Hello and welcome to this November update from Investec Wealth and Investment (UK) Ltd, part of the Rathbones Group, to discuss recent performance, market drivers, why we believe AIM is attractive today and closing with a reminder of our quality criteria and philosophy for investing. The target audience for this update is for professional advisers, and I hope it will help investors to understand what have been some very volatile market conditions over the short term, but also the last couple of years.
My name is Adam Greaves a Senior Investment Director within the AIM team.
The table on this slide shows the performance of the IW&I IHT planner clients. The numbers represent the actual average client net of fees. This compares to the FTSE AIM Allshare Total Return Index. As you can see recent performance has been difficult for both. The AIM market has continued to fall due to a poor/weakening macro backdrop with high interest rates and stubbornly high inflation. The ‘higher for longer’ narrative around interest rates is dominating sentiment currently and the prospect of a recession is increasingly being priced into equity values.
Saying that, in recent days we have started to see the very real prospect of the interest rate hikes having peaked, this will start to bring more risk appetite back to the equity market.
Despite capital values having fallen, we have continued to see our companies retain and mostly increase their dividend year on year. The current dividend yield is 2.1%.
If we now look into some of the AIM drivers in Q3 2023. The top five companies which contributed in total a positive 2.58%. As you can see on the right-hand side of the table, all of the companies we believe wouldn’t qualify for Business Relief. We have had EMIS previously and sold out before the CMA intervention around the take-out level price, therefore we banked that performance in a previous quarter.
Our worst absolute performer in the quarter was YouGov, the polling and consumer intelligence business, this cost us 115bps and the index 38bps, meaning our relative negative differential of 77bps. The move was generally on very little new news, we believe as a larger constituent of the index, it was the liquidity that meant the shares were freely tradeable if cash needed to be raised, overlayed with concerns on AI taking some of their lunch. However once it reported profits in line with expectations, the shares bounced 30% in October so maybe there is some evidence that the tide is turning and there is some recognition that the selloff has been too harsh.
CVS was hit due to the Competition and Markets Authority launching a review into the veterinary sector around pricing and if customers are getting a ‘good deal’. While this is just an explorative review currently, from our review and discussions with key individuals, we still believe the Company can achieve its medium-term targets through organic and inorganic growth.
Now looking at the month of October. The AIM IHT plan returned -5.7% for clients compared to the index of -6.2%.
The table on the right, Smart AIM index, is an index we construct within Investec Wealth & Investment (UK) which takes the AIM Allshare and removes companies that we believe won’t qualify for business relief. We then get a like-for-like index to see how well our stock picking is. As you can see this Smart AIM in October was down by 7.1% meaning that non-BR sectors of the AIM market insulated its performance. Sectors such as oil and mining largely removed and instead has a higher weighting in technology and commercial services that was hit harder.
Now using the same index, we have plotted the performance of the IWI AIM plan, the dark blue line, the FTSE AIM Allshare the light blue line and the Smart AIM the grey line since March 2021. As you can see the main index has outperformed the Smart AIM meaning that much of the stocks insulating the index performance are non-qualifying companies.
We outperform both indices, and the Smart AIM by some way giving the comfort that our stock selection has been very good, and this reiterates our quality criteria we overlay when looking at companies. I will touch on this later on in the presentation.
One of the main factors for UK Smaller companies underperforming, as mentioned previously is fund flows, and since August 2021, where the ‘transitory inflation’ was renamed ‘persistent inflation’ has meant risk appetite in the UK Smallers market has been poor. Lots of flows out through institutional redemptions has not helped the marginal share price. UK Smallers (including AIM) monies managed by UK institutions has halved since August 2021, from over £20bn to just under £10bn today.
When macro starts to turn, and as mentioned green shoots have started to show, we should see more funds flow back into the market where alternative asset classes offer less appealing returns.
This is the worst period for investment returns for 15 years, losses since the downturn started a couple of years ago are real and the factors that will bring a reversal of those losses are not ones that we can control. However, we are confident the businesses we are invested in have the resilience to trade through the current turbulence, so are well positioned for the medium and longer term, and also confident that as the interest rate cycle turns this will be reflected in the performance of our clients’ portfolios. Looking at the Investec AIM IHT plan portfolio from a valuation perspective. The price earnings ratio, i.e. how much an investor is willing to pay for each £1 of earnings a company generates has decreased from our 10 year average of 22x to the current PE today of 17.2x. A 22% discount to the 10 year average.
