Portfolio Manager George Ensor discusses the investment company's current positioning and answers investor questions.
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The company offers investors a rare opportunity to invest, via a closed-ended vehicle in the micro cap part of the market, into companies with a market capitalisation of less than £100 million.

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River and Mercantile UK Micro Cap Investment Company – January 2022

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Analyst: “[H]ow much flexibility do you see within your capex overall? Normally, in a down cycle, we see sustaining capex come down. We see … growth projects … moderate and so on. But how should we think about your capex in this cycle?”
Jackob Stausholm, Rio Tinto CEO: “[L]ook this is actually really fundamental. If we start adjusting our capex program because we think there is a recession in the next six months, we have lost it. We are in for the long haul here.”[1]
Capitalism’s karma, according to the strategy team at BNP Paribas Exane, is that “every cycle we end up paying for the sins of the previous cycle”. 2010-20 saw consumers deleverage household balance sheets while governments engaged in austerity to try and balance their own books. With a consequent lack of nominal growth, corporates shunned re-investment in capital expenditure (‘capex’) and embraced buybacks as a superior use of cash. We believe this has set up an investable opportunity today due to 3 converging elements: [1] today’s inflationary pressures are a symptom of last cycle’s underspend and a need for upgraded manufacturing bases (‘smart industrial’) and infrastructure is joined by decarbonisation, supply chain resilience or ‘near-shoring’, and energy security as critical investment priorities for the near, medium and long term[2]; [2] investor mindsets are conditioned by the past decade to expect that capex will undershoot expectations, particularly as macro expectations and cyclical companies’ earnings expectations roll over; [3] we have evidence that capex forecasts are proving more resilient than earnings forecasts, while market falls have made the risk-reward for companies exposed to this opportunity particularly attractive today.
How did we get here? Examining some key periods from the past two decades, we can make the following observations:
<ul>
	<li>Pre-GFC (2003-08): capex grew at an average rate of ~19% in the pre-GFC “golden era” (‘03-08). This wasn’t just driven by extractive industries – despite mining and oil &amp; gas leading growth, industrial capex (i.e., ex-extractive industries) still grew at a healthy ~15% rate.</li>
	<li>Post-GFC recovery (2009-13): while companies cut spending in ’09 (global capex down ~15%, or ~20% excluding extractive industries), good growth in 2010-13 (+7%) led by extractive industries meant that capex had recovered to ’08 levels by 2013 (though capex outside extractive industries was still some 7% below pre GFC levels).</li>
	<li>Extractive industry capex unwinds (2014-21): the mining capex unwind came first (2013) then a year or two later came oil &amp; gas. This capex reduction in extractive industries pulled down global capex to a 1% decline per annum on average. Excluding extractive industries, capex growth was ~4% over this period but was heavily influenced by semiconductors and technology (e.g., datacentres); excluding these industries, the balance grew at a ~2% rate.</li>
	<li>Where are we today: global capex is still 3% below its 2008 peak in dollar terms. Extractive industries have been a major drag but excluding these and semis &amp; tech, core industrial capex is only 1% above the ’08 peak.</li>
</ul>

But this is only part of the story. What we see in the charts above is the outcome (the actual capex dollars spent) which misses another critical element involved in the movement of equity prices – how expectations change. Below we show the capex forecasts for some major spenders between 2014-2018. Consistent moves down in expectations were the defining feature and our assessment is that this is embedded in investor memory and the mental shortcuts they consequently apply.

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This is important context for the dynamics we are witnessing today. Forecast revisions for cyclical sectors have weakened relative to defensive sectors, notably since the middle of 2022, leading to broad-based share price underperformance for economically sensitive companies.

Despite this, unlike 2009, capex forecasts are proving more resilient than earnings forecasts. We have aggregated the bottom-up analyst forecasts for capex in 2022, 2023 and 2024 for every company in the MSCI ACWI index to look at how these have moved over the past year. For 2023, for example, the aggregate level is +7% higher versus a year ago and the levels for all have hardly budged in US dollar terms since the end of Q1 2022 despite softening macro and the strong dollar. 2024 spend is expected to be higher than 2023, which in turn is higher than 2022.

