Why apathy in the UK market is great

March 2024

March 2024

The fund flow dynamic out of actively managed into passive funds is an established trend across global equities. In a recent Bloomberg podcast David Einhorn, founder of value focused investor Greenlight Capital, talks about the impact this has had on actively managed value funds.

The self-fulfilling negative feedback loop of marginal buying shifting away from active managers at the value end of the market to index funds at the opposite end is familiar to those that have observed the dynamics of the UK market in recent years. Except, instead of being focused on value manager redemptions the UK has seen a more widespread redemption dynamic, with a particularly acute impact on the small cap part of the UK market. UK equity funds have seen consecutive month on month outflows for almost three years now, since May 2021 (source: Calastone).

The follow-on impact of this on price discovery and reaction to price discovery is interesting and again, all too familiar. Undervalued companies that perform well and deliver in line or excess earnings growth are usually recognised by a wider audience (other buying market participants), leading to positive share price performance and a valuation re-rating. However, when there are not enough other buyers that are able or willing to participate these companies remain undervalued for longer. Einhorn refers to the current state in their market(s) as “apathy”. I wonder what we would call our UK small cap equivalent? We hope apathy does not become “atrophy”?

For our investment strategy, apathy is great. As a starting point we rarely assume a valuation re-rating in our base-case target return models for investee companies. This is not necessarily because we don’t believe companies are undervalued or that a re-rating is not justifiable, but because this is a more intangible source of value creation that is outside the control of the management teams running these companies and consequently difficult for us to forecast. We have clear views on valuation, where companies should re-rate to and what the catalyst(s) might be, underpinned by our due diligence process. But we don’t bank on it. Neither do we require a re-rating for wider UK valuations from where they are currently.

Perhaps more interesting then is how we can deliver attractive returns in an apathetic market, absent of a material re-rating. We look for quality companies with attractive profit margins, strong cash generation, structurally growing earnings and robust balance sheets. Whereas these companies may have historically traded at high single digit to low double digit earnings multiples (still not expensive) they are currently trading at close to half that level. This means that free cash flow yields are close to double what they might be. If these businesses are growing earnings and consistently converting earnings to cash flow at an attractive rate, the compounding cash flow returns to investors is compelling.

A good example is Angling Direct, an omni-channel market-leading retailer of fishing equipment and consumables, which has a market capitalisation of c. £32mn with roughly half of that in net cash £15.8mn. The business caters to a loyal, hobbyist enthusiast customer base with repeat ordering profiles and combines an omni-channel model with own brand and third party product to deliver an attractive gross margin of 35%. The company is delivering double digit revenue growth and is continuing to add to its significant existing net cash position. The shares trade on 6x historic enterprise value (EV) /earnings before interest, taxes, depreciation, and amortization (EBITDA) (on a pre-IFRS 16 basis), falling to <5x for January 2025.

However, it is not just at the small cap end of the spectrum that such opportunities present themselves. TP-ICAP, a global leader in the inter-dealer broking market, has a market capitalisation of c. £1.4bn with mid to high teens EBITDA margins, a strong balance sheet and good cash generation. The shares are forecast to pay an almost 8% dividend yield for FY24 and trade on 3.6x EV/EBITDA. There is also a “captive” data subscription business within the group that generates £80mn+ earnings before interest and taxes(EBIT) and is growing and underpins most of the current market cap.

From a simple screen there are c.50 companies below a £300mn market capitalisation in the UK that are valued on 5x EV/EBITDA or lower with a 15% or greater free cash flow yield. Most of these companies (c.70%) have net cash balance sheets (source: Quest). If these companies are growing EBITDA at 10% annually they will deliver a 2x return on investment in five years purely from compounding cash generation. The role of profit margins and operational leverage is key in this equation. Our portfolios have EBITDA margins typically ranging from 20-30%. To deliver 10% EBITDA growth on a fixed cost base a revenue compound annual growth rate (CAGR) of only c. 2.3% is required over five years (assuming a year one 20% EBITDA margin). Furthermore, should these companies grow at 10%, see no re-rating and assuming the excess cash is distributed rather than accumulates to lower the enterprise value, they will trade on c. 3.1x EV/EBITDA after five years. Delivering almost a 2x return over five years with a 38% reduction in valuation is compelling, in our view, and the UK market is not short of these opportunities.

Illustrative example

Year 0 1E 2E 3E 4E 5E CAGR
Revenue 100 102 104 107 109 112
– Growth 2.0% 2.2% 2.3% 2.5% 2.7% 2.3%
Costs (fixed) (80) (80) (80) (80) (80) (80)
EBITDA 20 22 24 27 29 32
– Margin 20% 22% 23% 25% 27% 29%
– Growth 10% 10% 10% 10% 10% 10%
FCF / EBITDA 75% 75% 75% 75% 75% 75%
FCF 15 17 18 20 22 24 10%
FCF yield 15% 17% 18% 20% 22% 24%
Net cash 17 35 55 77 101
EV/EBITD 5.0x 4.5x 4.1x 3.8x 3.4x 3.1x


We are not alone in adopting this view. The ongoing elevated level of takeover activity in UK equities, which has focused on the sub-£500mn market cap segment, demonstrates that a wider range of global buyers, both financial and strategic share our view on the opportunity set. Many of the companies that we invest in are attractive targets as our investment process and philosophy strongly aligns with that of private equity firms, and we have participated in our fair share of takeovers in the recent past. Perhaps these are the marginal buyers who will catalyse a valuation uplift in the UK market, but even so we are happy buying quality companies at attractive valuations and delivering returns for our investors through compounding cash flows.

Past performance is not necessarily a guide to future performance. Portfolio investments in smaller companies typically involve a higher degree of risk. Capital at risk. The views expressed by the investment team are correct at the time of writing but subject to change.

Brendan Gulston
Director, Public Equity


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