Minority Investing
Two years ago, Philip Best and Marc Saint John Webb illustrated their investment approach to minority investing by reference to the theme of how ‘constructive engagement’ with smaller listed companies could accelerate returns and reduce risk. This approach to investing in ‘small caps’ was compared to Private Equity minority investing in ‘midmarket’ companies.
Ever more relevant now.
Since then, private company valuations have peaked and listed small cap valuation multiples have compressed further, making the opportunity ever more attractive.
Investment philosophy
We have been investing with the same investment philosophy and process since the Argonaut fund (the Fund) was launched 21 years ago. We focus our efforts on the least efficient part of the market; the ‘grey area’ of European micro caps where mis-pricings abound, and our fundamental research approach enables us to accumulate a portfolio of ‘good’ companies acquired at ‘great’ prices. Experience, focus and an open (contrarian) mind have given us a competitive edge in this area.
Fundamental research
Our investment approach has always been based on travelling across Europe to find attractive but unloved companies trading at low valuations in out-of-favour corners of the market, then continuing in-depth research to increase our conviction and position weighting. Then ensued a period of waiting (and monitoring) for our investment thesis to play out, which often took several years. Our investment process already felt half-way between that of “Listed” and “Private Equity” with frequent visits to company sites and very regular direct contact with the top management. Even if we do not carry out formal Due Diligence, our research process has always been ‘Primary’ rather than ‘Secondary’. Our target companies were listed, but often were not covered (or poorly covered) by broker research, so we always do our idea sourcing and research inhouse.
Minority stakes
As the Fund increased in size, we found ourselves ever more often holding between 5% and 10% of the capital of a company and our interactions with management became progressively more ‘engaged’. With a larger equity stake we became longer term shareholders and management even started to consult our opinions on communication and strategic options for the business.
Shape the exit strategy
Once we were fully invested in a target company and the share was approaching intrinsic value, we always tended to put our ‘broker’ hat on and ‘reverse-broke’ the share to the investment community and encourage research analysts to initiate coverage of our orphan stocks. By the time the market was starting to get excited by a new name, we would probably start to gently offer out blocks of our shares to commence taking profits.
Rising PE valuations…
Over this 21-year period we have seen huge inflows into Private Equity funds. Strong performance had led to great enthusiasm for the Private Equity ‘magic’ that was really creating value. The funds raised money faster than they were able to invest it and the Private Equity industry now has ‘dry powder’ of more than 3 trillion Dollars waiting to be invested. This compares to dry powder of 0.5 trillion Dollars when the Argonaut fund was launched in 2003. The increasingly large Private Equity funds have since been queueing up together at competitive auctions to bid for targets whose valuations have been driven up ever higher. Over this period the valuation multiples in the midmarket had risen from circa 6x Ebitda to 11x in 2022 according to the Argos Index of Private Equity midmarket transactions.
…coming back down to earth
Since then, the median multiples have come down to just above 9x. However, this figure relates only to the recent transactions whereas the rest of the companies in Private Equity portfolios continue to be valued at the 10/11/12x Ebitda at which they were acquired over the last 5 years.
The PE model
The Private Equity value creation model is driven by investing in good companies at attractive valuations, improving operational performance, incentivising management to streamline the business, applying leverage, pursuing a longer-term strategy and ultimately exiting at a higher multiple via a stock market listing. The model remains intact apart from the purchase price valuations of Private Equity which are still substantially higher than listed equities.
“Listed” discount
Over the last two years, small caps have been an area of the stock market that has been out of favour and small caps funds have been seeing substantial redemptions. Quite the opposite of the buoyant inflows to Private Equity midmarket funds. The lower valuations of listed small caps relative to private have therefore become even more stretched. As minority investors we think more in terms of multiples of net profits and the Argonaut fund now has a median PE ratio of barely 11x this year’s net profits and less than 10x next year. In Private Equity speak the portfolio is trading on a median multiple of 5x Ebitda. Furthermore, the portfolio is now actually trading at a slight discount to accounting book value and the valuations are marked to market every day.
The (abnormal) discount of listed to private valuations is also illustrated by the current dearth of IPOs in Europe. With lower valuations, the stock market no longer provides an exit route for companies acquired privately at higher valuations. In fact, quite the opposite is now becoming the norm with listed companies delisting (at high premiums) from the stock market.
With listed small cap equities trading at a discount to Private Equity, it begs the question: ‘Can we reproduce part of the Private Equity value creation model through Constructive Engagement on under-valued smaller listed companies where we control a 5/10% stake?
“Constructive”
We have always kept a close relationship with management, but we also note that, with the onset of ESG lobbying, they are now even more open to hearing the views of shareholders. We have also found ourselves discussing more with other shareholders to have a louder voice and increasingly direct discussions with board members. Our engagement has always been ‘constructive’, and we shun the ‘Activist’ word as we want to preserve our positive reputation across European small cap corporate spheres as the long-term investors who arrive at a contrarian time and make positive suggestions for improvement. This keeps the doors of our European universe open.
“Encouraging Best Practice”
Our approach has been to label our engagement as ‘Encouraging Best Practice’, which underlines the positive nature of our process, and we set 6 areas of best practice we focus our energies on:
- Communication and engagement with the stock market and investors
- Operational improvements – benchmarking by subdivision
- Sustainability / ESG policy
- Governance / Management incentivisation
- Asset Allocation – acquisitions, consolidation, asset sales, debt reduction
- Dividend policy
Minority influence
There are a host of measures a PE firm with full control can implement, but there are others that minority stakeholders may also influence. The low hanging fruit for us has always been communication and engagement with the stock market. We want to assist the company in enabling the market to see the hidden value we have identified. We don’t pretend to have the authority to teach the management team their business, but we have found that reminding them what their best peers generate in terms of operating profit margin in each of their subdivisions has been a powerful driver for positive change in terms of operating efficiency and strategic capital allocation.
We have often invested in undervalued companies, with hidden assets that were difficult to understand because there were too many businesses, with the idea that a more streamlined and focused business would be better valued by the stock market.
Positive change
Since the launch of the Argonaut fund in 2003, we have been encouraging smaller companies to become more efficient, to streamline, to participate in sector consolidation, to focus their business and to pay dividends…or simply to communicate more openly with the stock market. We are often invested in listed family-owned companies, so are used to businesses that might not be optimally managed. This frequently means that there is room for self-help and improvement by the company management which ensures another driver for the share. Our constructive engagement can add further value to this positive change…and ultimately helps shape our exit strategy.
An additional lever
Constructive Engagement has provided an additional lever for the Argonaut fund to create value and contribute to the +767% performance (net of fees) over 21 years since launch. The process of stock picking through primary research in out of favour areas of the market and then applying Constructive Engagement to crystalise the value, should enable the Fund to advance even if the market were to stay flat for several years.
The Fund owns significant minority stakes (above 3%) in over half of its portfolio of companies and is currently ‘encouraging best practice’ to over a dozen companies.