Now looking at the other side of the formula, the E, or earnings. Our average company over the last five years has grown earnings by an annualised 9% per annum.
The chart shows the median earnings growth a company reports in that quarter, therefore there is some bias to when a company reports, but the general trend is good with mid to high single digit earnings growth. The decrease in 2020 and the subsequent rebound in 2021 is a factor of COVID-19 with hits being reversed the following year.
We can control the E and the team spends significant time in assessing the quality of the earnings of each of our investee companies. It is in our quality criteria that earnings should be predictable/recurring or have a history of continued growth.
Investing in AIM is high risk and volatile, however there can be significant rewards, namely good growth in capital values but also having the 40% inheritance tax break. On screen are two charts, the left chart shows the 2 year rolling returns for the Investec AIM portfolio, the FTSE AIM Allshare and the FTSE Allshare. This shows that there hasn’t been a time in the last 15 years (since the 2008 crisis), where the portfolio hasn’t outperformed the -40% level which would have been the tax to HMRC for surplus wealth. As can be seen in most of these levels, the returns over a 2 year period has been around the 25% mark.
The table on the right shows the same rolling chart but on 5 year returns. We have included this chart as five year is the average tenure for our client. I have highlighted a particular date on this chart. Q1 2013. 5 years after the start of the great financial crisis. As can be seen if you invested in q1 2018 and died in q1 2013, your portfolio would have in fact been up 47.5% from the initial investment.
With that thought in mind, let's look at this through the cumulative drawdown. The parallels with what happened in the Financial Crisis of 2008 can be instructive and it was even more difficult than what we are seeing now; the IW&I portfolios suffered falls of nearly 60%. Our focus on investing in quality businesses means that we suffer in an indiscriminate selloff like 2008 or now, but when investor appetite returns these are the kind of stocks that do well. Although our clients saw an 18 month period in 2008-9 when portfolios were down by more than the 40% tax break, from the start of the recovery it then took just eight quarters for portfolios to go up by 100% and be within a whisker of the pre-crisis levels. It took the AIM index five more years after that to recover, which shows how much it matters to be invested in the right kinds of business.
Our penultimate slide is a reminder of the Investec Wealth and Investment (UK) AIM investment philosophy. I say AIM but actually it is the fundamental basics for Investec Wealth and Investment (UK) in how we look and select quality companies.
Many of you who have attended a presentation or listened to our updates have seen and heard us reiterate those seven bullet points on the right-hand side.
Every single one of our companies must have each box ticked before we invest. In this environment more than ever I would draw your attention to proven financial track record, and this emphasises my consistency and predictability of earnings point earlier. But also the strength of the balance sheet and low financial risk. In the current environment where cost of servicing finance is significantly higher than it was just a few years ago, we want to make sure that the interest cover and percentage of interest required to be paid on their profits remains low. Ultimately a higher interest payment means lower profits for shareholders.
The ratios on the left emphasise that quality. Our plan has a superior gross margin, i.e. sales less cost of sales. A much higher return on capital employed. And then the bottom three are a focus on cash. In this environment which I have reiterated many times, cash is king, net cash is admirable. Our companies produce on average over 5% free cash flow yield, a much higher cash conversion of EBITDA, i.e. for every £1 of EBITDA or earnings before interest tax, depreciation and amortisation, our companies are generating free cash of 58p.
On a servicing of finance point of view, our average company pays only 4% of earnings as interest compared to the index of 11%.
I hope this short update has explained much of the moves in the market over the last three months, but also generally since the macro environment changed.
We are more confident now, than ever on the quality of our portfolio. And just as a final takeaway, our average forecast earnings per share has been 31% since September 21. Dividends have increased 31% yet the valuations have dropped nearly 50%.
When conditions favour the risk on appetite more, we believe we will be in a very strong position to generate good returns. Recoveries when they come can be rapid!
Many thanks for taking the time to listen to this November update, the AIM team and I thank you for your continued support. If you have any questions on anything in this presentation or in AIM generally, please do get in contact with your local business development contact or investment manager and we would be very happy to help.
