Wotton: Strategic Equity offers deep value after AIM sell-off

Strategic Equity Capital (SEC ) manager Ken Wotton expects to see a rerating of UK small caps in 2025, pointing to the stark ‘mispricing opportunities’ that are available in this part of the market.

His comments follow a challenging period for the £141m smaller companies trust, which saw its net asset value (NAV) fall 8.8% over the six months to the end of December. This compares to a 5.2% rise by the FTSE Small Cap index over the period.

Gresham House’s Wotton puts this down to a challenging period for the AIM market, which saw speculative selling ahead of the Budget announcement, which included a halving of IHT relief for AIM investments.

Wotton said sentiment had remained negative due to expectations of lower future allocations to AIM stocks compared to historic levels.

‘Recent newsflow from a number of AIM companies confirming - or contemplating - their intentions to migrate from AIM to the main market has also weighed on sentiment towards the AIM market,’ he said.

Wotton - who takes a private equity style approach to public companies - runs a concentrated portfolio of 16 stocks and 65% of these are listed on the AIM market. He noted that some of the trust’s holdings saw share prices derate over the six-month period, even though they continue to perform well from an operational perspective. 

‘We take confidence from the resilient fundamentals across the portfolio which, in aggregate, was subject to sentiment-driven derating, contrary to the underlying performances and future expectations for the majority of our portfolio companies,’ he explained.

In his opinion, a number of SEC’s holdings trade at material valuation discounts to comparable private market transaction values. He said this provides a ‘strong margin of safety’ which underpins the long-term upside potential of the portfolio.

‘Despite the market volatility experienced over the year, we remain confident about the resilient underlying fundamentals of the portfolio companies and their ability to withstand the macroeconomic headwinds that look set to persist through the current financial year,’ he added.

These headwinds include high interest rates, low economic growth and what the manager describes as ‘UK government-driven cost inflation’, referring to the national insurance increase and minimum wage rise which were both announced in the Budget.

Mispricing opportunities

Wotton believes macroeconomic and geopolitical volatility are driving mispricing opportunities across the UK stock market, particularly smaller companies.

‘UK small caps across multiple sectors are trading at a steep discount compared to both global markets and historical M&A transaction precedents.

‘This valuation discount underpins our expectations of sustained corporate takeover activity as we enter 2025. Buyers paid on average a 44% premium for UK companies in 2024, highlighting the appetite for undervalued assets despite elevated deal funding costs due to higher interest rates.’

He expects to see ‘multi-sector arbitrage’ between UK multiples and precedent M&A transaction multiples, that will catalyse a rerating of small caps.

He also points to significant amounts of private equity ‘dry powder’ yet to be deployed, which will buoy takeover activity across the UK market.

The value of carve-outs

The manager was also keen to discuss the growing theme of ‘carve-outs’, which refers to a parent company selling a subsidiary or business unit.

‘There have been 20 meaningful carve-outs through 2024, with several examples where businesses sold off divisions at valuations higher than their prevailing group valuation – sometimes exceeding the entire market cap,’ he said.

‘We believe that carve-outs represent an underrated but powerful tool for UK companies to unlock value and overcome market discounts, creating significant shareholder value.’

His team is currently engaging with a number of companies where they see a potential carve-out as a way to create value for shareholders.

Over the six-month period, specialist financial services company Alpha Financial Markets Consulting left the portfolio after it was acquired by private equity house Bridgepoint. Wotton also partially divested from XPS Pension Group (XPS), which realised £31m in proceeds, after it was included in the FTSE 250 index.

During this time, Wotton initiated new positions in Diaceutics (DXRX), a data analytics provider, and digital marketing agency Next 15 Group (NFG).

Narrowing the discount

Gresham House has continued to increase its stake in the trust, up from 5.4% in February 2022 to 10.2% at the end of December 2024. The asset manager is seeking to narrow the trust’s discount by using up to 50% of proceeds from sales to buy back shares if the discount is higher than 5%.

In addition, Gresham House has committed to reinvesting 50% of its management fee each quarter if the shares trade above a discount of 5%. During the six-month period, the trust traded at an average discount of 7.8%. This has since widened to 9%.

Later this year, shareholders will have an opportunity to realise up to 100% of their stakes. SEC’s chair William Barlow said the structure and timing of this would be communicated in due course. He said it is being given careful consideration, given the ‘concentrated and less liquid nature’ of the portfolio.

‘Any mechanism to realise liquidity would require striking a balance between the pace of realisation and value protection for all shareholders,’ Barlow noted.

Over the past three years, SEC’s shares are up 5.1% which compares to a 4.6% loss by the average trust in the AIC’s UK smaller companies sector.