Rockwood Strategic (RKW) has published its annual results for the year ended 31 March 2024, during which it provided an NAV and share price total returns of 5.1% and 15.4% respectively, which it says compares to an increase in the FTSE Small Cap (ex-ITs) index of 7.1% and a fall in the AIM All-Share Index of 8.6%. Despite the NAV underperformance of the indices, RKW’s chairman, Noel Lamb, describes it as a successful year, achieved against challenging UK equity market conditions, adding that RKW’s stock-specific driven approach has shown that positive returns are possible despite negative macroeconomic and market conditions or wider geo-political developments.
RKW’s management fees were charged at a fixed fee of £120,000 per annum whilst its assets were below £60m, but have recently exceeded this level, due to sustained absolute performance and new issuance, and so have switched to 1.0% per annum under the terms of the investment management agreement (this is below the previous manager’s fee level of 1.5%), although the hurdle for a performance fee was not met.
Portfolio activity and developments
Six new holdings were added during the year and Lamb says that a number of positive outcomes from ‘constructive engagement’ in existing investments were achieved. He adds that, of the 20 companies in the portfolio, 15 have been initiated since 2022 and, with a three- to five-year typical investment thesis, RKW’s board anticipates a fruitful period ahead. Shareholder value realisation is expected as operational turnarounds are delivered, strategic initiatives actioned and RKW’s investments mature under new or evolved management and boards.
Lamb says that RKW’s board and manager share the view that the UK small companies market continues to provide a significant investment opportunity, due to the inefficient pricing of poorly researched or misunderstood companies trading at historically low valuations, further depressed by industry outflow driven selling.
Premium rating has allowed share issuance
During the first half of the year, shareholders approved a 10 for 1 stock split which is expected to improve liquidity. RKW’s shares have been trading at a 1.9% premium to NAV, unwinding last year’s closing discount of 7.1%, which has allowed the trust to issue £11.5m worth of new shares. Issuance accelerated during the year and RKW has reached its 20.0% rolling annual limit. Lamb says that this is no mean feat given 34 months of consecutive monthly UK fund outflows at a sector level and the general level of sentiment towards UK equities, illustrated by the almost entire absence of IPOs, during the period.
Returning to dividend payment
The portfolio has generated good income though, including receiving two special dividends, and RKW will thus return to the dividend list in a modest way with a 0.6p final payment. However, until RKW has gained greater scale, it will retain the maximum capital allowable to maximise the compounding of NAV growth.
Investment manager’s comments on market backdrop
“This was yet another challenging period for UK small company investors with material mood swings through the year and rising media coverage about a weakening domestic capital market environment. With a moribund lack of new issues, sustained retail outflows from UK funds, a stagnant (at best) economy and interest rates rising a further 1.0% to 5.25%, the highest for 15 years, it is not surprising sentiment has been weak. CPI inflation started the year at an annual rate of 8.9%. The contrast has been exceptionally strong stock market performances from US household name technology companies; Amazon, Google (Meta), Microsoft and Apple alongside the phenomenon which is Nvidia. These stocks are freely available to purchase now for the average individual investor, ‘benchmark chasing’ fund manager and ‘non-thinking’ tracker or ETF fund. It is not difficult to see how a ‘broken’ UK narrative is leading to shunned domestic investment and the alternative attractions of momentum and Ai. John Templeton’s great insight into markets, though, springs to mind: “Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy”. How might this statement be applied to the ‘Magnificent 7’ and UK small cap equities?
“What should cheer everyone up? Or maybe, more importantly, what could stop the selling, or, we dare to ask, support the buying of UK equities, particularly small ones? The positive market backdrop factors appear to be as follows: The UK inflation rate has been consistently falling, to lower than half the rate a year ago. It appears on track now for the approximate target Bank of England rate and thus interest rates should start to fall during the next year. Unemployment is near multi-decade lows at 3.9% and consumer confidence in increasing, unsurprisingly when real income growth has turned positive. Market M&A is building as professional external parties, both trade buyers and private equity act on opportunities within the UK market, signalling value. Sceptics will chuckle, but the announcement of the Mansion House reforms, where a number of huge asset managers committed to increased UK investment, including the AIM and the creation of a British ISA, do imply politicians are now conscious that help is needed to stimulate demand for small listed equities. Indeed, without them the country will not end up with medium sized or large ones. These are, modest steps and will take time to impact investor flows, but are a good base to build upon from a policy direction perspective.
