Finding opportunities in a rapidly changing world

Update on LF Gresham House UK Micro Cap Fund and
LF Gresham House UK Multi Cap Income Fund

The impact of COVID-19 has been dramatic for everyone, in both their personal and business lives. The sell-off in equity markets has been severe, triggering the most rapid bear market in history. At Gresham House, we are trying to deliver ‘business as usual’ in a pretty extraordinary situation, while staying close to our investee companies.

Performance

Our portfolios have not been immune to the selling pressure we have seen in the market. However, in both funds we have materially outperformed the market and the relevant IA sectors year-to-date (as at 25 March 2020). We believe there are two main factors behind this outperformance:

• Cash weighting – we entered the crisis with elevated levels of cash within both funds and have largely kept our powder dry to take advantage of opportunities as they arise
• Quality focus – our portfolios focus on structurally growing companies with strong and sustainable market positions in their niches, high-quality management teams, profitable and cash generative business models, low financial gearing and sensible valuations. This has historically delivered relative resilience in periods of market volatility

Activity

We have maintained a higher than average cash weighting in both funds and have made some swift changes to our portfolios since the crisis hit.

• Tactical divestments – we have exited certain lower conviction, highly valued or more cyclically exposed companies to limit downside risk and maintain liquidity. We have fully or partially exited holdings in Gama Aviation, Volution, IG Design, Brickability, 4Imprint and Games Workshop
• Selective investments – we have added to some of our existing portfolio companies where valuations have become compelling. These include Angling Direct, Netcall, Inspired Energy, Finsbury Food, B&M, Domino’s Pizza and XPS Pensions
• Capital available – our current cash weighting will provide the firepower to support our portfolio companies or businesses we actively track. Those businesses with a strong franchise and good long-term prospects but where they may require additional capital to navigate the current market dislocation

Investee company perspective

The COVID-19 situation and the impact on businesses has moved rapidly in recent weeks and continues to evolve. The focus has shifted from businesses with material Asian supply chains or customers, to travel and leisure operators, to wider consumer businesses and now to those with second order exposure through serving customers in those sectors. In time, the impact on the wider economy will become clearer presenting challenges for some companies and opportunities for others.

We have made a point of communicating actively with the management teams of our investee companies to ensure we understand the impact they are seeing and actions taken to date, planning scenarios and future mitigating action they are considering. We have also sought to interrogate the financial strength of our companies and assess the balance sheet and cash flow liquidity risk to businesses from potential business interruption, disruption or demand reduction both short and medium term.

Happily our initial analysis suggests that the majority of our portfolio companies are financially robust and capable of trading through the current uncertainties. Where there are short term concerns but we believe the long term franchise is strong we are evaluating how we can selectively provide financial support and advice to help them through.

Liquidity

We continue to manage the liquidity of our open-ended funds using the approach we have implemented since launch, while now placing greater emphasis on certain elements, notably:

• Cash balances – we typically target a cash weighting of 5-10% of NAV in each fund. Current levels are temporarily elevated in order to provide greater liquidity and take advantage of opportunities as they arise

• Portfolio construction – we have tactically refocused the portfolios towards holdings with more robust financial positions and have taken advantage of opportunities to gain liquidity in lower conviction or higher risk holdings
• Market insight – the investment team are in active communication with our trading contacts to understand the stock level liquidity in each holding in real time to ensure we are able to take opportunities as required

Outlook

The current situation for equity markets and for many smaller companies remains very uncertain. However, we remain confident that our focus on high-quality companies with strong management teams, sustainable market positions and healthy balance sheets as well as good long-term prospects should provide some resilience. In due course, the current market dislocation will provide almost unprecedented opportunities to back fantastic businesses at attractive prices either due to forced sellers in the market or through capital raises allowing companies to financially de-risk and survive the crisis and recover strongly. Our strong cash balances will enable our funds to benefit from these opportunities.

For more information on our Funds, visit LF Gresham House UK Micro Cap Fund and LF Gresham House UK Multi Cap Income Fund.