Stuart Widdowson, fund manager of Odyssean (OIT ) investment trust, says fears of inflation are depressing shares in the niche global leaders he likes to buy. In this 10-minute interview recorded in May, Widdowson, who has smashed the FTSE Small Cap index over three years with a 60% return over the benchmark’s 23%, explains:

• the strategy behind his concentrated portfolio of specialist market-leaders he believes are trading below their intrinsic value;
• how the resilient, cash-generative businesses he likes are generally in a position to pass on rising costs to their customers;
• but concerns that inflation will hit company profits is discouraging investors and creating buying opportunities in their shares;
• leaving smaller companies as a whole trading at their biggest discount to the rest of the UK stock market for 20 years;
• how he works with company managements to improve their businesses;
• his joint venture with fellow smaller company fund manager Chris Mills at Harwood Capital.

Can’t watch now? Read the transcript

Gavin Lumsden: Hello, I’m at the Frostrow Investment Company’s conference in the City of London and with me is Stuart Widdowson, manager of the Odyssean Investment Trust. Stuart, very good to see you. Could we just start by you describing your approach and why you think it might do well in this 1970s-style stagflation era we seem to be in with inflation surging and fears about the economic impact?

Stuart Widdowson: So, we are concentrated special situations investors. Typically, in smaller companies. Our approach is informed and really, directed by the team’s experience in direct private equity investing over many years. We look to find the companies of above average quality, where they’re trading at a discount to their intrinsic value, but where that intrinsic value can be improved by specific management actions. Why do we think it’s going to be, hopefully, a resilient and profitable strategy over the next few years? We back market leaders. We really like market leaders because they can put pricing up and they have scale advantages. We like companies with strong positions to their supply chain and where they don’t have any material customer or supplier dependence. We like sensible balance sheets, and we are valuation sensitive. So, we never overpay when we get to an asset. Broadly, if the companies don’t rate to our view of fair value, they attend to attract other buyers.

GL: These are smaller companies. You’re a smaller companies fund, but this approach is different from the mainstream. It’s more high conviction, a more concentrated number of companies?

SW: Absolutely. So, we typically have up to about 20 companies in the portfolio. We’ve currently got 15. the market-cap range, we look typically, up to about £1 billion, but our sweet spot is really 250 million to 500 million and it’s really a gap between micro-cap investors and many of the big, diversified small-cap managers.

GL: Which of your holdings would you highlight as being in a strong position to pass on the costs?

SW: Well, hopefully most of them because we did an exercise last year. We never believed that inflation was transitory and in April last year, we went and looked at how many of our companies could pass on price increases and how quickly. Anything that couldn’t, we basically, exited from the portfolio. A really good example. Yesterday, one of our portfolio companies, it’s a small company, we’ve invested in recently. They had their AGM statement and they said, there are pricing pressures within our components, but we’re putting up our sales prices more than our cost inflation and we expect to enhance margins. Great example.

GL: You highlighted recently, the Elementis and NCC. Elementis, specialty chemicals. NCC, help me out. Information assurance. What is that?

SW: NCC (NCC) has two parts of the business. One is a cybersecurity business and the other one is a software escrow business where, effectively, if your software provider goes bust, they look after the code and make sure your business can carry on using the software.

GL: So very specialist. A leader in their niche I presume.

SW: Global market leader in the UK, global market leader in the US, but their assurance business is where people-, their cybersecurity business was where people had concerns around inflation and whether or not they could pass wage inflation on. They have successfully done that. They had results quite recently and their gross margins in cybersecurity actually went up.

GL: I think the share price took a hit, but has started to recover since then. I was just wondering, do-, inflation and supply chain pressures that we’re seeing, do they change the companies you target or are they just simply providing investment opportunities in a turbulent market, share prices falling?

SW: I think they started to change where we were deploying capital, really, last year as I mentioned. I think where we see the opportunities today, are really three-fold. Firstly, companies that we think are able to pass on inflation, where the market is sceptical because the market will be undervaluing those situations, as in undervaluing the quality of the businesses and the management. The second is, companies where the market really thinks they can, but actually, companies can’t straightaway, but maybe with a lag. So, they might come out of the trading statement that says we’ve not been able to put pricing up quickly enough and there’s a slight earnings downgrade. The market gets frightened, particularly in the current circumstances and pushes the share price down below fair value, that’s a good opportunity. The third one is supply chain or parts of the market where demand is depressed. Effectively, the market is pricing that that demand will never come back and that’s a pretty pessimistic view of life.

GL: What do you say to people in this kind of-, there’s a big market rotation, big fundamental changes going on and appreciate you’re doing something a bit different from mainstream smaller company investors, but smaller illiquid stocks, even within the context of a closed-end fund like an investment trust, it’s just not where you want to be necessarily? 