“The other key aspects of the market backdrop remain a robust US economy, creating headwinds for the timing of a reduction in their interest rates and a weak Chinese economy, where the effects of poor capital investment and lending discipline are unwinding. High profile conflicts in Ukraine and the Middle East have increased ‘tail-risks’, which when combined with Central Bank buying and anticipation of looser monetary policy, have provided support for Gold. Housing and property markets are weak as they adjust to higher interest rates and tighter credit markets.”
Investment manager’s comments on outlook
“We have provided a ‘market-backdrop’ section above, but as we have previously stated, over the medium-term, market factors will not be the primary determinant of Rockwood’s returns, it will be stock-specific risk and return. In this regard, we would express strong confidence in the portfolio. This is predicated on three contributing factors:
- Firstly the current valuations of our holdings are materially below our estimate of their combined intrinsic value. Low starting valuations are critical to future positive returns.
- Secondly, and rather frustratingly, a number of our investments have fallen in price during the year despite their fundamentals actually improving or management and Board evolutions having been completed. In essence, these stocks are on track with our medium-term theses, indeed further up the maturity curve towards shareholder value delivery, yet the current malaise in markets has led to lower prices than a year ago. Our experience suggests this will be a temporary dislocation.
- Thirdly, during the year we deployed a material amount of capital into new holdings. This has been even more than we anticipated at the start of the year when the proceeds from the Crestchic takeover had increased cash to 21.1% of NAV: We have had a number of takeover bids in the year, validating our approach to identifying unrecognised value, which has also been re-invested. We have also had the proceeds of new issuance to invest. Cumulatively this has meant we have been able to buy more of our maturing investments at favourable prices and also we have, in a buyer’s market, been able to purchase 6 new investments, all of which we target at least 100.0% upside, and represented 24.0% of the portfolio at period end.
“An understanding of the maturity stage of the portfolio holdings is paramount to the confidence which underpins our view of the future NAV growth opportunity. To simply illustrate, Flowtech Fluidpower’s new management team is now fully in place with initiatives to improve returns underway. In 2023 they generated 5.3% operating margins. Management are targeting “mid-teens”. At RM, their new strategy and cost savings were unveiled by the new management team, in which they stated their new goal to quintuple 2023 EBITDA. At Trifast the operating margin in the year to March 2024 is expected to be c.5.0%. The company target is 10.0%, re-committed to by the new management team. All three stocks fell in value during the period. We bought more of all three stocks. During the year our proposed candidate for the Board was appointed to RM and Nick Mills of Harwood joined the Board of Trifast. “Already, Jamie Brooke of the Rockwood Investment Advisory Group is on the Board of Flowtech Fluidpower. The main virtue required now is patience. Material profit recovery is likely at all of these key holdings above, alongside many others.
“Overall, the portfolio holdings are well-financed with strong balance sheets in almost all cases, or are de-leveraging quickly in the remainder. We finished the year with £3.9m of net current assets, 6.1% of NAV. We expect a hasty reversal of negative sentiment when interest rates start falling. Our pipeline of new investments remains busy with due diligence finished on some, where we wait patiently for an optimised entry point and is on-going on others, where we feel no rush to execute until we have sufficient clarity on the ‘margin of safety’.
“We expect the pickup in trade buyer acquisition activity and public-to-private transactions to accelerate in the coming years for our targeted part of the UK stock market. If the stock market doesn’t fairly value or provide growth capital to UK listed small companies then alternative solutions for shareholders will emerge. This dynamic should deliver material, absolute NAV growth for the current portfolio holdings as it did during the year. Whilst a dead IPO market is not ‘re-populating’ the UK market, we expect this to eventually pick up again as broader confidence improves.
“We ended with 7 ‘Core’ holdings and 12 ‘Springboard Opportunities’ with the top ten holdings accounting for almost the same as the prior year end at 64.3% of NAV.”