BlackRock Smaller Companies Trust plc

00:00:19:24 - 00:00:37:15

Unknown

So let's start here. This is not the slide I expected to be presenting this morning to an extent. As you can see, there is an empty space sitting beneath my name. Dan Whitestone has announced that he is leaving the firm and he is looking for pastures new. And to look at the next stage of his career. I think it's important to address this at the start.

00:00:37:21 - 00:01:00:22

Unknown

It is disappointing to see Dan move on from both a professional and a personal level. I've worked with Dan for 20 years and he is definitely going to be missed. It's like a funeral eulogy. He is definitely going to be missed, but I think it is worth highlighting that this does happen in this industry. In my time at this firm, we've had Richard Placket retire, we've had Ralph Cox retire, we've had Mike Prentice retire and now we have Dan leave the firm.

00:01:00:25 - 00:01:24:10

Unknown

These people are irreplaceable in some ways and replaceable in others. And we have a team around us that is strong, that is well experienced in both UK small and mid and global, small and mid-cap. And we will hire resource to fill the gap. So things will be different going forward, but things won't necessarily be any worse. So I think it is important to say that right at the start.

00:01:24:13 - 00:01:41:28

Unknown

We've obviously just conducted the transaction and the merger. And so for some of you. This will be new. The Throgmorton holders haven't been to a BlackRock Smaller Company meetings before. And for those from BlackRock Smaller Company investors some of this will be very very similar. But there are definitely new elements. So I think it's important to start with what's the same.

00:01:42:00 - 00:02:04:16

Unknown

The investment process is not changing. BlackRock Smaller Company holders will know this slide. We have used this in presentation decks for probably the last decade. The fundamentals of what we do. The belief in the philosophy, the quality growth, bottom up investment process that we have is unchanged by the changes that we've made in merging the portfolio in terms of company meetings.

00:02:04:19 - 00:02:27:08

Unknown

No change expected. Yes, there is one fewer fund manager at the moment, but there is also a world where we have more resource at our fingertips. The likes of AI make meetings different, the likes of Teams and Zoom. We can do more of them at our desks. We never had meetings with only one fund manager. Went to those meetings anyway, and the meetings are the bedrock of the process, and we will continue to do as many as we have done before and for research.

00:02:27:09 - 00:02:53:02

Unknown

Again, things like AI, like AlphaSense, like Visible Alpha. These are tools we have at our disposal, means the research process is not diminished by what has happened in the last 24 hours. Importantly, what we believe is still exactly the same. We believe in finding businesses that are run by strong, dependable management teams, well-capitalized businesses with strong underlying cash flows that demonstrate organic growth through their market leading positions.

00:02:53:04 - 00:03:23:06

Unknown

That is unchanged. That is the core of the process and that will remain the core, the process. Now, I'm sure I've said to you before that the flip side of this, looking at these investment philosophy, the flip side is the saying, well, we're looking for poorly invested businesses with liar management teams that are terrible market positions. This is not necessarily revolutionary in what we do, but we do believe that in UK small and mid-cap investing, identifying companies with these five criteria is core to long term success, and we will be sticking with this process.

00:03:23:08 - 00:03:46:02

Unknown

So what is new under the merger? Well, the main difference is the international allocation. This is a tool that Throgmorton used historically, the ability to invest up to 15% of the portfolio in international small cap and medium sized businesses. Why should we add this? What does it do? What does it add to the portfolio? Why are we keen to keep it?

00:03:46:03 - 00:04:07:18

Unknown

Well, ultimately, the dynamics of global small cap investing are very similar to the dynamics of UK small and mid-cap investing. But the potential to add uncorrelated alpha in areas of the market that you cannot get exposure to in the UK is a very, very powerful tool. In the long run as in the UK, global small and mid-cap companies outperform large cap companies.

00:04:07:22 - 00:04:25:01

Unknown

The market structure says the same inefficiencies that we see in the UK in terms of the depth of analyst coverage, how well known these companies are, the further down the market cap spectrum you sit, the fewer people look at use of price. Discovery is very different, and the hidden gem potential again is the same as we see in the UK.

00:04:25:08 - 00:04:49:01

Unknown

But the benchmark looks very different and well, the universe looks very different in the UK under the Deutsche Numis benchmark. There are 931 companies in global small cap. There are 4,000. It's a very different opportunity set. The average waiting in the UK index is 11 basis points. The average waiting in the global index is three basis points. There's just a wider proliferation of companies, a bigger set that we can that we can look at.

