; the alternative asset industry data provider. This is evidenced, in part, through an increase in takeover activity in the UK. The Company has benefitted more recently in the take-privates of IFG Group and Servelec.
According to Preqin, investors view small to mid-market buyout funds as presenting the best opportunities. We believe the portfolio’s characteristics with a strong combination of structural growth and cash flow, in many cases trading at a material discount to precedent transaction multiples, position the portfolio well to continue to benefit from this trend.”
Glad to see this trust performing again