When we drill down to a handful of key sectors and sub-sectors (below), the growth figures are like previous capex cycles while there is also a clear logic and narrative behind the current spend. The inflationary pressures we’re experiencing today are a symptom of last cycle’s underspend – the requirement to upgrade manufacturing bases (‘smart industrial’) and infrastructure is joined by decarbonisation, supply chain resilience or ‘near-shoring’, and energy security as critical investment priorities for the near, medium, and long term. Returning to the Rio Tinto CEO’s quotation at the top, “this is actually really fundamental” – rapid payback investments[3], helping build business resilience, or giving companies a licence to do business for the decades to come if we consider energy transition investments for oil &amp; gas companies or investment in electric vehicle platforms for autos. Or as Morgan Stanley puts it, “Even if we were to dip into a recession, we are of the view that these investments still need to take place as the problems do not get resolved with a moderating demand environment. In other words, the capex investments we envision and believe are necessary are incremental and largely cycle/capacity addition agnostic.”

The numbers involved are large. Morgan Stanley forecasts the following:
<ul>
	<li>~7.5% manufacturing capex CAGR over the next 3-5 years vs historical levels ~4%, and within this automation growing at ~10%</li>
	<li>Retrofit to enable EV infrastructure, onsite power generation and storage, and grid modernisation providing a 20-year runway of ~6% growth in electrical markets, incremental to industrial production growth and accelerating from 2025-30 (~$45bn opportunity between now and 2030)</li>
	<li>$350bn spending over the next 15 years to modernise the commercial building installed base, an additional $140bn over status quo investment requirements</li>
	<li>~$39bn from the CHIPS Act to bolster domestic US semiconductor manufacturing (plus $13bn for R&amp;D) versus a current ~$200bn manufacturing capex base</li>
	<li>~$370bn earmarked for Energy Security and Climate Change investments within the US government’s Inflation Reduction Act to incentivise the transition to greener energy sources</li>
	<li>~€200 billion by 2026 from the German government for investments in decarbonisation and energy dependence.</li>
</ul>
Some of the major investment opportunities come in what we might consider ‘derivative spend’. For example, we know that spend on renewable energy generation is ramping fast (captured above in Energy’s +23% increase in 2023 forecasts over the past year). A future grid with 20-30% solar is considered optimal, which requires a 3-5x acceleration in the pace of annual solar deployments. However less well known is that solar output typically flickers downwards by over 10% around 100 times per day[4] and building out power grids and inter-connectors is considered the best means of helping to resolve both short- and long-term variability in output. Thunder Said Energy estimates that power network investment can rise from an average $280bn per annum in 2015-20[5] to $600bn by the end of the decade, equivalent to all upstream oil &amp; gas capex in 2015[6]. Portfolio holding NKT is well placed to benefit from demand for its high-voltage cable solutions.
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Anticipation of a global recession has made accessing this long-term growth very cheap, with the prospect that for the select cyclicals that are beneficiaries, near-term earnings also look set to be more resilient than analysts are forecasting or share prices are embedding. Below are the price/earnings multiples (based on consensus earnings 1 year ahead) for a handful of companies held in the portfolio which are positively exposed to the trends mentioned:

And from a timing perspective, using the broad Capital Goods industry group as a proxy, capex beneficiaries have underperformed the bear market, but investors have nascently begun to differentiate their outlook versus other cyclical sectors. This suggests the idiosyncratic outperformance is in its early innings.

This entry point offers a positively skewed risk-reward: “heads we win, tails we don’t lose too much.” Nonetheless, it’s worth considering where we could be wrong. Firstly, and most obviously, monetary policy works with a lag – that’s to say, the capex cuts are coming, we just haven’t seen them yet. Do companies have the capacity to make the investments, even if they want to? Current analysis is relatively comforting on this point. Goldman Sachs “see the ability for public companies to spend $1.0 trillion in additional Green Capex without stretching balance sheets while still retaining 30%+ of operating cash flow.” The impact of rising interest rates is nuanced. For an announced project already underway and financed, corporates will likely have visibility on cost of debt for the coming 3-5 years; preparation for this spend is no doubt partly behind the reduction of short-term borrowing in Europe from 30% to 20%. Long-term lending (over 5-years maturity) is holding up well – it picked up slightly in August and is still above the pre-pandemic average growth rate. The broad observation is that although the bond market has repriced up sharply, banks have been happy to step in and so the true price shock for corporate borrowing is more moderate than bond yields suggest. Governments are clearly also stepping in with tax benefits and other incentives which reduces the bill that corporates will foot and shortens the payback on the spend they do.
We certainly don’t expect there to be no cuts, and indeed some have already emerged. Semiconductor company Micron recently cut its 2023 capex guidance by 30%, or $8 billion. Putting this in context, TSMC alone is still expected to spend $37 billion in each of the next 2 years and most of the semi capex cuts have so far been in memory, which was anticipated by many industry analysts given pricing trends there (logic and foundry are expected to be more resilient).

