Interim Results
MONTANARO UK SMALLER COMPANIES INVESTMENT TRUST PLC
PRELIMINARY ANNOUNCEMENT OF UNAUDITED INTERIM RESULTS
The Directors announce the unaudited statement of results for the period 1
April 2002 to 30 September 2002 as follows:-
STATEMENT OF TOTAL RETURN
(incorporating the revenue account*)
1 April 2002 1 April 2001
to 30 September 2002 to 30 September 2001
Revenue Capital Total Revenue Capital Total
£'000 £'000 £'000 £'000 £'000 £'000
Capital losses on
investments - (22,767) (22,767) - (19,082) (19,082)
Dividends and 1,244 - 1,244 1,227 - 1,227
interest
Investment (216) (216) (432) (276) (276) (552)
management fee
Other expenses (154) - (154) (261) - (261)
Return before
interest
and taxation 874 (22,983) (22,109) 690 (19,358) (18,668)
Interest payable and (154) (154) (308) (156) (156) (312)
similar charges
Return on ordinary 720 (23,137) (22,417) 534 (19,514) (18,980)
activities before
and after taxation
Return per ordinary 1.93p (62.05)p (60.12)p 1.34p (48.88)p (47.54)p
share
* The revenue column of this statement is the revenue account of the Company.
The financial statements have been prepared using accounting standards and
policies adopted at the previous year end.
All revenue and capital items in the above statement derive from continuing
operations. No operations were acquired or discontinued in the period.
These financial statements are unaudited and are not the Company's statutory
financial accounts.
SUMMARISED BALANCE SHEET
As at As at As at
30 September 31 March 30 September
2002 2002 2001
£'000 £'000 £'000
Fixed asset investments 57,117 78,543 68,979
Net current assets/(liabilities)* 4,235 (4,774) 4,517
Long term credit facility* (10,000) - (7,500)
Net assets 51,352 73,769 65,996
Less current period revenue (720) - (534)
Net assets for the purpose of 50,632 73,769 65,462
calculating the net asset value per
ordinary share
Net asset value per ordinary share 135.79p 197.84p 175.56p
* The 31 March 2002 figure for net current liabilities included £7.5 million in
respect of the credit facility. At this date the credit facility was considered
a short term liability as it was repayable on 1 August 2002. A new credit
facility with ING Bank was entered into on that date and is repayable in 2007.
SUMMARISED STATEMENT OF CASHFLOWS
1 April 2002 to 1 April 2001 to
30 September 30 September
2002 2001
£'000 £'000
Net cash inflow from operating activities 687 50
Servicing of finance
- Interest and similar charges paid (319) (308)
Net cash outflow from servicing of finance (319) (308)
Taxation
-Taxation recovered 1 -
Net inflow from taxation 1 -
Capital expenditure and financial investment
- Purchases of investments (12,126) (13,572)
- Sales of investments 10,038 15,384
Net cash (outflow)/inflow from capital
expenditure
and financial investment (2,088) 1,812
Equity dividends paid (690) (120)
Financing
- Proceeds of credit facility 2,500 -
- Ordinary shares repurchased and cancelled - (4,017)
Net cash inflow/(outflow) from financing 2,500 (4,017)
Increase/(decrease) in cash 91 (2,583)
These financial statements are unaudited and are not the Company's statutory
accounts. Full financial statements for the year ended 31 March 2002 include an
unqualified audit report and have been delivered to the Registrar of Companies.
INVESTMENT MANAGER'S REPORT
We are witnessing a period of considerable uncertainty causing erosion of
shareholder value unprecedented in my experience of more than twenty years in
the City. The Investment Manager's report this year is somewhat longer than
usual in an attempt to shed some light on the prevailing gloom.
PERFORMANCE
Over the six months ended 30 September 2002, the Company's net asset value
('NAV') declined by 31% compared with a fall of 29% by its benchmark, the
SmallCap. From the start of the calendar year, the NAV has fallen by 29% and
has outperformed its benchmark by 2%.
