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*A unit class launch 10 March 2003

Past performance is not necessarily a guide to the future. The value of your investment can go down as well as up; you could receive back less than you have invested.

Bid prices of some small to mid-cap stocks in the Fund were marked down quite sharply in December 2018 as global equities came under renewed pressure. However, these stocks rebounded strongly during the first few trading days of January 2019, in no small part owing to the Federal Reserve signalling that it would take a more pragmatic view and slow down future rate rises.

Following the rebound, the Fund had a satisfactory first calendar quarter in 2019. That well-known financial-world adage ‘Sell in May and go away’ did not apply this year as seasonal exuberance in the first calendar quarter continued into the second. However, a strong start in May 2019 then petered out in June 2019. Overlaying this were growing political anxieties in the shape of Brexit and in reaction sterling fell, which left domestically focused stocks in the doldrums. The Fund is, at least in part, cushioned from this by a good number of holdings that have material foreign earnings and benefit from structural growth.

The third calendar quarter was unusual in that two of our investments received takeover bids. Private equity and foreign buyers are snapping up United Kingdom (UK) quoted companies at a time when price earnings multiples are one third below United States (US) levels and sterling has been weaker. We consider that the UK equity market continues to be materially undervalued on a number of measures compared with both other asset classes and other global indices as many global fund managers shun the UK. We expect this to throw up some excellent buying opportunities.

Post period end, the return of a pro-business government after the snap general election, which promises a speedier conclusion to Brexit, has already brought an enormous improvement in sentiment. A number of our UK domestically orientated stocks have already rallied.

The outstanding contributor during the period was specialist publisher and fast-growing media company Future Group. It rose +131% and contributed +6.62% as the share price benefitted from upgrades. The company has had a transformative year crowning this achievement with admission to the UK Mid Cap index. The company has greatly increased in scale mostly through focused acquisitions but also via double digit organic growth. Expansion in the US, where organic revenue growth was a stellar 40%, has been key to progress with the region now accounting for 54% of revenues, up from 31% in 2018. One of the keys to Future’s success is its scalable media platform. Post the US acquisition of Purch in 2018, all Purch’s key web sites, such as Tom’s Guide, have been migrated to this proprietary technology platform, driving rapid top line growth through the monetisation of media assets in the form of e-commerce and digital advertising. The latest proposed acquisition (subject to regulatory approval) of TI Media, owner of titles such as Country Life, is a highly earnings enhancing deal. This brings new verticals in lifestyle, women’s interest and sport, creating yet further opportunities to leverage the company’s media platform. Post completion there will be 220 brands globally, the bulk of which will be monetised digitally. The acquisition of independent content creator Barcroft Studios helps to future-proof the business by adding specialist video production capability. The company expects full year results to be ahead of expectations.

Entertainment One succumbed to an agreed $4 billion bid from toymaker Hasbro underpinning a share gain of +51% and +1.79% contribution. Hasbro is clearly interested in the Peppa Pig and PJ Masks franchises, with all their associated merchandise. The UK Competition and Markets Authority is considering whether the yet to be completed deal might result in a substantial lessening of competition. A deadline of 21 January 2020 has now been set for it to decide whether, or not, to refer the merger for an in-depth investigation.

Veterinary chain CVS continued its startling recovery, contributing +1.58%. A warning in January 2019 took the shares down to 395p. They closed on 30 November 2019 at 1084p. The change of Chief Financial Officer (CFO) seems to have been pivotal to an improvement in fortunes. Under its previous ‘command and control’ approach the company had been instructing vets in detail on how to run their practices. One effect of this approach was a 12.5% vacancy rate, forcing the company to hire expensive locums. These temporary vets were also only half as productive in revenue terms as experienced vets, so the impact on profits was stark. Under its new CFO the approach has been to set budgets for each branch and then let the vets use their own judgement. The vacancy rate fell to 8.4% in the second half of the year to June 2019. CVS will not see a return to the heady growth of earlier years when it was able to buy practices at a big discount to its own share rating. This easy arbitrage has closed because of competition from private equity. Instead the company is focusing on operational improvements and organic growth. At the end of November 2019 the company confirmed that the improved trading performance continued in September and October 2019.