The long-term requirements for investment are relatively well-established by now, but we detect nervousness among investors about how a combination of tightening financial conditions, demand weakness, inflation and earnings forecast reductions will feed into an ‘air pocket’ and capex cuts during 2023 and 2024. We expect this is conditioned by the experience of the previous cycle, but the evidence is currently incontrovertible that we’ve entered a different regime. Many companies can’t afford not to invest today. Cleansing capitalism’s karma – or fixing the ‘sins’ of the last cycle – suggests casting off the ‘lower for longer’ playbook of 2010-2020 and instead looking to the 1970s for inspiration. Then, as now, inflation was the ‘disease’ and investing in the cure – the capex winners – was a profitable strategy.
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[1] Rio Tinto 2022 Interims earnings call, 27 July 2022.
[2] We introduced these ideas in our Q1 2021 investor letter.
[3] According to surveys, the key factors limiting Eurozone production currently are equipment followed by labour; until 2021 this was demand.
[4] Source: Thunder Said Energy
[5] Of which one-third was transmission, two-thirds distribution
[6] Thunder Said estimates $1 trillion annual spend by 2045 assuming wind and solar at just 20-25% of all global energy in 2050. 'Aggressive' renewables scenarios can require $2-3 trillion p.a. of power grid spending.

A global equity fund which combines valuation discipline and contrarian thinking with sustainability integration (SFDR Article 8)



Cleansing capitalism’s karma

Article

George Ensor, manager of the R&amp;M UK Micro Cap Investment Company, discusses his latest thinking in this interesting section of the UK equities marketplace.

