JPMorgan UK Smaller Companies (JMI) has announced its annual results for the financial year to 31st July 2022, which its chairman, Andrew Impey, describes as “disappointing”. Over the year, JMI’s NAV total return was -23.8% as compared to the Numis Smaller Companies plus AIM Index (excluding investment companies) which returned -16.0%. In addition, and in contrast to the previous year, the Company’s share price discount to NAV widened from 8.0% on 31st July 2021 to 11.0% on 31st July 2022. Whilst the Company’s peer group also experienced widening discounts, this nevertheless amplified the negative share price total return to shareholders which was -26.1%. The rotation away to growth in the face of rising inflation and interest rates, particularly in the aftermath of the invasion of Ukraine as energy costs ballooned, is identified as a key reason for JMI’s underperformance. The malaise has continued into the current financial year – since the year-end, the discount has widened to 16.6% (as at 12 October 2022) and the return on net assets was -15.9% compared to a decrease in the benchmark of -13.2% and the return to shareholders was -21.2%.
Managers’ comments on the portfolio
“A number of our largest positions continued to perform strongly, among them OSB (formerly known as OneSavings Bank), Alpha FX, Ergomed and Serica. OSB specialises in lending to professional landlords in the UK market, benefitting from rate increases and growing strongly through market share gains and refinancing activity. It has also initiated a buyback of shares as it has significant excess capital on its balance sheet. The high growth company Alpha FX, which provides currency solutions for corporates, has again outperformed market expectations and is continuing to expand its operations outside the UK. Ergomed, a provider of services to the pharmaceutical industry, continues to demonstrate its resilient business model and its expansion into the US is bearing fruit as pharmaceuticals continue to outsource specialist activities, while Serica, a North Sea gas producer, is a beneficiary of high gas prices and was also subject to a takeover approach.
“However, these successes were not enough to outweigh the detractors in the portfolio. These included Halfords, Reach, Victorian Plumbing, Luceco and Joules, all of which were exited in the year as the underlying performance of the businesses declined. The three retailers, Halfords (car parts and bicycles), Victorian Plumbing (bathroom related products) and Joules (clothing), suffered from poor sales and inventory issues. Luceco, a producer of LED bulbs and electrical accessories, faced difficult end markets as a supplier into the DIY chains. The national and regional news publisher Reach disappointed as its progress in expanding into digital media unexpectedly slowed, and in its traditional newspapers it suffered from rising newsprint costs.
“Additionally, the share prices of a few of our largest positions such as Future, Dunelm and Games Workshop declined precipitously as the market de-rated these consumer exposed names, despite a notable lack of earnings downgrades from company guidance. With hindsight, we were slow to react, as our analysis of the specific outcome for these individual companies was very much counter to the market perception. While we did reduce the sizing in these positions, the magnitude of the market de-ratings has led us to maintain holdings in the above names, given their current valuations and long-term prospects.
“That said, we have of course made a number of significant changes to the portfolio in 2022, given the dramatic change in outlook over the year for inflation, consumer confidence and interest rate expectations. Among the many changes to the portfolio, we have increased our energy exposure with new positions in Ashtead Technology (a recent IPO which provides subsea rental equipment to the global offshore energy sector), Hunting (oil services) and Energean (gas producer) and added to our holding in Serica (oil and gas producer). Other new additions include FRP Advisory Group (insolvency/debt advisory company) and H&T (pawn-broker), which should be well-positioned in these difficult economic times, and more defensive names such as Wilmington (professional services) and Telecom Plus (a utility provider). On the other side, we have significantly reduced our consumer exposure as the outlook has darkened. Among the exits from the portfolio are Saga, Marston’s, Moonpig, Curry’s, Rank and Restaurant Group.
“Overall as can be seen from a number of our sales in the year, we have significantly reduced our exposure to the UK consumer. However we also believe that a number of consumer-facing companies will weather the economic downturn well and continue to take market share; we strongly believe this is not reflected in their current share prices. We continue to remain overweight to the UK (and the USA), in underlying revenue terms, relative to our benchmark. We also reduced our gearing and paid down £10 million of our debt during the second half of the year as the economic backdrop deteriorated. In navigating these uncharted waters we have endeavoured to position the portfolio to have a balance between structural growth companies and cheap ‘recovery’ names; the portfolio compares favourably with the benchmark on all our key metrics, which will hopefully serve us well when market sentiment shifts.”
Managers’ comments on outlook
“As we write this report, we have a new Prime Minister. There are too many unanswered questions to enumerate at this time but it seems clear that her absolute priority is to help UK citizens and UK companies to deal with the energy price crisis, which would otherwise threaten to overwhelm many. Among the many things we do not know, key questions include: How long will energy costs remain elevated? How much will the proposed energy cap cost the UK? While it will lower inflation in the short term, will it prove of itself to be inflationary? When will the Russian war with Ukraine end? Will there be gas shortages in Europe and the UK this winter? How high will interest rates need to go? The answers to these questions will have a direct impact on the looming recession in the UK – small and short, or long and severe, as suggested by the recent Bank of England forecast.
“Our present view is that there is likely to be a recession in the UK in 2023. Currently, key metrics in the UK such as employment levels, PMIs (purchasing manager indices), the housing market and retail sales are all holding up to a greater or lesser extent – and indeed that is the message we are receiving from talking to our companies. However, both we and they are obviously aware of the many risks on the horizon. These include significantly higher interest rates, higher mortgage rates impacting the consumer and house prices, inflation remaining elevated for longer and the impact of sterling’s devaluation. But the key metric we are focusing on is inflation, and in particular a fall in core inflation. If this eventually starts to emerge, then we believe stock markets will start to rally. If history provides a reliable guide, markets will rally prior to the GDP data turning more positive.
“The last year has been a painful one for all investors. However, we believe that the structural drivers that have driven the superior performance in the small cap arena over longer time frames have not changed. Over the last many years we have seen periods of extreme volatility and drawdowns, such as we experienced during the Brexit referendum and the onset of COVID, and now once again in 2022, when the domestic UK market has fallen dramatically out of favour. These have proven historically to be very advantageous buying opportunities in this area of the market, and we do not believe this will prove to be different in this economically challenging time.”