00:04:49:01 - 00:05:00:21

Unknown

And the top ten in our universe here, the top ten are 10% of the benchmark for the global index, the top 10 or 4% of the benchmark and half of that 2% is SanDisk. In one company.

00:05:00:24 - 00:05:20:02

Unknown

So what has it added? Well, here it is. Here's the straight figures. In the time that the international portfolio was in Throgmorton, in the eight years that they had it, international generated positive return in five out of those eight years. So that doesn't sound like a great hit rate. But then you look at the return, the actual return on capital dedicated to to international within that portfolio.

00:05:20:02 - 00:05:38:00

Unknown

And the average return on capital over that period was 14% for the funds that we allocated to international shares. That compares to about 3% for what's happened in the UK over the last eight years. So there are true excess returns that we can gain through this part of the market.

00:05:38:02 - 00:05:56:06

Unknown

And I think it's worth dwelling on what sort of thing we look at, what the what the process is, and we kind of split this into two sides. The question we get asked is how can a UK small and mid-cap team, or UK small and mid-cap manager possibly identify the companies that sit in this larger, wider universe? Well, firstly, I'm going to point to Matt.

00:05:56:06 - 00:06:14:21

Unknown

That is clearly going to be his responsibility going forward and Matt is a global manager. This is the universe that he looks at. I think secondly, importantly, we are leveraging the skills and the research that we already do in the UK. And to draw out a couple of examples, LPL Financial Holdings, which is a US domestic wealth platform.

00:06:14:24 - 00:06:46:24

Unknown

The reason why we stumbled across this was the work that we did in IntegraFin and AJ Bell in the UK. The well-known platform businesses here. LPL does a similar thing in the US, but the market is absolutely enormous. Clearly it's the biggest wealth management market in the world. And so having the ability to use the research we've done in the UK that identified a candidate in the US made it a sensible position to put within the portfolio SPX technologies, very similar research to the research that we did on Spirax Sarco in the UK.

00:06:46:27 - 00:07:08:02

Unknown

SPX is HVAC and detection business. It has the IP that sits around cooling towers in the US. It has a strong repeat business on an installed base exactly the same as Spirax Sarco. So, leveraging the research process we have in the UK means we can draw out results from international and global holdings. But perhaps more excitingly, are the ones on the right hand side.

00:07:08:04 - 00:07:29:21

Unknown

These are the categories where we simply cannot get exposure in the UK. We all know the performance of stocks this year related to data centres, to semiconductors, to memory. Those stocks simply do not exist in the UK market, in any scale or in any liquidity. And yet we can buy stocks like Advanced Energy, like Rambus in the US that give us those exposures.

00:07:29:24 - 00:07:42:13

Unknown

So we believe that this international element that we will try to keep around 10% of the portfolio, is a valuable tool in portfolio construction going forward and will be a valuable driver of returns.

00:07:42:15 - 00:07:57:08

Unknown

So to move on to the current portfolio, the chart here shows the annual performance and is disappointing once again to be talking about a year of underperformance. And I will talk about the factors why.

00:07:57:10 - 00:08:27:26

Unknown

The same dynamics that I've been talking about for the last 2 or 3 years on this lectern have continued for another year. The underperformance of growth, the outperformance of value, the outperformance of large cap, the underperformance of mid-cap, the same dynamics, the liquidity, the outflows that sit within the UK market have continued for another year. And we'll talk about some of them individually, but I think it's worthwhile just dwelling on the actual attribution of the portfolio and looking at some of the names that have driven both under and outperformance on both sides of the balance sheet.

00:08:28:03 - 00:08:48:07

Unknown

When we look at the underperformers, as we obviously have to do in a year where performance has struggled, it is telling that when we look at those bottom ten names, actually most of them haven't had issues in terms of their earnings. The biggest negative contribution the portfolio has had this year is XPS Pensions Group, and XPS has hit every number that is set before it.

00:08:48:08 - 00:09:06:18

Unknown

Bakkavor was acquired and we didn't own Bakkavor. We do own Greencore, the business that acquired it, and we haven't necessarily seen that offsetting performance. Bloomsbury Publishing had a very small downgrade during the course of the year that caused the shares to fall. It has had a small upgrade this year and the shares are back to the level they were before this fall.

00:09:06:19 - 00:09:34:04

Unknown

There is outside response to minor earnings changes. The first actual disappointing business we've had last year was Treatt. So in that bottom ten it's the fourth bottom was the first one that actually had an earnings problem or an earnings miss that justifies the share price reaction that we've seen. Alpha Financial caught up in the AI “sasapocalypse” trend but Alpha again not missed a number, Goodwin performed well.