SW: We think the valuation opportunity today, looks pretty compelling. We’ve just been at the conference, as you know, talking about what Quest, which is a cashflow based model, is saying about small-cap and it’s the first time in 20 years that small-cap has traded on a discount to its Quest DCF fair value.

GL: Discounted cashflow.

SW: First time in 20 years and these stocks are trading on 20% discount to their Quest fair value. The average over the last 20 years is that they traded on a 37% premium. So, it looks the most mispriced part of the UK equity market at the moment.

GL: So, you’re seeing a big buying opportunity. Just tell me, industrials are a big category of your stocks, but what exactly are they?

SW: These companies are typically, market leaders in a particular niche. So, industrials are at a very generalist-, about half the exposure is business-to-business electronics companies. Xaar (XAR), a specialist printhead business which is going through a multi-year recovery. We’ve made very good money on that, so far, the last 18 months. There’s a lot more to go for. Great team, great IP. It doesn’t look cheap on the current valuation, but we think it has very, very good medium to long-term prospects.

The other electronics company is Dialight (DIA), which again, is a recovery story. We’ve been in about a year. It’s a company I looked to take private, funnily enough, in 2002. Known it a very long time. It is a specialist in LED for industrial, high reliability solutions.  So chemical plants or mining, for example. Replacing, typically, sodium or halogen lights with LED. Has massive payback for the people operating these sites. With energy costs going through the roof, it’s really compelling. They’re got the highest ever order book they’ve got at the moment. Way ahead of what they’d normally have. We think the prospects in that business look really good.

GL: Sounds very interesting. You’ve mentioned recovery a couple of times already. There’s quite a lot of special situations here, good turnaround stories. How engaged, how involved do you get with a company? Do you sit on the board, for example? How much do you get involved with the management of the businesses?

SW: It depends on circumstance, and it depends on what proportion of the company’s equity we own. In the most extreme case, we will be heavily involved in chairman change because we think, ultimately, the chairman is the person that sets the direction of the board. You can look at our portfolio companies. A very high proportion of them, sometimes through interactions, sometimes just happens anyway. A lot of them have had new chairmen in the last three years. We think that’s a very positive catalyst for change. We don’t meddle. One thing that we do help companies with is investor relations. In the same way that Frostrow really helps small trust investor relations. So, outfits that help small-caps that maybe, aren’t as well covered by brokers.

GL: Sometimes, it’s just about getting the message across, not so much about fixing the business.

SW: We had one of our portfolio companies had only met three non-holders in the previous three years before we invested, and the shares were very cheap and no one had gone out to try and sell the story. So, we introduced an outfit to help them redo all their investor relations material and reach out to new shareholders and the company’s rerating was something like-, the equivalent market-cap increase was 100 times what they paid for the IR guy. So, you can make very good returns doing that.

GL: Again, that sounds impressive. Speaking of chairmen, you’ve got a history of attracting committed and loyal investors. One being Ian Armitage. Your ex-boss at HG Capital. It’s going back a bit, but that’s where you started out, made your name and he’s the chairman of the company, the fund management you’ve set up Odyssean Capital, which runs the Odyssean trust that we’re talking about. You’ve also got a fan in Chris Mills, who’s also a very well-known UK smaller companies fund manager because you’re part-, are you part of the Harwood Capital fold now? He’s helped you set up the business.

SW: He’s our JV [jont venture] partner for Odyssean. So, he’s a non-exec on the fund management board and he’s our biggest client as well.

GL: You share offices in the west of London.

SW: Chris and Ian approached me to set a new business up some time ago and the attraction of Christopher’s approach was, he basically said if you can set the business up, attract the money and run the money, I’ll provide everything else. The last thing most fund managers want to do is deal with is there an office, is there milk in the fridge, do we have meeting rooms, operations, do the systems work? So, it was a very, very good deal for both parties. Chris has been an excellent and supportive backer for the business and-.

GL: He’s an engaged investor like you. He does something a bit similar.

SW: There’s a meeting of minds. He doesn’t interfere, but he’s very supportive and I think the key thing is, the values that Ian and Christopher have and the way they’ve run their businesses in the past and in the case of Christopher, still do, there’s a shared culture. Skin in the game and the order that you should run your business is client, team, self. It’s unusual in the city and it’s a culture that works really well for us.

GL: Well, it’s fascinating to hear about. It’s a platform or nexus of similarly minded smaller company investors at work in the west of London. Stuart, a pleasure to talk to you and thank for your time.

SW: Thanks, Gavin.