This report marks the largest stock market fall over any six-month period since
the launch of the Company over seven and a half years ago. It also covers the
worst six-month performance by the UK small companies market since 1973-74. At
30 September 2002, the SmallCap stood at levels last seen seven years ago.
From the launch of the Company in March 1995 to 30 September 2002, the SmallCap
has risen by just 6%. Over this period, the NAV has appreciated by 38% and
outperformed its benchmark by 32%.
REVIEW
Over the quarter ended 30 June 2002, the NAV declined by 10% in line with the
SmallCap. Most of the fall came in the month of June as investors became aware
of high profile corporate scandals such as the collapse of Enron and WorldCom.
The bear market has exposed corporate excesses that proliferated during the
euphoric era of the dotcom boom.
Investors faced an unprecedented loss of confidence in management, auditors and
advisers as conflicts of interest became ever more evident: auditors receiving
more in consultancy fees than for auditing companies, several of which have
been forced to restate accounts; stockbrokers remunerated on the basis of
corporate deal flow rather than impartial advice and who gave preferential
allocation of new issues to the favoured few; or management, incentivised
through stock options, who manipulated their company accounts to artificially
inflate earnings for self-gain. Who had the interests of investors at heart?
Who should investors believe?
Further uncertainty increased over the summer period, as investors were faced
with geo-political tensions over Iraq as well as continuing corporate
governance issues, disappointing earnings announcements and concerns over the
global economic outlook. The need to restore investor confidence was
highlighted in mid-August when 947 chief executives and finance officers in the
US were obliged to sign off and be criminally liable for their company accounts
- indicating a serious break down of trust.
Selling of equities accelerated in the third quarter ended 30 September 2002,
which saw the SmallCap fall by 22%. Unlike previous periods of uncertainty,
such as the collapse of hedge fund manager Long Term Capital Management in
1998, both large and small companies have suffered almost identical falls.
There has been a general exodus by investors from equities in favour of bonds
or cash.
ECONOMIC PERSPECTIVE
Perversely, recent economic data has been encouraging. Second quarter GDP
figures showed growth of 0.6%. The headline inflation rate in the year to
August 2002 was subdued at just 1.4%. Unemployment benefit claims this summer
were the lowest for 27 years. The housing market remains strong, encouraging
consumer spending. So far, the UK has avoided a recession, unlike the US, which
went into recession in the second quarter of 2001 (well before the terrorist
attacks on September 11) returning to modest growth in 2002.
HISTORICAL PERSPECTIVE
UNITED STATES
From the peak on 14 January 2000 to 30 September 2002, the Dow has fallen by
33% over almost 33 months. 'Looking at the period since the end of the Second
World War, and starting with the market peak in May 1946, there have been 11
bear markets [in the US] including the one we're in right now. The first ten
saw an average decline of 28.5% from peak to trough and lasted an average of 13
months.' (Source: Standard & Poor's - 26 March 2001).
'If one combines time and severity, only four other US bear markets since 1914
are more significant: 1919-21, when the Dow fell 47 per cent over 21 months in
post-war economic disruption; 1929-32, when the Dow fell 89 per cent [over 34
months] at the start of the Great Depression; 1939-42, when the Dow fell 40 per
cent [over 32 months] in the early stages of the Second World War; and 1973-74,
when the Dow fell 45 per cent [over 23 months] in the face of Watergate and the
oil price surge. All those declines were linked to severe economic or political
disruption'. (Source: Financial Times - 22 / 23 September 2001).
UNITED KINGDOM
From the peak on 10 March 2000 to 30 September 2002, the UK small company
market as measured by the Hoare Govett Small Company Index (the smallest ten
per cent of the UK stock market) has fallen by 45% over some 30 months. Since
the Second World War, there have been six UK quoted small company bear markets
and five recessions. The 1973-74 bear market was shorter, lasting only 2 years,
but fell by 67% - a time when the oil price quadrupled to $12 per barrel,
inflation hit 19% and the economy suffered a deep recession.
