How stock picker bucked trend as interest rates rose

Stuart Widdowson, of Odyssean Investment Trust (LSE:OIT), is the latest manager to appear in our Insider Interview series. Widdowson runs a very concentrated portfolio of UK smaller company stocks, currently comprising just 16 stocks. He explains to interactive investor’s Collectives Editor Kyle Caldwell how the investment trust outperformed peers over the past five and three years, with the latter period particularly proving a tricky backdrop to navigate investing in smaller-sized companies. Performance, however, has come off the boil over the past year, which Widdowson also addresses.

Also in the interview Widdowson explains the most recent purchase for the investment trust, plays down the risk of a recession severely harming smaller company shares, and explains why interest rate cuts could be a potential catalyst for this part of the UK market.

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Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today in the studio I have with me Stuart Widdowson, manager of Odyssean Investment Trust. Stuart, thanks for coming in today.

Stuart Widdowson, manager of the Odyssean Investment Trust: Thank you for having me.

Kyle Caldwell: The past couple of years have been a tricky backdrop for investors to navigate in UK smaller companies, since interest rates started rising at the end of 2021. However, you've outperformed peers over the past three and five years. How have you achieved that?

Stuart Widdowson: Well, there's a number of factors. I think the first thing is our focus on valuation. This concept of focusing on buying a discount to intrinsic value and being very clear what intrinsic value is. If you look at where small cap peaked in late 2021, there are many companies we saw in the market that looked to be trading at very significant premiums to their takeover valuations, and we were very wary about investing in those companies. Particularly growth companies, which is consistent with a basically zero interest-rate period where growth significantly outperforms. So, I think we've avoided valuation extremities.

The second is where we did find real value in the market. The market had become very polarised. We had a significant number of takeovers throughout 2021 and 2022, I think three in both years, and at quite significant premiums to the share price level before.

I think the final thing is this focus on companies that can improve themselves, even if their markets are quite difficult. And what we find is these companies take a number of years of action before the stock market tends to almost see the opportunity coming through. We think that's a very differentiated investment style to many of our peer group, which are maybe price and earnings momentum-focused, as opposed to fundamentally focused. So it's a very different, and we think quite complementary, style to many of our peer group.

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Kyle Caldwell: Over the past year, the investment trust has fallen behind peers. Why has performance come off the boil?

Stuart Widdowson: It's not unusual, although our long-term track record is fantastic. We tend to only outperform two out of three years compared with the broader market. And a number of things happened last year. So, we don't reinvest in consumer stocks. And there was a significant recovery in consumer stocks, particularly in travel and leisure stocks, last year. I think in aggregate, they went about 30% in small cap, and we don't own those stocks. So, not owning things that did particularly well.

The second was that we weren't really significant beneficiaries of M&A last year. Much of our portfolio now is in industrial companies. And although 10% of UK small-caps got taken over last year, none [were] in the industrial sector did. So, we didn't have that that positive kicker. And we had a few things that didn't work, and in a normal year, we have maybe two things that don't work. In a good year, one thing doesn't work. Last year we had three things that didn't work and that impacts us negatively. So, it's really a combination of effectively not having enough good news to compensate for probably slightly more short-term bad news than we would normally have.

Kyle Caldwell: Over the past couple of years, with UK smaller companies out of favour, we've seen a lot of money come out of UK smaller company open-ended funds and, as a result, the UK smaller company part of the market has become more attractive in terms of valuations. So, when you're looking across the market, are you finding more value opportunities than usual? And could you talk us through your most recent purchase?

Stuart Widdowson: We typically make only three or four new investments a year and sometimes we don't make any. What we did find was a large number of companies in 2022 where we became investors and they were trading [at] prices and levels where we thought we were going to get a much better return in those stocks than we would normally do over the sector.

A couple of very good examples [include] a new holding in the portfolio, which is a company called Gooch & Housego (LSE:GHH). We started building the stake in late 2022, and it's a company I know quite well because I originally invested in it just after the global financial crisis.

It's a niche provider of optoelectronic products and systems, and it had quite a difficult period going through Covid. It went through a period of having been a darling pre-Covid to having several operational issues as it tried to restructure and consolidate factories during the Covid period when, effectively, people weren't there, which was quite difficult, and the shares got derated very significantly.

Over the long term, the companies typically trade on two times EV (enterprise vale) sales. By the time we invested, we bought in [at] about one times EV sales. So, half the long-term average valuation. There's a relatively new chief executive there, again, a common theme. And he's set a target to get to 15% operating margins in the medium term, which we think is about three years, and sales are likely to improve.

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So, in that [sense], we thought this would be very interesting, a discount to intrinsic value, self-help going on to drive margins and effectively a company that we think is going to be worth a lot more in three to four years’ time, even if the stock market doesn't really improve, than the company is valued at today.

Kyle Caldwell: We're at the start of a new year and plenty of predictions have been made. In terms of UK smaller companies, the valuations are lower than larger companies in the UK market. However, a risk is a possible recession occurring in 2024. Will that harm the UK smaller company part of the market?

Stuart Widdowson: Look, this is the most talked-about recession that I've ever remembered in my career. The stock market doesn't always necessarily behave in the same way as the economic cycle. And quite often, once recession is announced, the stock market may have already bottomed as the stock market tends to look forward nine months or so.

The other thing about small companies, there's a perception that the health of the UK small companies’ sector is somewhat correlated to the UK economic cycle. There are many companies that are listed in the UK, in the small companies’ sector, that have very little exposure to the UK. You know, companies that are in the industrial sector that maybe export most of what they do. For them, a UK recession isn't that relevant. I think it's a factor and it will impact the different portfolios in different ways.

Kyle Caldwell: One potential catalyst for UK small companies could be the peaking of the interest rate cycle, and potentially there could be some interest rate cuts on the cards in 2024. Is that a view that you share?

Stuart Widdowson: I think it's one of the potential catalysts. Historically, as interest rates have been cut, risk appetite improves, and asset allocators do look at smaller companies in a broader way than they might have done in the past. The whole flows issue is quite important generally, because certainly we do find that there tends to be a domino effect, one or two things happen, people change their minds.

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UK small companies has been so unusual for such a long time, we don't think it requires much in the way of assets back into the sector, be it triggered by interest rate expectations, or just the absolute valuations [and] people seeing the opportunity. We don't think it's going to take much to see some quite significant moves in the market.

We can't predict when that's going to be but having worked through 2009, in the aftermath of the financial crisis, when it happened, it happened very quickly and very substantially. We don't know how quickly it's going to happen. We don't know when it's going to happen, but my gut feel is it will happen within the next 12 to 18 months.

Kyle Caldwell: And finally, the question we ask all fund managers. Do you have skin in the game?

Stuart Widdowson: Absolutely. So, for my kids and for me, our investment in Odyssean Investment Trust is by far and away our biggest investment.

Kyle Caldwell: Stuart, thanks for coming in today.

Stuart Widdowson: Thanks Kyle.

Kyle Caldwell: So that's it for this episode of our Insider Interview video series. Check out the rest of the series on our YouTube channel. Please let us know what you think. You can comment, like and please do hit that subscribe button and hopefully I'll see you again next time.