IWG, the global operator of leading co-working and workspace brands, contributed +1.55% after rising +76%. The company has embarked on a programme of franchising out its 3,300 centres around the world which has already unlocked substantial shareholder value, starting with the £320 million sale of its Japanese centres in April 2019. The high price being achieved is the main driver behind the rise in the share price. In August 2019 the company had announced the sale of its Taiwanese operations to a franchisee for £22.7 million. This may sound small potatoes but Chief Executive Offier (CEO) Mark Dixon said at his meeting with us that other deals, not on a national scale, are also happening but not being announced individually. Most recently in November 2019 the company confirmed its latest strategic deal to divest its interests in Switzerland for CHF120 million. The sale of the Swiss business on similar terms to the Taiwan sale demonstrates that the franchise strategy is gaining good momentum and, if sale prices are replicated, suggests that IWG is materially undervalued.

Clinical contract research and pharmaceutical services specialist Ergomed contributed +1.46% after the share rose +148%. Market forecasts were upgraded following interim results which confirmed strong year-to-date trading. Pleasingly, positive momentum has continued into the second half. Its Clinical Research Organisation (CRO) arm produced a better than expected performance with sales up 40%. Trading in the Pharmacovigilance business was also brisk with revenues ahead by 33%. The company has refocused exclusively on these two profitable, growing niches and is no longer distracted by drug development, which is behind the sharp improvement in profitability. Management says that there is potential for explosive growth on the CRO side. First, however, the company needs to scale up its CRO operational infrastructure in the US. The importance of the US is clear given that it accounts for 50% of global clinical trials market. The company expressed an aspiration to accelerate its US market entry through acquisition.

Liontrust Asset Management rose +56% contributing +1.24%. Assets under management (AUM) stood at £14.6 billion at the time of the interims in September 2019. The acquisition of Neptune Investment Management added a further £2.7 billion which together with continuing strong positive net inflows resulted in AUM reaching £17.9 billion by mid-November 2019. There have been strong flows into the company’s Sustainable offering where AUM has hit £4.6 billion. Liontrust’s next big push will be into Europe. Currently only around 5% of its AUM is for European clients. The regulatory base is Luxembourg, so it is Brexit-ready. Neptune has already been completely rebranded and the 15 fund managers have been retained but most of the other staff have left as Liontrust streamlines the operation. Liontrust is one of the winners in the asset management space and a core holding. It is hard to fault this business, which has been adept at spotting popular trends in fund management and hiring the teams to profit from them.

Games developer and publisher Codemasters delivered a very satisfying +0.77% contribution, powered by a +31% rise in the shares. The company produced a good set of interims helped by the earlier release of Formula One 2019 where sales leapt by 30%, a growing back catalogue, which now represents 25% of sales, and the introduction of microtransactions which extends the life cycle of games. Growing digital channel sales, up from 53.4% to 61.2% are also delivering a higher gross margin making the group more profitable. Looking forward, digital sales have the potential to reach 70% over the next couple of years driven by downloadable content, streaming and deluxe game versions. Its joint venture with NetEase could become a significant contributor in 2022 with the potential for the release of a blockbuster racing game in China. The share has already re-rated on the back of the clearance of a stock overhang (Indian-owned Reliance Big Entertainment has now sold its stake), the renewal of its Formula One licensing deal with Liberty International which substantially de-risks the investment proposition, and the acquisition of racing developer Slightly Mad Studios (SMS), which brings together two leading developers in the racing genre. SMS also broadens the list of global partners to include a Hollywood Studio with whom it has a deal to produce a series of games for a blockbuster film franchise. All-in-all, a great turnaround from last summer’s disappointing launch of Onrush.

Multi-brand franchisor and owner of Metro Rod Franchise Brands contributed +0.77% after rising +44%. The company reported positive trading together with strong momentum. Year-to-date sales growth in its core drainage business has accelerated and is up 15% compared with just 6% in 2018. The number of Metro Rod franchise businesses and territories being purchased by ambitious new owners is also accelerating. The company is also seeing an improvement in franchise recruitment across its consumer brands where year-to-date it has recruited 54 new franchisees at ChipsAway, Ovenclean and Barking Mad. In what is a ‘significantly earnings enhancing’ deal, the company has acquired a leading water pump supply business. The transaction will benefit Metro Rod’s national network of 400 drainage engineers enabling them to tender for pump services contracts increasing their total addressable market.