Only three bear markets this century have been longer, two associated with the
Second World War and one with the Great Depression. 'The UK market, as measured
by the FT Ordinary share index, finished lower year on year in 1947, 1948, and
1949…In the four years 1937-40 the FT Ordinary index fell every year, ending
the sequence 43 per cent lower than at the start. Happily, that's as bad as it
has got so far. In neither the UK or the US have the main market indices fallen
more than four years running since decent records began' (Source: Investors
Chronicle - 4 January 2002).
INVESTMENT RETURNS
As we head towards the third consecutive down year for the UK stock market,
such analysis offers some comfort. However, the end of the bear market is no
guarantee of high returns. 'The last three stock-market manias that ended in
1901, 1929 and 1966-68 were followed by 15 to 20 years of horrible average
annual returns, ranging between 2% and 5% - or zero to a negative 1.8% after
adjusting for inflation' (Source: The Business - 30 June / 2 July 2002). Since
January 1996, UK 10-year Government bonds have outperformed cash and equities -
returns of 74%, 47% and 15% respectively. Yields on 10-year US Government bonds
at the end of September 2002 fell to 3.6%, the lowest since 1958. What returns
can an equity investor expect?
For investors on Wall Street, Morgan Stanley estimate that '…since 1982, 8.4%
of the 15.2% annual return from the S & P 500 has come from a rising
price-earnings ratio [which cannot continue] …share prices are likely to rise
only in line with earnings. And these have only grown 6.5% a year since 1962'
(Source: Investors Chronicle - 10 May 2002). 'Mr Buffet believes that 6.5% is a
reasonable return for investors in a bear equities market' (Source: Financial
Times - 1 October 2002).
For investors in the UK, 'What is a 'decent return'? Even if dividends grow
more slowly than the economy over the long term, that could still offer a 2 per
cent real growth. Add to that the dividend yield and you get a real return of
just over 5.5 per cent (or 8 per cent nominal if you allow for inflation). That
is not a bad return in historic terms.' (Source: Financial Times - 27 / 28 July
2002). Annual real returns in the 1970s and 1990s were 5% and 7% respectively,
a far cry from the unprecedented 17% of the 1980s.
SHARE OWNERSHIP
UK quoted equities are held by a number of major classes of shareholder
(Source: ONS Share Ownership - February 2002):
OVERSEAS HOLDERS: 32.5% (£589 billion)
Overseas investors are now the largest holder of UK quoted equities (from 11.8%
in 1990 to 32.5% in 2000) often held by private investors in mutual funds.
Direct holding of shares by private investors has fallen over this time from
20.3% to 16%. These figures may have fallen recently - mutual funds recorded
net outflows this year of $14 billion in June, $53 billion in July and $6
billion in August. Global funds (with high weightings in European equities) saw
significant redemptions with record new investments in bond funds (Source:
Lipper - September 2002).
At times of market uncertainty, overseas (particularly American) investors
traditionally have returned to their domestic markets and repatriated overseas
investments. This happened in the October 1987 crash and also during periods of
emerging market turbulence. Such strategic decisions typically take time to
reverse.
INSURANCE COMPANIES: 21% (£380 billion)
Holding of UK equities by insurance companies has remained broadly unchanged
over recent years. Anecdotally, insurance companies have suffered recently from
the need to match liabilities on guaranteed annuity rate policies. These
policies, sold (or possibly 'missold') to the general public when returns from
equities and bonds were high, have become the Achilles heel of many insurance
companies as returns have fallen. The obligation to maintain free asset and
solvency ratios (the required minimum margin) has led to insurance companies
being forced to sell equities in favour of bonds.