R&M UK Micro Cap: March 2021 manager update

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It is hard to believe that this year marks the 40th anniversary of Transformers first hitting television screens. The fact that Paramount have confirmed plans for their eighth and ninth(!) films offers up two cultural observations: one is that film studios still can’t find any new ideas, and two is that the wider public have a long-standing affinity for anything robotic. 
The concept of Transformers was originally licenced by Hasbro from a Japanese toy company called Takara. They had created a line of smaller toys called Microman, supposedly in response to the high oil and plastic resin prices of the 1970s and to suit the limited storage space available in a typical Japanese home. An offshoot was exhibited at the 1983 Tokyo Toy Show and after a travelling Hasbro representative spotted them, the rest as they say is history.
Takara still enjoy the royalties today, but it is not the only case of Japanese behind-the-scenes ingenuity, efficiency and adaptation. The latest holding in the fund added at the start of year, Ebara, is more than one hundred years old, but houses a collection of businesses that collectively save energy, resources and money for their customers. It started with large-scale centrifugal pumps for water but soon broadened out into other applications and processes. Many companies have a corporate philosophy, but few have a “founding spirit” that sits above that. Ebara’s identity is translated as: “to address people and work with passion, repeated originality and ingenuity”.
The problem has been that this has not always gone hand in hand with healthy financial returns, despite technological success and the expansion of the company overseas. In some years profits might be reasonable, but margins would often revert back to the low single digits, and the company lost money in five out of the ten years from 1999 to 2009. Ebara had taken on debt in the 1990s and this became a burden when combined with falling infrastructure investment in Japan, a strengthening Yen and competition in the pump market. Revenue in 2012 was at roughly the same level as 1993, and the dividend was cut to zero in 2009 and 2010.
It can be dangerous to generalise this combination as being typical of most Japanese companies, or to write it off as unworthy of attention. Nonetheless, as was covered by Alex Stout in his <a href="https://river.global/news-insights/not-just-a-flash-in-japan">article</a> last year, many things in Japan are changing, and this includes Ebara. Unlike Transformers however, companies can’t shapeshift into something shiny and new at the press of a button. Generally, it takes lot of work, and time.
Starting in 2011, Ebara embarked on a series of 3-year plans to move into a position of decent profitability and growth. Despite not reaching some of its initial targets, it stayed the course, increasing research and development and added further divisional disclosures and improvement initiatives.
The efforts are paying off, and the company is now looking for at least a 10% operating margin and return on invested capital, and a 15% or higher return on equity. Given it already meets those, it also wants to improve growth, to be at a level of at least 7% in the coming years[1].
A division called Precision Machinery will do the heavy lifting, which makes a special type of vacuum pump, as well as chemical mechanical planarization systems. In the past these were small niches in the semiconductor supply chain. Now, the manufacturing requirements of new microprocessors are becoming far more demanding. Ebara’s products are among the few that can make sure that the facilities of its customers are clean, and their wafers flat. And not just flat, but very flat. If a wafer was scaled up to the size of a city like Singapore, one of Ebara’s machines could flatten it to within 1mm precision[2].
That division, which was losing money in 2008/2009, is on track to make up the majority of group profits. A significant difference. Along with improved project management, product development and incentives, the company has also made a step change in shareholder returns. The dividend payout ratio has moved up from only 10% around the time of the financial crisis, to 35% or greater today. With no net debt, the company should quickly start to produce excess cash flow for buybacks or acquisitions.
When we put all the components together, we were able to buy into an improving business with strong market positions, some unique technology, the potential for recovery and newfound pricing power and a strong balance sheet. At a dividend yield above 2% and a cash-backed earnings yield of above 10% within a few years, it was available for well within our valuation criteria. Just like Transformers, industrial companies come in many shapes and sizes. But rather than the fast, flashy and noisy ones, it can be the quiet and inconspicuous ones that are more impressive.
<a href="#_ftnref1" name="_ftn1">[1]</a> Ebara “E-Plan 2025” announcement, February 2023 
<a href="#_ftnref2" name="_ftn2">[2]</a> Ebara
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The focus of the fund is to invest in leading global businesses offering lower risk and modest share valuations.

We conduct proprietary research focusing on businesses’ long-term earnings potential, including ‘worst-case’ scenario modelling.

The outcome is a differentiated, conviction portfolio with a high active share.

Robot in disguise

River and Mercantile announces it has changed its name to River Global.  The rename reflects the bringing together of our combined investment talent under a single fresh and modernised brand; it does not impact the way any of its funds are managed.
River Global CEO, Alex Hoctor-Duncan, says: “We have strengthened our business through a series of strategic acquisitions and combined some truly exceptional talent under one brand identity. We wanted a new name to signify the company’s future and River Global now reflects this unifying strength and alignment.”
In recent years, the Company has acquired equity boutiques Saracen Fund Managers, SVM Asset Management and Indian specialist Ocean Dial Asset Management. 
Alex Hoctor-Duncan continues, “We have simplified and streamlined our business and product offering to better meet the needs of our clients. Whilst it hasn’t been an easy 18 months for our industry, we have used that time to consolidate and leverage the capabilities our acquisitions have brought us. I am confident that River Global will go from strength to strength, providing top-rated investment products and excellent service to its clients, underpinned by the complementary talents of an exceptional team of portfolio managers.”.
River Global manage £2.8bn in assets (as at 31 March 2023) for a range of wholesale and institutional clients focussing on listed equities. The investment boutique offers a focused range of investment products investing in UK, European, Regional and Global equity markets run by a number of industry veterans. As a fund house it employs a pragmatic, sometimes contrarian approach; as a result, a number of funds tilt towards value investing. 
James Sym leads the team as Head of Equities. Top performing manager George Ensor manages the UK Micro Cap investment trust, as well as the UK Listed Smaller Companies fund - which has a since launch performance of +392% vs index 111%. 
On the global front, Graham Campbell, who joined from Saracen, runs the Global Income and Growth fund, which has returned 54.7% over three years, outperforming the IA Global Equity Income sector by 21.3%. 
SVM’s 17 year veteran, Neil Veitch, manages the UK Opportunities fund, returning 508.5% compared to the index’s 200.9% since inception.

