Schroder UK Mid Cap Fund (SCP) announced its annual results for the year ended 30 September 2023. The company’s NAV total return for the year was 17.6%, outperforming the benchmark which produced a total return of 13.6% over the year. The share price total return was 17.4% due to a very small widening of the discount of the share price to NAV.
Given the very challenging equity market and economic environment over the last twelve months the board takes the view that this was a very encouraging level of outperformance. Combined with the fact that the NAV of the trust has outperformed its benchmark in four of the last five years. The company also announced a 10% increase in its dividend to 5.5 pence per share.
Regarding the performance and the outlook, the managers commented:
“The year ended September 2023 yielded a welcome return to the long-term trend of outperformance for the company, with a positive, inflation-beating total return. That the UK market, particularly Mid-Caps, has had a difficult time, driven partly by bad PR (including incorrect GDP data from the ONS, which had masked the economy’s complete recovery from the COVID pandemic, corrected only in September), and partly by more stubborn than expected inflation and a return to interest rates last seen around the time of the Global Financial Crisis, is unlikely to be a topic of hot debate.
“Geopolitical risk has increased since we wrote our mid-year outlook, but this fact does not seem to have put much of a dent in the market’s confidence in the “Magnificent Seven”, which have streaked ahead on a cloud of AI (recall that by the end of the film, only three of the seven were still alive). We see opportunity in the fact that UK mid cap aggregate valuations are now sitting at a discount to where they started in autumn 2022. Most strikingly, they are on a discount to UK large caps, and the yield of the dividend payers in the Mid 250 index is now at an aggregate 5.3% for the 12 months ahead, vs 4.6% for the FTSE 100.
“Inflation is slowly, but mechanically, easing, and although interest rates are higher than we might have hoped a year ago, the Bank of England would appear to be showing a more dovish stance at this point. Our response, in this environment, is to stick to our strategy of choosing resilient businesses which can deliver high risk-adjusted returns with rising cash flows and earnings. We have maintained our focus on two categories of investment. First, those unique assets with scarcity value and franchise power that allow management teams to raise prices without noticeably impacting demand. We can logically expect to be able to buy more of these types of assets if the current indiscriminatory selloff continues.
“The other category (flex) takes in more cyclical businesses or industries that are undergoing some sort of change, or that might be at some form of a strategic crossroads. This could be industry consolidation, management change or supply retreating out of the market. As a result of this change, we believe these companies will deliver better returns on capital in the future, rewarding shareholders. Additionally, portfolio companies tend to be net cash, or to have low levels of debt. This is important as refinancing costs have increased sharply, hurting profitability, and increasing risks for equity holders. Our cautious approach has meant that, in aggregate, around 80% of our portfolio holdings are geared at 1.0x net debt: EBITDA or less2, which means that they are far less indebted than the aggregate of the underlying index. This also means that they are in a position to invest for growth, organic or acquired, to pay dividends (ordinary or special – we have had five portfolio companies pay special dividends this year) and/or to carry out share buybacks, where appropriate. Provided this activity can be done generating a return which beats the company’s opportunity cost of capital, shareholders will benefit.
“This year, fifteen of our fifty-two portfolio companies have carried out a share buyback programme and twelve programmes are ongoing at the time of writing. Companies such as asset manager Man Group ($1bn of shares bought back over 5 years) are typical of the cash generative business models which we favour in our portfolios. And what of M&A? It would seem that the prospect of more settled credit markets, together with eye catching valuations, has spurred acquirors into action post a summer lull, particularly in the small cap arena, with recent bids for property listings company On The Market, media company Kin & Carta and The Restaurant Group, the owner of Wagamama. After a protracted negotiation period, media mid cap Ascential has announced the disposal of two of its three business divisions, one to private equity and one to a US corporate. It seems logical to us that, if so many UK Mid Caps continue to be priced below their intrinsic value, we will see more bid approaches. We would like to remind readers that we are fishing in an attractive pond. In terms of the long-term potential of UK equities, we suggest that investors willing to look beyond the ongoing negative headlines will find the UK punches above its weight. This can be seen in terms of multi-baggers relative to the US and this is why the Benchmark has beaten the S&P 500 return over the 25 years to 30 September 2023, when measured in local currency. In US dollar terms, it has very nearly matched the popular US index. The Mid 250 is populated by multiple “unique” companies, with strong growth prospects, generating cash and delivering attractive returns on capital.
“As stock pickers, we are confident that the collective strength of our holdings’ balance sheets will continue to provide resilience in a challenging economic environment. We are sticking to our sell discipline, avoiding companies whose business models are in danger of being disrupted while seeking out companies which have the ability to reinvent themselves, or which might be the next mid cap disruptor.”
SCP : Impressive year for Schroder UK Mid Cap Fund