Lok’nStore rose +51% contributing +0.69%. The rise in the share price has been helped by an 11% rise in Net Asset Value to £5.33 and a 9% increase in the dividend. Also, there was an increase in margins to July 2019. Whilst these are important markers the new store pipeline has grown significantly and is the key metric driving the share. There are now eight Landmark stores in the pipeline and a further six more with lawyers. So, the current pipeline is up to 14 in total compared with the existing 33. Moreover, there has been a slight change in store selection criteria which is seeing a move out of the South East with new sites in the North and Midlands coming into play. Another factor driving profitability in this expansion phase is the mix of tenure. Over time, the proportion of leasehold sites has declined which reinforces the rising margin trend as do positive metrics on store occupancy and pricing. These factors all add up to a period of rising assets as new stores are revalued on hitting profits and this trend now appears to be an extended one. This stock still has a long way to go as a growth vehicle.

Staffline, the blue collar employment business, contributed a handy +0.67%. We took part in a £34 million rescue fundraising at 100p in June 2019 and were delighted to sell the holding at 180p in July 2019 in a single transaction.

Safecharge International contributed +0.64% after it accepted a $889 million cash bid from Nuvei, a private Canadian company. The payment processing industry is one of scale and staying small is not an option. Safecharge was a very pleasing investment for the Fund.

Charles Taylor (+0.61% contribution), the insurance services group, received a private equity backed management buyout bid at 315p. We had been unhappy with the share price performance and engaged with the Chairman to find a buyer for the company. On 8 November 2019 the offer was increased to 345p and this was approved by shareholders. We closed the position at 350p and collected the 3.7p interim dividend. Although this has been a profitable investment we are not overly pleased with this outcome, especially with the Executive Directors so conflicted. The shares have laboured under the extreme complexity of the financial statements, made much worse by the presence of a small life assurance business on the balance sheet. Underlying cashflows have been hard to analyse as a result. We suspect Charles Taylor is about to see an acceleration of growth from its insurance technology business. The take-out multiple was only 13.6 times earnings and the dividend yield 3.6%.

Document management and shredding specialist, Restore contributed +0.54% after gaining +15%. In November 2019 the company confirmed that trading was in line with expectations during the calendar third quarter. The core records management business continued its positive momentum with net box volume growth whilst the other businesses also performed satisfactorily. The company continues to see opportunities for selective mergers and acquisitions and during the quarter made three small acquisitions. Outside records management, there is ample headroom to grow given it only has 11% of its £1.8 billion end markets, particularly in the IT asset disposal end of life sector where it has a modest 3% share. Cross-selling, increasing market share, price increases, selective acquisitions and margin expansion from increased scale, property rationalisation, and more value-added services are the order of the day. The company has established its cash generative credentials by reducing net debt by £20 million in the 12 months to June 2019 and reducing leverage to 1.8x, which, judging by the positive share price action, has eased investor concerns. 

Hutchison China MediTech (HCM) had its best ever news in the clinic in June 2019 with spectacular phase 3 results from Surufatinib, leading to the early ending of the trial because they were so strong. Despite this news, the shares have drifted down resulting in a -1.60% detraction. This divergent performance was due to the very poorly handled reduction in the stake of parent company Hutchison Health to 49.9%. The turbulence in Hong Kong was a further factor, causing float plans to be aborted. In late September 2019 HCM gave further details on the Surufatinib results. These showed 9.3 months of progression free survival versus 3.8 months in the placebo arm, though there were also more frequent complications in treated versus untreated patients. One broker’s valuation assigned $11 per ADR to Surufatinib as it is wholly owned and seems likely to command a very high royalty if HCM chooses to out-license it. The highlight from a further raft of positive news flow in October and November 2019 was that Elunate, HCM’s anticancer drug for advanced colorectal cancer, will be eligible for reimbursement in China. The company is expected to become heavily profitable from 2023.

The Fund sold its positions in Charles Taylor, Diversified Gas & Oil, First Derivatives, Hotel Chocolat, Matomy Media, On The Beach, Quiz, Safecharge International, Staffline, WYG and XL Media. A range of investments were reduced. These included Future Group, River & Mercantile and Lok’nStore.

The proceeds were reinvested in a range of existing holdings including Applegreen, Charles Taylor (which was sold post period), Clinigen, Codemasters, Entertainment One, Ergomed, Franchise Brands, Gamesys, IWG, Restore and Randall & Quilter. A number of new holdings were also established. These included Arrow Global, Bonhill, CVS, Instem, Kape Technologies, Kin and Carta, Sports Direct International, Ten Entertainment, Tesco and SimplyBiz.

The Fund has performed solidly since inception and continues to offer the potential for capital appreciation. Our focus remains on the underlying operating performance of the businesses we own. With very few exceptions they are trading robustly. If they continue to deliver operationally then we confidently expect their share prices to appreciate meaningfully over the medium term. 

Slater Investments Limited.

December 2019