River and Mercantile rebrands to River Global

William Lough explains why his why his price disciplined, balanced portfolio, offers outstanding value today.
<h3>October Outlook</h3>
As we stand, the key risk in markets is high valuation multiples in long duration equities, in which lots of other investors’ capital is still invested. We have a ‘balanced’ rather than a ‘defensive’ portfolio, as we are not trying to make a directional bet on the macro cycle. Instead, we are simply staying true to the price discipline at the heart of our investing philosophy &amp; process.
We believe that the price discipline of our strategy is one of its key differentiators in a market that has appeared to favour chasing the share prices of popular companies higher over considering downside protection. It is worth highlighting that, despite falling for three consecutive months, the Tech-dominated NASDAQ 100 index is still up +33% year-to-date. The lack of follow-through from higher rates to the share prices of longer duration (“growth”) equities has surprised us thus far in 2023. We are not convinced that the recent weakness makes such companies exciting investment prospects, above all because investors can find superior risk-reward elsewhere.
Despite the re-emergence of a ‘proper’ yield in the bond market, multi-asset investors must not forget that one can also put together equity portfolios today with very attractive future return profiles and highly asymmetric risk-reward. Our well-diversified portfolio of equities yields 8% today but, crucially, that yield should rise to over 20% due to earnings growth. We think it offers outstanding value today.
 
<h4>Investment Background</h4>
Global equity markets fell for the third successive month in October (MSCI ACWI -3.0% total return in USD). The global benchmark has now fallen ~10% from its July peak. Risk-off sentiment continued in October as cross-asset volatility picked up due to rising rates, weak Q3 results, and geopolitical tensions in the Middle East.
Gold (+7%) and the US dollar were among the few assets up on the month, while within equities low volatility was the best performing factor. One traditional safe haven that didn’t fulfil the moniker last month was US Treasuries: US 10-year bond yields continued to march higher, from 4.6% to 4.9%, and breached the 5% level during the month. However, they have subsequently fallen back below 4.7% following Fed commentary in early November. Within Q3 results so far, weakening revenue momentum has been a more widespread feature, suggesting that monetary tightening has started to take effect.
 
<h4>Strategy Update</h4>
Performance
The fund returned -4.8% in August. In comparison, the MSCI ACWI index returned -2.4% (all in GBP). Since inception, the fund has returned +7.8%, compared to the global benchmark’s +5.9%.1
October was notable for punishing share price reactions to earnings announcements which showed any sign of weakness in demand or reduction in margins. According to Morgan Stanley, the divergence between short-term winners and losers in Europe is the highest since 2007.2
The largest detractor from relative performance was not holding a position in Microsoft (+7%). The largest detractors within the portfolio were US dental and healthcare distributor Henry Schein (-12% in USD terms) and US industrial Valmont Industries (-18%). The whole dental space performed poorly following a weak update from Align Technology. Recent survey data has been more positive regarding industry volumes. Specific to Henry Schein was the news of a cybersecurity incident. The company has not yet scaled the financial impact, but we are currently inclined to see this as a one-off, rather than an ongoing effect on profitability. Valmont reduced its full year guidance and now expects a modest decline in group sales. We had constrained our position size based on the potential for this near-term outcome (albeit it was not our original base case) and the shares now trade near trough valuation multiples.
Willis Towers Watson +13% was the top positive contributor. It delivered Q3 results which were ahead of analyst expectations. Having built up an unenviable reputation for reducing guidance, which has contributed to the stock’s valuation derating, this positive performance and re-iteration of 2024 guidance was well-received by investors. McKesson (+5%) had another strong quarter. Alongside the merits of its defensive characteristics in a weak market, investors view it as a potential winner from the distribution of new and rapidly growing weight-loss drugs.
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Activity
We built a new position in the CDW, the US-listed value-added-reseller of IT products. CDW is an underappreciated compounder, having delivered mid-teen EPS growth and 40%-plus cash return on capital over a sustained period. It has consistently taken share in a fragmented but large ($460bn) addressable market and continues to expect revenue growth 200-300bps above market growth rates. CDW sits between customers and technology vendors, creating value for both: on one side, it provides a wide range of technology providers, such as PC producers, software publishers, and cloud providers with cost-effective access to over 250,000 predominantly small- and medium-sized businesses; on the other, it supports these customers by using an understanding of their specific requirements to help them navigate the changing tech environment. The management team are excellent capital allocators, consistently widening the competitive advantage with bolt-on M&amp;A which adds incremental distribution or technology capabilities. We anticipate that a new wave of technology which is complex but productivity enhancing, such as AI, means IT budgets for smaller businesses will grow. Constrained internal resources to implement this suggest both addressable market expansion and an acceleration in the demand for the higher margin services within CDW’s offering.
Our position in Kenvue was sold following analysis into litigation related to its Tylenol product. Calls with US legal experts lead us to believe that, while Kenvue is likely to be able to successfully defend itself and limit settlement payouts within the range consensus expects, the legal process has potential to drag on for five years. Kenvue was bought as an attractively valued spin-out with margin upside, within the most defensive consumer category, not a litigation ‘special situation’. In addition to our desire to follow process and avoid ‘thesis creep’, we are also aware of the challenges similar investment cases have faced in recent years (e.g., Bayer / Monsanto). Therefore, while disappointing to sell so soon after purchasing the shares, we felt it best to move on with limited damage done due to our favourable entry price. We also exited the remaining small position in glass bottle manufacturer Verallia. Our view that there is near-term risk to the profitability per tonne of glass produced has subsequently been confirmed, with the company’s guidance lowered at the Q3 results.
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<h4>Upcoming Webinar</h4>
We will be giving an update on the Global Sustainable Opportunities Fund, hosted on BrightTalk, on Thursday 30th November at 10.30am (Duration 20 mins). You can register to attend <a href="https://bit.ly/3ugtqSj" target="_blank" rel="noopener">here</a>
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1Inception: 7 July 2022. Fund: F share class (GBP), midday to midday pricing. Benchmark: close-of-business to close-of-business pricing.
2https://www.reuters.com/markets/europe/investors-deliver-harshest-punishment-earnings-warnings-16-years-2023-10-27/

