The markets tell us what investors are doing. But what, exactly, are they thinking? Edison’s Inside the mind of investors aims to find out. In this edition, we talk to Richard Penny of Oberon Investments.
After several challenging years, is the UK small-cap market finally finding its bottom? Richard Penny, fund manager at Oberon Investments, believes we may be reaching an inflection point after an unprecedented period of underperformance.
‘We think the market is bumping along at the bottom’, explains Penny. ‘The peak for us was in September 2021 and, since then, we’re coming up for four years of decline. The absolute low point might have been the pre-budget period last October or November.’
Historic underperformance
The scale of this downturn puts it in extraordinary territory. ‘The AIM market is down some 59% behind the UK 100. So, the UK 100 is close to a 30-year relative low and AIM’s underperformance has been driven by outflows’, notes Penny.
This relative decline far exceeds previous downturns, including the global financial crisis and COVID-19 market crash, as illustrated in Penny’s analysis of small-cap cycles. Many AIM-listed companies have suffered even more dramatic falls, with approximately 30–45% of them down 80% or more from their peaks.
Market psychology and value opportunity
Penny sees strong parallels with previous market bottoms he’s navigated in his long investment career. ‘At some point, what we’re looking for is the point of the market cycle where people are buying the downgrades’, he explains. ‘When it’s the bottom, you can’t see it – it doesn’t come with a signpost saying this is the bottom.’
His contrarian philosophy echoes that of noted investor Howard Marks: ‘It’s easier to predict psychology than economics and, judging by how pessimistic everybody in the UK has been, usually that’s when you should be buying as an active manager.’
Exhibit 1: AIM down c 45% since 30 September 2021, but that is just the average
Source: LSEG Data & Analytics (compiled by Oberon Investments)
What drives the recovery?
Penny identifies several factors already triggering positive momentum:
Corporate action: ‘What we did see through quite a lot of last year was bids, which are an indicator the market’s cheap because external participants show it. If private equity and corporates are buying, they’ve done the work and know what’s cheap.’
Share buybacks: ‘Companies are taking the market out of the equation. They’re doing buybacks because they know the shares are cheap.’ He cites Imperial Brands, which combined a 10% yield with aggressive share repurchases, leading to approximately 60% returns including dividends.
Pension fund reallocation: after years of UK pension funds reducing their domestic equity exposure from 40–50% to as little as 4%, there are signs of reversal. ‘We are hearing that there have been mandates awarded by some local government pension schemes, with more to follow in the hundreds of millions of pounds, with money potentially landing in April or May.’
Investment approach
Penny employs a disciplined recovery strategy targeting beaten-down companies with solid fundamentals. He looks for businesses that:
- have previously demonstrated profitability;
- maintain strong balance sheets with limited debt;
- haven’t diluted shareholders despite market challenges; and
- possess tangible assets or valuable IP.
‘The triple whammy for multi-baggers is when you get growth in revenue, which drops through to profits even quicker with high gross margins, plus a re-rating’, explains Penny.
He draws an analogy to property investment: ‘If you buy a rental property and it’s without a tenant for a while with no income coming in, it doesn’t mean you’d sell it for a really low value. You’d sell it reflecting what it can make when you get tenants back. We know at some point the world will recover.’
Exhibit 2: Common characteristics of multi-baggers
Source: Oberon Investments
Sector focus
Industrials represent a key area of opportunity, according to Penny. ‘Industrials are easy because they tend to have factories and market positions where you can see sales over the years’, he notes. The typical industrial downturn lasts 12–18 months, but the current cycle has stretched to 30 months.
For more adventurous investors, Penny suggests that carefully selected biotechnology companies could offer the most extreme upside. ‘When the rules change from being very defensive, some companies that people might have worried would run out of money just rebound the most. The IP they’ve often had £100–120m spent on them.’
Optimistic outlook
Penny highlights his fund’s historical success in similar market conditions: ‘We had very good returns in 2008–09, we did 171% by buying some of these things, and coming out of COVID, we did 150%.’
While acknowledging the challenges of timing the exact market bottom, Penny remains convinced the opportunity is compelling given the extreme undervaluation. ‘Since 2016, the UK has been difficult, but that sell-off of 59% is as big as we’ve seen, and 3½ years is way beyond when it normally lasts.’
The current opportunity, in Penny’s view, is to exchange short-term uncertainty for significant long-term value, particularly in the sub-£200m market cap space where institutional investor participation has dramatically declined. ‘For companies below £200m, there are probably fewer than 20 institutional investors who will invest a couple of million pounds or more.’
We would like to thank Richard Penny for sharing his views in this edition of Inside the mind of investors.
