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When it all comes together

29th September 2023

Decisions in life are rarely straightforward and even less so in the world of investing where the multitude of actors, noise and informational inputs make financial markets inherently complex systems. Sometimes, however, a confluence of factors come together resulting in ‘no-brainer’ choices. Our recent decision to introduce a position across the Hawksmoor Funds in Strategic Equity Capital (SEC), a London listed closed-ended fund investing in UK smaller companies, whilst perhaps not a no-brainer, was pretty darn close. In this week’s blog, we look at the multiple building blocks of the investment thesis.

First and foremost when investing in a fund, we have to like the underlying portfolio, which for us typically means assets that look cheap relative to their intrinsic value, and which therefore offer a margin of safety. As regular readers will know, we are pretty bulled up on UK equities at the moment, especially smaller companies where valuations are at a significant discount to other markets but also, more importantly, look compellingly cheap versus their own history. The SEC portfolio currently trades on an EV/EBITDA multiple of less than 9x, offering lots of value in a historic context and at a level that is well below the private equity backed transaction multiples we are seeing similar UK listed companies getting taken out at. In the context of the valuation, it’s important to note that this is not a portfolio stuffed full of deep value cyclicals. Indeed, balance sheet risk in the fund is low and most of the companies operate in areas enjoying strong structural growth tailwinds. The prior point regarding M&A and the potential upside this can drive is particularly relevant to SEC bearing in mind the private equity perspective manager Ken Wotton (a PM we know well via a longstanding investment in his open-ended multi-cap fund) weaves into his stock selection process.

As a high conviction, concentrated portfolio investing in less liquid small caps (80% in top ten), the strategy makes the best use of the investment trust structure. Many open-ended smaller company funds will either limit capacity or have to run with a longer list of names and lower conviction positioning. Managing redemption led outflows and being a forced seller is never a nice thing but can be particularly harmful when the underlying assets have patchy liquidity and bid-offer spreads can widen at the hint of a sell order. With a fixed pool of capital, SEC does not face these problems and is free to run with pure exposure to the manager’s best ideas. Diversification is normally a good thing, but a trusted manager constructing a portfolio of best ideas where the bar for inclusion is extremely high can be an incredible base from which to generate alpha. Concentrated positioning also allows the manager to build meaningful stakes in holdings facilitating an activist approach which, where required, seeks to influence underlying business strategy and capital allocation to the benefit of shareholders. Crucially, we don’t believe it would be possible to construct a portfolio like SEC’s in an open-ended structure so view the trust as a fairly unique option for investors (although big hat tip to Odyssean Investment Trust (also held in the HFM funds) which pursues a similar strategy, with an equally excellent manager).

Another attraction of SEC is the fact that the Company comes with a number of attractive shareholder features, including a defined buyback policy to address what has been a stubborn discount and, perhaps more pertinently, a 100% realisation opportunity in 2025 which should come at around NAV (less costs). This facility provides a liquidity backstop for what is admittedly a fairly small trust (c.£150m market-cap) but more importantly presents an opportunity to amortise the discount over what is a relatively short time period. Whether or not we choose to exercise our right to participate in the realisation opportunity when the time arrives depends on a number of factors, but clearly presents another, idiosyncratic driver of returns over and above the strong NAV performance we expect in the interim. This facility also illustrates the confidence of the Board in the ability of their manager and the future of the Company.

Finally, we were able to establish our position in the trust via participation in a clear-out trade which priced nicely below the spread resulting in an attractive entry point (over 10% discount) for our funds whilst also helping to clear an overhang of stock. Good relationships with brokers and being able to nimbly move our portfolios around are key factors in being able to benefit from these kinds of opportunities as and when they arise, with our long-term involvement in the investment trust sector and the capacity constrained nature of our funds conferring us with distinct advantages in this regard.

The introduction of SEC on a 10% discount was funded from existing open-ended UK equity funds at NAV (including Ken’s), resulting in limited change to risk or market exposure, but as an individual investment ticks lots of boxes, offering exposure to a manager we rate highly at the helm of a portfolio that is housed in the perfect fixed capital structure enabling the purest expression of his investment views and providing the best platform for maximising returns. The shareholder friendly provisions and ability to establish a position at a favourable price are the considerable cherries on the top which we believe will augment both liquidity and returns. If only all decisions were this straightforward.

Ben Mackie – Fund Manager

For professional advisers only. This article is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. FPC1254.

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