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The price discipline of our strategy is one of our key differentiators.

We think that there’s a sensible four-point checklist for investors who are negative about the prospect for UK equities.
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1. Depressed valuations
Small Cap valuations on both an absolute and relative basis are at levels that have historically been rare and only experienced in times of extreme stress.
With price to earnings multiples only being cheaper in January 1979, 1980, 1981 and 2009, you could be forgiven for thinking this could be an attractive opportunity.
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2. Depressed positioning and negative sentiment
UK small cap funds have seen an unprecedented run of outflows in both duration and quantum, despite a more recent improvement in both earnings and consumer sentiment.
Putting capital to work in this un-loved and undervalued sector could prove to be very rewarding on a three to five-year basis.
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3. Peak interest rate and inflation expectations
The rate of inflation is expected to continue to fall as the impact from lower input prices and energy costs depress the rate of year-on-year price growth.
June’s larger than expected slowdown in the rate of inflation, whilst only one data point, is the first in some time and supports our case that the UK is not an outlier on inflation.
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4. A slow-down in the rate of economic deterioration
Whilst economic growth remains low, the “longest period of economic contraction on record” predicted by The Bank of England last year has not materialised, as consumer spending has proved more resilient.
In fact, when compared to IMF forecasts at the start of the year, the UK economy has actually seen the biggest improvement within the G7.
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When will you invest?
Following the Global Financial Crisis, UK smaller companies experienced a phenomenal 12-year bull market (2009-2021) with a total return of almost 500%, double that achieved from the wider UK market. Since the end of this bull run, UK smaller companies have been in a bear market.
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Whilst no one can call the bottom, we’re asking: does all this bearish data make you more bullish? If it does, read George Ensor’s latest Quarterly UK Micro Cap Investment Company Ltd Report below.

What could all this negative data really be telling us?

