Read Seneca Fund Manager Mark Wright on our philosophy for selecting UK Equities
At Seneca, three important observations have shaped our approach to UK equity investing. First, mid-caps have outperformed both large-caps and small-caps over the long run. Second, mid-caps are under-researched and so provide good stock picking opportunities. Third, within mid-caps, higher yielding and higher quality stocks tend to do well.
As a result, within UK equities we have a heavy mid-cap slant, with a particular focus on quality and value. Because of the stock picking opportunities, we also think it’s right to run relatively high concentration portfolios.
We define mid-caps as having a market capitalisation of between ￡400 million and ￡5 billion. They have tended to do better than large-caps simply because they are smaller and have greater growth potential.
Small-caps similarly have good growth prospects, however, they’re typically more vulnerable to business failure or severe business setbacks. This can be because they have more concentrated customer bases or supply chains or poorer access to capital markets than mid-caps.
Mid-caps are researched by fewer analysts than large-caps, which means there can be greater potential for investors like ourselves to deliver alpha through stock selection. It’s possible that mid-caps are yet to be ‘discovered’ by the wider investment community, reflected in lower valuations. The investment opportunity is both related to growth as the companies get bigger, as well as higher valuations as they get discovered.
We also think there are good reasons why high dividend yielding stocks and high quality stocks tend to do particularly well over time. With high dividend yielding stocks, investors are often distracted by more exciting “jam tomorrow” investments i.e. potential high growth companies. However they will often overpay for these and be disappointed when the companies under deliver on growth.
There is usually also some sort of negative news flow surrounding high dividend yielding stocks - if there wasn’t, they probably wouldn’t be trading on low valuations. The majority of investors are fearful in such circumstances, but as Warren Buffett would say, it’s wise to be “greedy when others are fearful”.
With respect to high quality companies, investors often underestimate the longevity of their business models and consequently undervalue the compounding effect of sustainable, high returns on capital.
Conviviality, the UK’s largest independent drinks wholesaler and franchised off-licence and convenience chain, is an example of the potential opportunities in the mid-cap space. In January last year, it was yielding close to 6%. At the time, the stock was covered formally by only four sell-side analysts. Furthermore, there was widespread fear of a consumer retrenchment, following the UK’s vote for Brexit.
We felt the revenues were defensive and as a result were attracted to the company’s strong cash generation and high return on capital business model. At the time of writing, the stock yields closer to 3% and is evidently more popular with investors. We are no longer invested, having crystallised a 65% return in just 10 months.
In September of 2015 we invested in a company called Diploma – one of our highest quality investments. Diploma is a distributor of low cost, but essential niche consumable components across a diverse range of industries and carefully selected geographies. The business model has consistently earned a high return on capital that has helped deliver strong cash generation and enabled the dividend to grow by over 15% p.a. over the last 10 years.
At the time of investment, investors were concerned that the plunging oil price would slow growth in the overall business. It did to some extent, but that part of the business has been bouncing back and the shares have re-rated accordingly. The stock has returned 107% since purchase, but we think it is still cheap and so remain happy holders.
Please remember the views expressed here are aimed at professional advisers only, are current at the time of writing and may change. They are not intended as investment advice or a recommendation to invest in the asset class or the specific investments referred to in this communication. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content. Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at 10th Floor, Horton House, Exchange Flags, Liverpool, L2 3YL FP18 001