PENSION FUNDS: 18% (£326 billion)
Holding of UK quoted equities by Pension Funds has been in steady decline,
falling from 32.4% in 1992 to 17.7% in 2000. The average UK pension fund has
reduced weightings in equities from 81% in 1992 to 71% last year, with foreign
investors taking up the slack. This secular shift out of equities has
accelerated as Pension Funds have been forced to take action to address under
funding of defined benefit schemes highlighted by FRS17.
According to UBS Warburg, at 30 August 2002 a total of 355 of the S & P 500
companies were estimated to be in deficit on their defined benefit plans for
the first time since 1993, with an average shortfall of 11%. The scale of under
funding is large - in the case of General Motors, over $22 billion. Morgan
Stanley estimate IBM may need to contribute over $2 billion to its pension plan
in 2004.
OUTLOOK
Institutions have become trapped in a vicious spiral of ever decreasing share
prices: forced to sell at depressed prices, they drive the stock market lower
and have to sell even more equities. Forced sellers are generally less
sensitive to price, causing havoc to share valuations. This in turn causes
private investors to panic leading to redemptions from funds managed by
institutions, creating self-perpetuating value destruction. So where do we go
from here?
The key issue is an absence of buyers of equities at a time of forced sellers.
However, there are glimmers of hope. Several insurance companies have already
reduced their equity exposure substantially (e.g. Equitable Life, Swiss Life,
Zurich Financial, Royal & Sun Alliance). Many pension funds have closed their
defined benefit schemes and others have increased their weightings in bonds
already (Boots Company plc now hold no equities at all). Pressure from forced
sellers should start to diminish soon. Furthermore, as the dividend yield of
the UK stock market increases, the argument for holding bonds to match
liabilities becomes less compelling.
HOW FAR COULD THE UK STOCK MARKETS FALL?
At 30 September 2002, the FTSE-100 Index ('FTSE') was at 3,722 and offered a
dividend yield of 3.75%. A decline to 3,460 (-7%) would increase yields to
above base rates (currently 4%) for the first time since 1965; a fall to 3,165
(-15%) would equate to a yield of 4.4% in line with 10-year gilt yields; a
collapse to 2,750 (-26%) would imply a yield in excess of 5%, a healthy premium
to gilts and above the long term average yield since 1965 of 4.6%. No benefit
from share buybacks is included in these numbers. An extreme fall of 26% would
bring the market price/earnings ratio to 12.3x, below the historic average
since 1965 of 14.6x, and would represent a loss of 60% by the FTSE from its
peak in December 1999.
However, there are important caveats when looking at dividends. 'Dividends have
grown by just 5.5 per cent since the start of 1998. According to Lombard Street
Research, UK quoted company dividends fell 4 per cent between the first
quarters of 2001 and 2002…[dividend] cover in the UK was 1.6 compared with a
peak of 3 in the mid-1970s and a figure well above 2 in the early 1980s. That
suggests that dividends will not keep pace with profits when the latter
recover' (Source: Financial Times - 27/28 July 2002). Dividend cover among UK
small companies is better, currently at 2.4x at the start of 2002 (Source: ABN
Amro). However, there must be some concern about the risk of dividend cuts
among insurance companies and some banks, which must be finding life difficult.
WHEN WILL THIS BEAR MARKET END?
History provides some clues. 'Many bear markets do not end until there is some
kind of crisis in the financial system, such as the collapse of many US banks
in the 1930s or the UK secondary banking crisis in the mid-1970s…bear markets
often end with a bang rather than a whimper; a climactic sell-off characterised
by massive trading' (Source: Financial Times - 6 July 2002).
Potential catalysts for such a sell-off include: confirmation of a double dip
recession in the US; insolvency of an insurance company unable to maintain the
required minimum margin or a bank due to problem loans; emerging market
defaults, such as Brazil; a geo-political catastrophe (perhaps linked to Iraq);
or, high on the list, problems related to the opaque and murky world of over
the counter derivatives. The proliferation of hedge funds has all the feel of a
bubble - an accident waiting to happen.