William Lough delivers his monthly update on the R&amp;M Global Sustainable Opportunities fund.
<h3>May Outlook</h3>
The recent market dynamics remind me most recently of October-November 2020 during the speculative blow-off phase of the last tech/growth bubble. There are certainly echoes in the dynamics of the market beneath the headline figures. The exciting thing for us is that the extremes around valuation dispersion, covered later in this update, have got wider still. A new one to me is small and mid-caps in Europe now trading at their largest discount to the broader market in the past 20 years (source: CS HOLT).
If I put myself in our clients’ shoes for a moment and play asset allocator, the risk-reward for equities appears modest relative to other asset classes, but only if we judge this by the market-cap weighted indices. The opportunity set for equity investors with a valuation-driven approach who are benchmark agnostic, in contrast, is abnormally good.
Simply put, many share prices – particularly in smaller companies and/or cyclical companies – already reflect recessionary conditions. The 3-month gap between equal-weighted and market-cap weighted index performance has only ever happened in and around US recessions since 1990. The most recent 12-week rate of change is more extreme than all but two instances in the last 35 years – close to March 2020 and only exceeded in November 2008.
A combination of volatility induced by interest rate increases and fear of recession has driven mis-pricings across multiple sectors in both higher quality compounders and turnaround companies or cyclicals at or near the bottom of their cycle. This is truly a ‘target-rich environment’ in which to build a well-balanced portfolio with a wide margin of safety. I’ve not seen much higher than the ~60% upside to fair value we currently assess (weighted across the portfolio) and certainly not with the level of quality owned (13% cash return on capital and 10% sustainable growth). This is a good starting point to deliver returns which are uncorrelated to headline equity benchmarks.
Investment Background
Global equity markets were down slightly in May (MSCI ACWI -1.1% total return in USD), but with AI mania driving wide dispersion – a tale of two markets. In March, we flagged the disparity between the returns of a selection of mega cap US stocks and almost everything else (a notable exception being Japanese shares). This gap has expanded. MSCI ACWI Equal Weight underperformed the headline (market-cap weighted) index by -2.8% in May and is -6.7% behind year-to-date. Segmenting the market by factors, MSCI Growth outperformed MSCI Value by +6.3% last month, the 3rd largest spread since 2000 (after March 2020 and March 2023), stretching year-to-date outperformance to +19%. This is despite US 10-year bond yields moving higher, from 3.4% to 3.6%, as excitement about AI-related growth trumped the higher cost of capital.
&nbsp;
Strategy Update
Performance
As in March, what we do not own negatively impacted our relative returns (NVIDIA, Microsoft, Apple and Amazon.com accounted for -1.2% of the underperformance). We have, hopefully, been quite clear in our communication that we do not expect to perform well in markets with narrow leadership driven by the growth factor and larger companies. We typically expect to offset at least some of such a headwind through stock selection and last month we fell short on that front.
We cut our original Topgolf Callaway position in half over March-April and have halved it again. It fell -22% (in GBP) following reduced earnings guidance relating to corporate spend at Topgolf and higher interest rates on its debt. The share price has recovered some ground in early June off heavily oversold levels (supported by excitement around the merger of the PGA Tour and the breakaway Saudi-backed LIV Tour) but remains ~25% below its recent February peak. We are undertaking a full review of the investment case and have a meeting with the company in June. If we do not have sufficient conviction to rebuild to a normal weight, we will exit the position.
We cannot even claim to have got the short-term timing considerations partially right at Waters Corp (-15%), having been adding to our position at ~$300 per share. We understood Waters to be relatively sheltered from the bioprocessing and small biotech funding issues impacting other Life Sciences instrument companies which had reported weaker-than-expected revenues (such as Danaher and Sartorius). Having met the company, we understand the reasons behind the guidance change better and have an improved perspective on the path to a more attractive return on the Wyatt acquisition than is currently guided. The intermediate term looks bright but there remains enough risk to very short-term guidance to stay at our reduced weighting, despite the valuation gap that has opened up (in other words, we’re not prepared to ‘catch the falling knife’).
Activity
We started to build a position in Prudential, a recovery investment case where we expect a positive inflection in profitability to drive both earnings growth and a valuation re-rating. Following the spin-off of its US and UK life insurance and asset management businesses, Pru is now a pure play Asian life and health insurance business. It has new management, based in Asia for the first time, which takes over an excellent franchise which is under-earning versus its historic levels. Our analysis suggests this franchise is not impaired and therefore we can enjoy both a cyclical recovery as, for example, cross-border visits from the Chinese mainland to Hong Kong resume, and a re-rating as investors once again appreciate the long runway for growth its products have across Asia.
We exited our remaining holding in Industrie de Nora, which trades near our base case fair value. Upside and downside scenarios from here appear balanced and we therefore believe the capital is better deployed elsewhere.

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