A trust available at a double discount, plus two recent buys

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today, I'm joined by Jean Roche, fund manager of the Schroder UK Mid Cap Fund (LSE:SCP) Fund, which is an investment trust. Jean, thank you for joining me today.

Jean Roche, fund manager of the Schroder UK Mid Cap Fund: Very glad to be here.

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Kyle Caldwell: So far in 2022, the UK mid-cap part of the market has been out of favour and has underperformed even UK smaller companies. Why is investor sentiment so poor at the moment?

Jean Roche: Yeah, I was thinking about that myself in the last couple of days, and there could be a number of reasons which I could surmise. One could be that the mid-cap stocks tend to be held more in baskets, if you like, so baskets of stocks that you would sell or buy, and if the general view is negative on the UK, and on domestic UK, then you might be more likely to have a basket of mid-cap stocks that you'd sell rather than necessarily small caps, because you might not get the liquidity in those, so that could be a reason.

Another reason, again a technical reason, is that you've had a lot of significant outflows from some mid-cap funds, which has been in the media, and so you have forced sellers, then, of those mid-cap stocks. Because when you look at the fundamentals, there's not much difference between upgrades and downgrades between the mid 250 index and the small-cap index.

You have a roughly 50/50 split of them upgrading and downgrading over the year-to-date. There hasn't been a big divergence there, so I think it's probably more to do with technicalities rather than the company's performance.

And then maybe the other thing to say is that we may have started from a higher valuation at the start of the year, relatively speaking, so the mid-cap index had further to fall as well, so it might just be that, you know, the more expensive one has fallen more because it was more expensive because that's what's happening in the market at the moment.

Kyle Caldwell: Investor sentiment towards the UK market generally is very poor at the moment, so what do you think the potential catalyst will be for that sentiment to improve?

Jean Roche: Yeah, well, I think it depends on your definition of investor, because we are seeing at the moment that 8% of UK mid-cap companies are in a bid or merger situation. That compares to the usual average of 2% to 5%.

I think some investors are seeing great value in mid-cap and it's very much in favour for them. I think that sterling being weak is what's helping that as well, because a lot of these new investors who are coming in and getting involved in these bid situations, their home currency wouldn't be sterling, so that is helpful for them.

• Watch the other part of this video interview with Jean Roche: These three ‘disruptive’ shares could be FTSE 100 firms of the future

Kyle Caldwell: And with all the volatility that's been going on in the markets, have you been increasing portfolio activity more than usual? And could you run through your latest buys and sells over the past couple of months?

Jean Roche: No, I haven't been doing anything particularly sudden, as I think investors would hope to hear. We've been fairly slowly and steadily maybe nudging down, dialling down a sector exposure a little bit or a company exposure a little bit, and dialling another one up, depending on valuations. But we haven't tried to make a significant rotation into any sectors, I think that's maybe what you're asking.

In terms of new companies bought over the last six months or so, I'd point at Clarkson (LSE:CKN), which is the world's number one shipping services company. What is quite nice was that they had a significant upgrade to their numbers yesterday and that one is doing something rather disruptive.

It owns a lot of the shipping data across the world and it's built a new platform called the Sea Platform, and disruptors and companies with disruptive tendencies or qualities are companies that we like to invest in, so Clarkson fits very well with our portfolio.

Very strong management, the CEO works with the rest of his colleagues, very strong balance sheet, and a global, niche, number one position, so a very strong player, not just in the UK but on a global scale. And so that was one that fit very well with the investment approach.

Another example that I could give is a stock we've added to, which actually is an example of one we've held for rather a long time, five years or so, and that one is Cranswick (LSE:CWK), probably better known for sausages and bacon, but also increasingly in the growth market of poultry, and they are supplying the breaded chicken for your McDonald's chicken sandwich, if you're a fan of that.

And that is a very big growth market in the UK more generally, and I think it's very exciting that you've got a UK company supplying a global winner like McDonald's. So that's what's very interesting about this opportunity set of companies as well, they can be part of a global growth story like McDonald's.

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Kyle Caldwell: Have gearing levels changed at all over the past six months, potentially being increased in an attempt to buy low?

Jean Roche: There hasn't been a deliberate attempt to increase gearing. It's been around 8% to 10% over the last six months and it obviously moves depending on the net asset value, and there has been a bit more volatility in that in the last six months as well.

What I would say is if I see a good opportunity, it doesn't stop me raising the gearing. But if a company gets promoted to the FTSE 100, I don't automatically look to replace the gearing. So, it's on an opportunistic basis, not a deliberate attempt.

What I will say is, it's so difficult to time the bottom of the market that the gearing acts as a great way of accelerating your exposure to buying the bottom of the market. Because I think that's notorious and I think you're quite a fan of investment trusts and you understand the power of gearing.

Kyle Caldwell: Two things investors are having to contend with at the moment, which they haven't had to for a long time, is high levels of inflation and interest rates moving upwards. Are both those things in your mind when you're managing the portfolio? Are they influencing your investment decisions?

Jean Roche: I think that's a really important question. I think with interest rates, it's very much looking at balance sheets and being aware if your companies are exposed to floating rate debt, clearly, or if they have a lot of debt, and how they're managing that. And so, because we buy companies generally with strong balance sheets, interest rates aren't so much of a problem, but obviously they're sort of a product of inflation as well, and so inflation would be the more key debate.

And because we invest in companies with pricing power, more generally speaking, I think that's a great way to combat inflation. I definitely wouldn't be batting away the risks of inflation, but I can give you an example of two companies with gross margins of above 50% and you know, as the valuation guru Aswath Damodaran will talk about, it's a great way to protect yourself from high levels of inflation.

And so Victrex (LSE:VCT) would be one, the speciality chemicals company, and Games Workshop (LSE:GAW), the owner of the Warhammer games, also has gross margins around the 50%. Another one I could give is Future (LSE:FUTR). All those have good, high gross margins and I think that is a very good way to protect yourself.

But absolutely, it's something we're asking all our companies about. Are you passing through price rises, or in some cases they can do even better than passing it through. So that's becoming a very key part of the investment, health-checking your investments, making sure the pricing power that you thought was there, is now there. Now is the big test.

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Kyle Caldwell: The trust is trading on a discount. Would you argue that this is a good time to potentially pick up the trust as a bargain?

Jean Roche: Yeah, I think you're getting a double discount, you're getting mid-250 stocks, which are at a discount to their average, at a discount to global developed markets, a valuation discount, and then you [get] the additional discount via the investment trust with a healthy dividend on top. The dividend has grown by 32% in the first half of this year - we announced that in the last set of interim results. So, I think, yes, I do think it's a good opportunity.

Kyle Caldwell: And that leads me on to my final question: do you personally invest in the trust?

Jean Roche: I think the answer has to be of course, and that would be as you would expect. I would like to see a list of fund managers who don't invest in their own trusts, and I would be very curious to know the reason why they're not doing that. Both myself and my co-manager invest in the trust and can add at various times when we think the opportunity looks best.

Kyle Caldwell: Jean, thanks for coming in today.

Jean Roche: My pleasure, really nice speaking to you.

Kyle Caldwell: That's all we have time for today. You can check out the rest of our Insider Interview video series on the interactive investor YouTube channel, where you can like and subscribe. Hopefully see you next time.