'Bear markets usually end when shares are remarkably cheap; in the mid-1970s,
the UK market was trading on a dividend yield of 13.4 per cent and a
price-earnings ratio of 3.8. But current valuations are well above their
historical averages' (Source: Financial Times - 6 July 2002). History shows
that markets generally overshoot both on the way up and down. 'Over the 40
years to 1995, the S & P 500 traded at an average of 15 times historic
operating profits; today the ratio is 20. Moreover experience shows that
markets generally overshoot on the way down: at the trough of the previous bear
market in 1982, the S & P 500 traded at only eight times profits' (Source:
Economist - 28 September 2002).
The current bear market for UK small companies has lasted more than 30 months,
the longest since the Second World War. Over this time, investors have lost
45%, approaching the 67% losses in the 1973-74 bear market, which lasted two
years. Pre-war bear markets typically lasted 35 months and saw declines of 49%
compared with declines of 37% over 20 months since. 'Investment led recessions,
which were common before the Second World War, tend to be deeper and to last
longer because it takes longer to purge the financial excesses and
over-capacity than it does to tame inflation' (Source: Economist - 25 August
2001).
Based on the longevity of this current bear market, history would suggest that
we might be nearer the end than the beginning. Potential catalysts for a
recovery may be linked to resolving some of the problems that caused it in the
first place. Restoring confidence and credibility with investors (particularly
in the US) will not be quick or easy. It might be helped by changes in the
regulatory environment, such as relaxing solvency tests for insurance
companies, reviewing the implications of FRS17 and increasing the regulation of
hedge funds (particularly disclosures on short-selling).
CONCLUSIONS
Following one of the longest bull markets and greatest bubbles in history, it
would be unsurprising to experience a symmetrically extreme bear market of long
duration. There are some signs of the panic and capitulation normally
associated with the end of bear markets: heavy selling by private investors in
the third calendar quarter of 2002 led to losses on Wall Street of $1.75
trillion. The equity risk premium is at the highest levels since 1957,
indicating that investors have become extremely risk averse.
Many 'investors' did not understand the risks of equities and will never
return: 'A 28-month bear market that destroyed an estimated $7 trillion of net
worth [equivalent to two thirds of annual GDP] has damaged both confidence and
personal balance sheets, making an early return to ardent equity-fund buying
seem an unlikely scenario' (Source: Lipper - 23 September 2002). It will take
time for people to lick their wounds.
Although it is quite possible that markets will overshoot on the downside,
particularly in the event of a global recession or deflation, yield support
(for those confident about dividend cover and growth) increasingly offers
investors some comfort and an incentive to accept the risk of holding equities
once again. Valuations are becoming more compelling: Credit Suisse First Boston
estimate that UK quoted companies below Euro 1 billion (£650 million) in size
at 30 September 2002 are valued at an estimated 2003 price/earnings ratio of
9.0x and a yield of 4.15%. Moreover, prospective returns from alternative asset
classes such as bonds and property appear increasingly unattractive.
We would not be surprised to see volatile market conditions continue. We remain
alert for evidence that sound value and confidence has returned to the UK stock
market such as an increase in management buyouts; corporate activity as
industries consolidate through mergers and acquisitions; debt issuance used in
part to buy back equity (the cost of debt for companies is the cheapest in
years). Good stock selection will be more important than ever. Over the course
of the past two years, we have strengthened our research team and in-house
analytical capability - which we are confident will prove beneficial in the
current environment.
As always, we make no attempt to make stock market forecasts. Our goal is to
identify well-managed UK quoted small companies at attractive valuations that
offer the potential for capital growth over the medium term (generally 3-5
years). To quote Warren Buffet: 'Great investment opportunities come around
when excellent companies are surrounded by unusual circumstances that cause the
stock to be misappraised… The future is never clear; you pay a very high price
in the stock market for a cheery consensus. Uncertainty actually is the friend
of the buyer of long-term values'.
CHARLES MONTANARO
Montanaro Investment Managers Limited
15 November 2002
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