Ken Wotton: structurally undervalued UK small caps

Macroeconomic and geopolitical uncertainty have given UK small cap investors a rough run of late. The Numis Smaller Companies index (ex investment companies) has fallen by 10 per cent over the past six months, compared with a 3 per cent rise for the FTSE 100.

But such volatility means “the market is throwing up some really interesting entry points for businesses”, says Ken Wotton, managing director at Gresham House and head of the firm’s public equity investments division. “For most of the last few years, UK smaller companies have traded at a material discount to larger UK-listed companies, so I think we’re in an area which is structurally undervalued,” he says, adding that high-quality businesses which are suffering a discount by virtue of the asset class they sit in can present a good opportunity to make money.

Wotton joined Gresham House in late 2018, having spent a decade at private equity firm Livingbridge running its quoted markets division. He co-manages several portfolios, including the Gresham House UK Micro Cap fund (GB00BV9FYS80), Gresham House UK Multi Cap Income fund (GB00BYXVGS75) and the Aim-traded portfolios on behalf of the Baronsmead VCTs. He was also appointed lead fund manager of Strategic Equity Capital (SEC) in 2020, which has net assets of £194mn and recently survived a takeover bid from Odyssean Investment Trust (OIT). 

SEC is a concentrated portfolio of just 18 companies. To value potential holdings, Wotton takes a cue from private equity to estimate what price they might look at buying the company for. “We look at multiples today for the appropriate earnings metric, and then we look at what we think that metric can do over the life of the investment, and then what we think of fair multiple will be for those earnings if certain things happen as we predict in three, four or five years time when we come to exit.” 

Since September 2020, Wotton has been repositioning SEC so it invests in companies typically with a market cap of £100mn to £300mn, because he thinks there is more of an opportunity to find undervalued, under-researched companies down the market cap spectrum. It also gives him an opportunity to take bigger stakes in companies and actively engage with them on issues where he and his team think they can unlock value. As an example, they recently introduced a non-executive director to the board of Wilmington (WIL) with expertise in digital remote learning, a key component of the company’s future growth strategy.

The trust doesn’t have a hard limit for the size of stake they would be prepared to have in a company, but Wotton says he wouldn’t own more than 30 per cent because he wouldn’t want to trigger a mandatory offer for the business. The downside of having large stakes is that it is difficult to sell these positions quickly if something goes wrong for the company. But the quid pro quo, according to Wotton, is that with a large position, where companies are taken over, he’s in the conversation around whether or not the price is right. “Frankly, if we don’t want to sell then it might well prevent the whole thing from happening,” he says. 

Given the portfolio runs a concentrated portfolio of small cap companies, Wotton says that the strategy scales to about £500mn – much more than its current £194mn of assets. It’s also significantly more than than the combined value of SEC and Odyssean Investment Trust (around £350mn in assets), but as the board and shareholders have backed Wotton and his team to continue as an independent manager he says “as far as I’m aware there’s no intention for Odyssean to come back”. The board also announced a tender offer and a share buyback programme to commit up to 9 per cent of the net asset value to buy back shares to a target discount level of not less than 5 per cent for the rest of the year.  

Individual holdings

The trust’s largest position is in a company called Medica (MGP), a provider of platform-based clinical support services, primarily linked to diagnostic interpretation for radiology departments. “It’s taking advantage of what is a structural under supply of qualified radiologists in the UK and globally and an increasing demand for imaging as a component in diagnosis.” The company employs and engages with trained radiologists who can interpret scans and they sell that service to the NHS. “Because of the structural driver it’s not particularly cyclical and it’s an area in which we think there is likely to be double-digit growth for a number of years,” Wotton says, adding that a competitor of the business has recently gone through a private equity management buyout at an Ebitda multiple representing a material premium to the multiples that Medica trades on in the public markets.

While healthcare made up almost a quarter of the fund at the end of December, Wotton says that financial services – specifically pensions, wealth management and advice – are providing interesting investment opportunities as there’s a lot of consolidation in the sector and regulatory drivers are changing things and driving economies of scale. Companies that he thinks are on the right of these big trends include XPS Pensions (XPS), Brooks Macdonald (BRK), Mattioli Woods (MTW) and Fintel (FNTL) – all of which can be found in the top 10 holdings among the funds that Wotton manages. River and Mercantile (RIV) was a new addition to the SEC portfolio last year and promptly had its UK solutions division bought by Schroders.  

While Wotton doesn’t look for companies explicitly because they will be taken over on a short-term view, takeover bids do play an important part in the fund’s returns. “Inherently the kind of companies we like typically are attractive to private equity and trade as well,” he says. Recent takeover bids from holdings include medical services provider Clinigen (CLIN) which is in the process of being taken over by European private equity firm Triton Partners. Triton offered 883p per share before Christmas, but was forced to increase the offer to 925p early this year in what SEC’s chairman described as a “good conclusion”.

While Russia’s aggression in Ukraine and the spectre of inflation have made the operating environment for many companies more challenging, Wotton tries to be “agnostic” about macro factors and focus on picking high-quality companies in structural growth markets that have a competitive advantage or where he sees a specific “self help” opportunity for a company to improve. However, he recently sold global exhibitions company Hyve (HYVE) because one of its biggest shows was in Moscow which made the risk profile of the company “too great”.  

While Wotton looks to invest in companies that are profitable, Hostelworld (HSW) is an example of a holding that has struggled – an online travel agent which specialises in hostel bookings. However, he says it recapitalised itself and has cash on the balance sheet so he thinks it can continue to trade and survive until bookings pick up again.

As part of the team’s research process, Wotton says they use screens to create a shortlist – mainly focused on quality factors such as margin, free cash flow generation, earnings growth, return on capital and balance sheet leverage. The team then meets with around 500 companies a year. “I think it’s important particularly in small caps to see the whites of the management’s eyes and actually see the end of their Zoom call if it’s been in the last couple of years, and actually hear from the horse’s mouth, how they articulate their strategy in what they’re trying to do,” he says.

Advice to younger self

Wotton says the one bit of advice he’d give to people starting investing is to back their own judgement but constantly reappraise it. Investors starting out can have high conviction in their point of view but don’t necessarily have the humility to admit when they were wrong or when the facts have changed. “I’ve definitely learned over the years that you need to constantly take a fresh look at things, be humble enough to let other people take a fresh look at one of your ideas and challenge it,” Wotton says. “When the facts change, I’ll change my view. But I probably wasn’t like that when I first started.”

Ken Wotton CV

Dec 2018 – present, managing director at Gresham House

Feb 2007 – Nov 2018 – director, Livingbridge

Mar 2005 – Jan 2007 – equity research analyst, Evolution Securities

Jun 2000 – Nov 2004, equity research analyst, Commerzbank

Sep 1996 – Jun 2000, ACA, KPMG

1992 – 1995,  PPE, University of Oxford

Source: FE Analyitcs, 26.04.22