CITS market update

It has been a difficult year for investors. As recently as March the Federal Reserve funds rate was 0%. Since then we have had five successive hikes to a range of 3-3.25%. Most major central banks in developed markets (with the exception of Japan) have followed suit in short order. As the dominant reserve currency, the US dollar has strengthened against pound, euro and yen. The value of a whole constellation of assets has shifted wildly to reflect the new reality of a higher-rate world.

From a global investor’s perspective, the UK government’s much-maligned ‘mini-budget’ was perhaps a sideshow. In the UK, it merely added uncertainty to markets already in flux. It was an ill-considered time to choose dogma over stability in both political and market terms.

Smaller companies have been hit harder than their larger peers in this risk-off environment. The lower liquidity in their shares means that, as investor confidence wanes, daily trading volumes can fall – with a dearth of buyers, the “voting machine” sends stocks lower.

For some companies (regardless of their size or index) the falls are entirely justified. In the broadest sense, higher interest rates decrease the relative attractiveness of all risk assets when compared to the “risk-free” rate of government bonds. This has proved particularly painful for long duration and high-growth assets. These have suffered due to compounding - as yields rise, one would logically expect that their present value would experience a proportionately higher fall as more of their implied value sits further out in time.

The weighting towards highly-rated, fast-growing companies on AIM, particularly those with direct consumer exposure, has seen the market underperform wider smaller companies indices, but underlying this, there are reasons to remain calm.

Remember the pandemic?

From a typical investee company’s perspective in the Close Inheritance Tax Service (CITS), the volatile credit and currency markets are unhelpful but not life-threatening. Balance sheets either have remained strong or were bolstered by capital raising during the pandemic, giving them a number of advantages over their privately held peers.

For our investee companies, management teams’ guidance has been cautious since the early days of COVID-19 in 2020. This has broadly stood them in good stead, limiting the number of downgrades as they face markets in flux.

Underlying this, trading for many is holding up well, with input-cost inflation being passed on more easily than anticipated. Companies are finding ways to cope with tight labour markets and the supply chain disruptions that blighted the start of the year, often by using their financial strength to build inventories, protecting revenues and margins.

Markets remain open for business

Away from the starkly negative news of late, AIM companies have been raising capital to execute their strategies. In portfolios, we have seen H&T Group, Strix Group and Wynnstay Group raise a collective £40 million to further their growth ambitions in the third quarter alone. Markets have not dried up. On the other side of the coin, M&A activity remains elevated. Weak sterling may see this trend accelerate as foreign investors cast a slide rule over quality companies worth perhaps 20% less in dollar terms than a year ago.

It pays never to overreach

In the 21 years since CITS was launched, we have learnt that discipline is key to building optimal portfolios. For example, the lower interest rates since the global financial crisis tempted many analysts to reduce key variables in their forecasting models, such that it became increasingly justifiable to pay more today for future earnings. In some cases, this was exacerbated by using estimates that were overoptimistic.

By using a consistently high cost of capital and our own conservative forecasts, we eschewed the most highly-rated, long-duration stocks which have since fallen so dramatically, although they looked so tempting at the time. We focused on strong management teams steering quality companies with robust balance sheets and dominant market positions. We have held positions in countercyclical companies such as insolvency practitioners and secured lenders through the cycle. Where possible, we have sought to diversify the geographic sources of revenue from portfolio companies to reduce reliance on the UK economy.

In the downdraught, an opportunity to reduce risk

The sell-off in recent weeks is bringing a raft of quality AIM companies back onto our radar. This is allowing us to strengthen portfolios for the future; by reducing weightings in the Service’s largest constituents, we can fund quality additions while diversifying risk for our clients.

For new client money, we are making full use of our 6-month investment window, adding to positions cautiously by working with our experienced dealing team to purchase names at sensible levels.

Government support for growth companies continues

Lost in the volley of criticism of the ‘mini-budget’ was some good news in the growth investor arena. Rolling back the 1.25% increase in NI for employers is helpful for all UK businesses. EIS and VCT reliefs are being extended beyond 2025 removing uncertainty for investors and entrepreneurs alike. (Since 2011 these reliefs have been considered state-aid by the EU and therefore anti-competitive within the bloc, but under a ‘sunset clause’ the UK has used secondary legislation to prolong them). And a range of SEIS measures and limits were improved. This is all positive news for early-stage companies, “filling the hopper” with businesses that may eventually graduate into CITS holdings.

All to play for!

It is understandable if investors are struggling to feel optimistic about prospects for smaller companies, given recent market falls driven by the unhelpful macroeconomic and geopolitical backdrop. But looking beyond the short-term picture, we believe the current market reset offers several reasons for the patient investor to take heart. The inflationary pressures on the economy look set to recede going into next year. Our portfolio companies are well positioned and, perhaps more importantly, well capitalised. And last, but certainly not least, we are seeing compelling valuations return to AIM after a multi-year hiatus.

 

 

This communication is for professional advisers only and may not be reproduced or redistributed in any format, in whole or in part, without the express written approval of Close Asset Management Limited. This does not constitute a recommendation or advice regarding the shares or other securities of any issuer. Statements reflect the knowledge and information available at the time of its preparation. Capital at risk. Past performance is not a reliable indicator of future returns.