In the past few years, mentions of the UK market have been quickly followed with the phrases “undervalued” and “unloved”. The public market has flocked to the US amid the success of the Magnificent Seven, leaving little to work with for UK stocks. But now, many of these companies seem to have found a new suitor in the world of private equity.
Despite relatively strong balance sheets for many UK companies, valuations have settled at the bottom of the barrel, where private equity has started to see opportunities.
Katen Patel, co-manager of the JPMorgan UK Small Cap Growth and Income trust, said valuations for UK small caps have reached such a level where a standard bid coming in is at a 30-40% premium to its valuation. Even at this rate he said, he would sometimes advise companies that the price is too low.
“We’re seeing bids for companies almost every couple of days across the UK market. That definitely reflects the valuations. We’ve been talking about the UK market being cheap for a number of years, but it’s just become cheaper and cheaper, particularly relative to the US,” Patel said.
“Company balance sheets are generally in pretty good shape and that’s reflected in lots of companies doing buybacks. So that means pretty attractive targets for either private equity or other industry players. And we’ve seen a significant spike in activity this this year.”
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Dan Green, portfolio manager and equity research analyst for the Martin Currie UK Equity team, said there were 16 bids for companies in the fourth quarter of 2023 with market caps over £100m. In 2023, it recorded an average bid premium of 50%, increasing to 55% for the cash offers made in Q1 2024.
Within Martin Currie’s UK Smaller Companies fund, which has 41 holdings, there have been five bids completing or being approached in the past six months.
“While it is a short-term gain when companies in the fund receive a bid, we believe that many of our companies which have been bid for could create more value over the long term by remaining listed and we have voted against some of the bids our companies have received,” Green said.
“If UK investors are unwilling to give companies the appropriate valuations we will continue to see this feeding frenzy of companies leaving the UK market at a rapid pace.”
Green added: “The danger is that the quantity and quality of UK listed companies continues to decline as the highest potential businesses are taken off the market,” Green said.
“We need the IPO market to reignite to replace the companies which are leaving. We are seeing tentative signs that this is beginning to pick up in to the second half of 2024, but nowhere near the scale to replace the companies which are leaving.”
Currently, Green said there are about 80 companies that fit the fund’s investing requirements which the team actively monitors and models.
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John Warren, manager on the Tellworth UK Select fund, which holds a market neutral exposure through long and short positions, emphasised that it is a cyclical market, and right now, it seems to be in a phase of more mergers and acquisitions than new companies coming into play.
“I expect we will see more IPOs than what we’re seeing [currently, following] our discussions with the big banks,” Warren said.
“We expect to see more IPOs later in the year, which would be good. You want a thriving equity market, you need new companies coming in and old companies going out. It’s just at the moment we’re definitely seeing more companies leave and then we are seeing join.”
One standout bid occurred in November, when snacking and petcare company Mars approached UK company Hotel Chocolat. Martin Currie’s fund has held stake in since 2016. The bid valued the company at £534m, a 170% premium to its last closing price.
“While the share price decline over the 18 months was challenging for us as shareholders, we believed the management team were setting the company on the right path for value creation and building brand value. Mars have shown that they recognise the quality and the long-term potential of the brand,” Green said.
Share buybacks
While some companies are snapped up in acquisitions, others have decided to bet on themselves.
In February, Barclays announced it would buy back £10bn in shares over the next three years, in addition to the £3bn bought back in 2023.
Adrian Gosden, investment manager for the UK equity income team at Jupiter Asset Management, said the strategy is becoming more popular to maintain share prices.
“(We) are receiving more and more information from the companies that they’re fed up with their share price. And they’re now going to do something about it themselves, which is buy themselves back,” Gosden said.
While buybacks have been a known method among large scale companies, small-cap stocks have also jumped into the ring despite often favouring more liquidity.
While Gosden admits that it’s a slightly unconventional feeling for small and mid-sized companies, for now, he said, it is often the most beneficial move.
“I’ve never met a CEO who has come to a company to make it smaller. If you’re a mid-cap CEO, you look at the people at the top of the big companies and think, ‘One day, I’m going to be massive too.’ That’s your DNA from business school. You don’t sign up and go ‘Great, this is a really lovely little company, very dynamic, I’ll try and make it smaller’”, Gosden said.
“So it is a problem, but it is literally maths. When you do the maths, the internal rate of return of buying your own shares versus buying something else, that’s more expensive, you’ve got to buy your own shares.”
Green said in the UK, share buybacks have escalated over the past 18 months, with companies in the UK Smaller Companies fund buying back at an all-time high. He has encouraged the choice due to the low valuations.
“Some companies have pushed back as they don’t want to impact on their liquidity by reducing the number of shares in issue. We would argue that effective capital allocation is a barometer of a competent executive team and that in many cases the value creation for shareholders of appropriate buybacks outweighs the reduction in liquidity in the current market,” he said.
“Some companies may be reluctant to initiate share buybacks as they may indicate they are ex-growth and without other options to allocate capital to grow the business. We would argue that the current valuation gap in UK equities won’t last forever and management teams with excess capital should make hay while the sun shines.”