00:09:34:04 - 00:09:58:14

Unknown

We didn't own it. FRP has hit every number set on it last year. The trend is exactly the same as we have seen historically. Businesses delivering but not seeing it in this share price performance. And on the flip side, we're not getting the outperformance from those ideas either. The businesses that are delivering and beating numbers are not seeing the excess share price performance that we would expect to see.

00:09:58:16 - 00:10:17:07

Unknown

And you can see from the three months to date at the start of this financial year, something very similar. The worst performer we have is Greencore. To be absolutely clear, Greencore hit its numbers. It met its expectations. It's just completed the acquisition of Bakkavor, we as fund managers were not expecting Greencore to increase its earnings forecasts at this point of the year.

00:10:17:07 - 00:10:31:14

Unknown

So soon after doing the largest acquisition that it's ever done. It has not had time to bed that acquisition in. Yet the shares fell 20% on the day of results. These sort of outsized returns continue to happen.

00:10:31:16 - 00:11:04:06

Unknown

And so to the market environment, what is driving this strange phenomenon that we are continuing to see in terms of the share price reactions to our companies? Well, the first is this value growth dynamic. The market remains in a very pro value negative growth mentality, and that has continued through the course of this year. This is a process of period that started its interest rate cycles normalised back in 2020 2021.

00:11:04:08 - 00:11:24:03

Unknown

And the terrible underperformance of small and mid-cap continues. This chart is showing FTSE250, but it's exactly the same if you look at the Numis Smaller  Companies or you look at the small cap benchmark, this is the longest and deepest period of underperformance of small and mid-cap shares versus large cap that we have seen in. I keep saying recent history, but here we go back to 1980.

00:11:24:03 - 00:11:44:08

Unknown

So we're talking about the best part of 50 years now. We have not seen a market condition like this for some time. And we do believe and continue to believe in the dynamics and the growth opportunities that sit within small and medium sized businesses. And we do continue to struggle to see the growth opportunities that sit within many large cap businesses within the UK.

00:11:44:08 - 00:12:14:09

Unknown

So at some point we do expect to see this phenomenon change. But ultimately, this is the chart that continues to drive the UK small and mid-cap market. For whatever reason, people like myself standing on lecterns just like this cannot persuade people like yourself, sitting in rooms watching us to buy the UK small and mid-cap market. There may be fundamental reasons for that, but the outflows continue for this sector and the outflows continue at exactly the same pace they have done for the last few years.

00:12:14:09 - 00:12:42:00

Unknown

Despite the fact that the sector is getting smaller, the absolute numbers are staying the same. So actually people are accelerating the pace with which they are selling UK small and mid-cap holdings. And until this changes, the market dynamics in the UK are not going to change. And one of those market dynamics is valuation. Categorically, when we look across sectors, when we look across markets, this is a phenomenon for small and mid across the globe, not just the UK, but it feels particularly pronounced in the UK.

00:12:42:02 - 00:13:08:07

Unknown

Small and mid is trading at valuation levels that remain attractive valuation levels that really they haven't seen since global financial crisis, Brexit, European debt crisis type levels and whilst the UK political outlooks I'm sure there'll be some questions on later may not be the rosiest it's ever been. We are not in a global financial crisis type market. That is not what the valuations of these companies are telling us.

00:13:08:09 - 00:13:27:10

Unknown

But for me, when looking at the years performance, this is the slide that really sums it up. As a fund manager, what do we look for? Well we look for companies that meet our five criteria that we laid out at the start. The quality of the management. Strength of the balance sheet. The cash flow generation. The market position, the long term track record of delivery.

00:13:27:13 - 00:13:50:19

Unknown

We look for those businesses and those companies where earnings are moving in the right direction. Businesses where we expect them to meet or beat their forecasts. Because ultimately that's what stock markets should reward. They should reward good quality companies delivering ahead of earnings expectations. This is the top ten positions in the portfolio. I've not cherry picked. I've not just chosen some names at random to fit the argument.

00:13:50:19 - 00:14:13:25

Unknown

This is the top ten of my top ten positions in the portfolio. Nine of the ten of them last year delivered and beat their earnings expectations. These are not companies that are failing, and even the one company that shows us a downgrade their Helios Towers, well, that was a downgrade at the EPs level. But that beat at the EBITDA level, which is the main driver of earnings for this business.

