Ollie Smith: Now, if you were paying attention to the well-known pension correspondent at a certain pink newspaper this week, you will have seen the sad news that the UK Parliamentary Pension Scheme is decidedly underweight UK equities. Is that another story about talking Britain down and negativity? Well, you won't find any negativity in this studio about UK equities and not indeed about mid-caps. Joining me to discuss the plight of mid-caps and some well-performing businesses that are doing great work to know a claim whatsoever is Alexandra Jackson, Manager of the Rathbone UK Opportunities fund.
Alexandra, thanks so much for being here. I believe you've come armed with three examples of companies in your portfolio that are really sort of, shall we say, fundamental mid-cap stocks.
Alexandra Jackson: Absolutely, yeah. So, as you say, we do like to do ourselves down in the UK. But if you can go a little bit beyond below the FTSE 100, there are some really interesting mid-caps. We in the UK, we don't always have those big-name household brands, the direct-to-consumer names, the Magnificent Seven, for example. We don't tend to have those in the UK. What we are really good at here with particularly our homegrown businesses is often the plumbing, the next stage back, the picks and shovels, if you like, of these big businesses. And you get slightly different metrics in there. One of the reasons we like that is because you get to divorce the fundamentals of the company from, say, the oil price or the interest rate or house prices. And the company is able to then work through those with its own levers to pull.
So, for example, one of the stocks that actually has reported great numbers this week is Bytes (BYIT). It IPO-ed in December 2020. So, could have been classed in that sort of difficult group of late 2020, early 2021 of IPOs. But actually, it's returned 70% total shareholder returns since then, so very, very strong in terms of share price. But it's a brilliant business. They sell software essentially for particularly Microsoft, Adobe, those big software players, those big household names in the US. If you are a small, medium-sized business in the UK, or maybe if you're HMRC or the NHS, and you don't necessarily know exactly what software and services you need to push your business forward, a reseller like Bytes will come and help you do that. So, in the first half of this year, they build a billion pounds worth of software and services just in six months to UK corporates and public sector. It offers quite similar cash flow and growth metrics to a Microsoft or similar. So, you get to access some of those factors. You get that great growth. You can benefit from those structural drivers. It's not just cloud and digital transformation anymore that companies are struggling with. Now, we've got this AI boom. And people need advice on how to put that into their business and implement products effectively. Microsoft Copilot, which launches next week, that's going to be hugely popular. But what I hear amongst businesses is they don't know how to use it and how to make it work for them. You could go to a company like Bytes and ask them for some help. So, that's a sort of, kind of, slightly behind-the-scenes way to play Microsoft and that growth in software, but in a UK way.
Smith: Okay. And what are the other two companies then? How do they do it?
Jackson: Okay. The other one is – we talk about plumbing and liking the kind of plumbing of some of these big household names. Volution (FAN) is basically a plumbing business, in fact, almost anyway. They manufacture and install bathroom fans, so ventilation for your bathroom. So, it's not very exciting. It's not very glamorous. But it does make a great stock to invest in, potentially. Because – okay, so there is scepticism about owning a business right now that is facing into new-build housing, the construction sector generally in the UK, that repair, maintain, improve sector is also looking quite challenged at the moment. But if you have a huge regulatory driver behind you, which Volution does, which is around indoor air quality, it's around mold reduction in public sector housing, actually, you've got this enormous tailwind behind you. So, new-build homes are required to have a certain number of ventilators, fans used in the build process. Volution have also diversified geographically. So, they're not just facing into the UK. They've got a business in the Nordics, continental Europe and Australasia as well. So, you get this kind of nice revenue diversification from a geographic point of view. You're not just putting all your eggs in the UK new-build basket.
Smith: And would it be too cynical to say that as the new-build market and specifically, the practicalities of new-builds which are, they don't have a reputation internationally for being the best new-build houses in the world as they tend to go wrong, which they sometimes inevitably do. Is there any benefit to be derived there from the secondary look at a problem and then fixing it?
Jackson: Yeah. Well, I mean – and again, you can by not being a housebuilder, you're not vulnerable. Volution is not vulnerable to some of those issues around 5-star ratings and complaints and those sorts of issues. So, again, you get sort of the step back and then again, Volution will offer different products. So, they offer a sort of good, better, best strategy in terms of their products.
Smith: And in terms of what the government says about housing strategy, which is a very live issue at the moment, how exposes it to those kinds of chops and changes in share prices?
Jackson: Yeah. I mean, I think the mood music coming out of the Labour Party is much more supportive in terms of new-builds. So, that would potentially be a benefit to a company like Volution. It's not just government policy though, regulation around air quality and mold reduction is coming from all over the place.
Smith: Interesting. And our final stock, if you will.
Jackson: Yes. Okay. Another not particularly glamorous stock, it's JTC (JTC). Again, there are some great fund management and asset management businesses in the UK, but you're exposed to asset prices. Particularly at the moment, that could be quite challenging. We like to go a step back again to the plumbing of these businesses. If you are a fund manager, you need an administrator to run your fund, to do fund accounting, to calculate your NAV. JTC are also offering now increasingly tax services, banking, treasury, those kinds of things are sort of commercial offering, if you like. Again, a brilliant business which has grown both organically and inorganically. So, they do make acquisitions quite often and they also regularly raise equity to fund those. So, that's something to think about when you're looking at stocks like this. But they generate 30%-plus margins, which is very attractive in this environment. Really nice, solid kind of almost double-digit organic growth as well. So, there's lots of drivers behind a business like that.
Really strong management. They own a lot of stock. They're very, very cautious and conservative. So, the outlook for their business at the moment is incredibly strong because of the way they've positioned themselves and because of the growth in alternative products, wealth management, private client services, all of those areas that are in structural growth. And fund managers like me always try and get management teams to talk up their stock to say, yes, we're going to make even more money this year than you could expect or than we did last year. And they're very, very cautious people. They refuse that and they say, no, you know, keep your expectations on the ground floor. And that beaten raise cycle is really, really important for share price appreciation. And UK investors particularly like to see that.
Smith: I mean, I dare to see – and this is my final question – I dare to see this almost as quite an enjoyable job working on fund management with mid-caps. Is there any temptation to actually not encourage such businesses to make the larger leap into the large-cap space? I mean, businesses want to grow, don't they? But if you're enjoying these kinds of fundamentals businesses that don't attract too many headlines, but do a really, really good job really well, what are your thoughts on that?
Jackson: No, I think, that sort of organic rise into the upper echelons, into the FTSE or whatever, we've seen lots of our portfolio companies, Diploma or Unite Group move into the FTSE 100. For us, that level of market cap isn't – it's not a driver of whether we own shares or not. If you can be flexible around market cap, I think that's probably the best way to get the best chance of generating excess return in this market is by focusing on the fundamentals of the business, whatever size it is, and making sure the share price is reflecting something close to reality.
Smith: Amazing. Alexandra, thank you so much for your time. For more on UK economic prospects and indeed the mid-cap fund investing space, check out our regular editorial updates on the Morningstar.co.uk website. Until next time, my thanks to Alexandra once again, I've been Ollie Smith for Morningstar.