00:14:13:25 - 00:14:39:12

Unknown

Helios is a telecoms tower business. It has to invest in telecoms tower real estate. So actually when the EBITDA beats by definition, sometimes the earnings misses because there's more cash flow generation going into these. So to my mind, ten out of ten of these businesses beat on their earnings expectations. And yet the average derating of these companies last year was 30% of the companies that reported only two of them beat the benchmark, despite all ten of them beating expectations.

00:14:39:12 - 00:14:56:13

Unknown

And this comes back to the flow perspective. Now as fund managers, we ask the question, what can we do? We're doing the right thing in terms of identifying the companies. We're doing the right things in terms of identifying the earnings momentum. We're doing the right things in terms of finding the sector champions, the businesses we really like run by the management teams that we trust.

00:14:56:15 - 00:15:12:24

Unknown

At some point, this dynamic has to change. And the question that may come later, the question I get asked quite a lot. We heard all this from the value managers in the last decade. They spent a decade saying that at some point value would come back into favour. It would come back into focus. Are you just not this decades value manager?

00:15:12:24 - 00:15:37:25

Unknown

Is growth just not last year's story? The difference is growth. Those value managers that stood there for a decade saying the strategy going to respond, the earnings will start to come through. Their companies were typically high levels of capital employed, low levels of capital return. They were typically low growth businesses on, yes, relatively attractive valuations, ten, 12, 13 times, but they weren't growing into those valuations.

00:15:37:27 - 00:15:59:07

Unknown

XPS is trading on 14 times earnings. It's growing its revenue at 20%. It can return capital to us because it doesn't have debt on its balance sheet, and it doesn't have a massive CapEx bill. It can buy back its own equity. This cannot go on forever. These companies cannot grow at these rates on these valuations, and it not start to factor into share prices.

00:15:59:09 - 00:16:14:01

Unknown

I do not know what the catalyst is, and I'm not going to stand here and pretend that I do. Unfortunately what we need is duration. We need the time for this to come through. And at some point given this backdrop, I'm sure that it will do.

00:16:14:03 - 00:16:46:09

Unknown

And it needs to happen before some other things happen. The universe is shrinking. This is another reason why adding international to the portfolio is so important for us. There have been two IPOs in the UK so far this year. Again, leaning on that political backdrop, I find it very difficult to believe we're going to see much of a change to the IPO market until we've had, well, election tomorrow, new prime minister, perhaps new chancellor, perhaps it's a brave company that's going to try and push into those markets before we've had a budget that sort of sets what the new store is going to be.

00:16:46:10 - 00:17:08:26

Unknown

So a number of companies is going to continue to diminish within the portfolio. And we're reflecting that in the portfolio. We have fewer holdings in the UK in the portfolio today than we have had historically.  As the universe shrinks, so does the number of holdings to have to have the same relative and active weights. And you can see here the green slide, the green line is the number of companies within the portfolio within the universe.

00:17:08:27 - 00:17:32:17

Unknown

Going back to 2007. It has been uni directional since that point. The number of companies has fallen year on year pretty much through the last 20 years, let's call it. And so the average market cap and the upper market cap of the benchmark has also continued to change. So the other change we've made to the portfolio, not just how many holdings we look to have within the UK, but is also the upper limit of the market cap that we have within the UK.

00:17:32:19 - 00:17:51:02

Unknown

We used to have a 2 billion restriction, no, no new investments, greater than 2 billion market cap. Well, the largest company in the benchmark this year with 2.6 billion. So that rule is no longer relevant. So we've removed that. And it's just reflective of the change that we're seeing within the universe.

00:17:51:04 - 00:18:16:03

Unknown

I'm going to leave it on this slide and then invite questions. And this is more a thought experiment now rather than the case for investing in smaller companies through all of my career. And from this chart back to 1955, which definitely predates my career, it has been true that over a medium to long term period, UK small companies have outperformed large no period of ten years of underperformance.

00:18:16:06 - 00:18:48:06

Unknown

We can't say that anymore. The last few years, the last 4 or 5 years have reached such a state now where actually we can no longer say that UK small and medium sized companies have outperformed large cap over a 5 or 10 year period. When I look at that chart, I have a question. Has something fundamentally changed? Should we no longer believe in the growth and the compounding capability of UK small and medium sized companies, or are going back to that chart I showed earlier of the underperformance of mid-cap versus large.

00:18:48:08 - 00:19:07:07

Unknown

Is this just a very extreme environment that at some point starts to come through? Now I know what I hope, I know what I think, I believe, but ultimately, as so many things, it's whether you guys believe it rather than me. And so I sort of leave you with that thought process and I invite questions. Thank you very much.