Schroder UK Mid - Half-year Report

Schroder UK Mid Cap plc

Half Year Report and Accounts

Schroder UK Mid Cap plc hereby submits its Half Year Report for the period ended 31 March 2023 as required by the Financial Conduct Authority's Disclosure Guidance and Transparency Rule 4.2.

The Half Year Report is also being published in hard copy format and an electronic copy of that document will shortly be available at the link below:

http://www.rns-pdf.londonstockexchange.com/rns/1118E_1-2023-6-27.pdf

This is also available to download from the Company's website 

www.schroders.co.uk/ukmidcap

The Company has submitted its Half Year Report to the National Storage Mechanism and it will shortly be available in unedited full text at  

https://data.fca.org.uk/#/nsm/nationalstoragemechanism.

Enquiries:

Paula Lockwood

Schroder Investment Management Limited 

Tel: 020 7658 6000

Half Year Report and Accounts for the six months ended 31 March 2023

Chairman's Statement

Investment and share price performance

During the six-month period to 31 March 2023, the Company's net asset value total return ("NAV") rose by 18.5%, comfortably outperforming the 15.0% return of the Company's Benchmark (FTSE 250 ex Investment Trusts Index). The share total return price rose by 18.7% over the period.

More detailed comment on the performance of your Company can be found in the Portfolio Manager's review.

Dividend

As portfolio income continues to recover the Board is pleased to announce an increased interim dividend of 5.5 pence per share for the financial year ending 30 September 2023, an increase of 10%. This will be payable on 4 August 2023 to shareholders registered at the close of business on 14 July 2023.

Discount management

The discount started and ended the period around the 11% mark, which is broadly in line with the Company's mid cap listed peers. The Board regularly monitors the discount and will continue to consider share repurchases should it widen to a level at which the Board believes buy-backs are in shareholders' best interests. During the six-month period to 31 March 2023, the Company did not buy back any shares.

Gearing

Net gearing as at 31 March 2023 was 8.8% versus 10.8% at the beginning of the period with £25.0 million of the Company's Revolving Credit Facilities deployed. It is expected that the Manager will continue to use this gearing to take advantage of attractive new investment opportunities and to participate in capital raisings by portfolio companies.

Outlook

After a challenging financial year for the Company in 2022 it is most pleasing to report a period of strong performance during the first six months of the current financial year. Despite the ongoing challenges of stubbornly high inflation and increasing UK rates, investor sentiment has much improved in 2023 and there are some good reasons for optimism in the outlook. Energy prices have decreased to more sustainable levels, relieving pressure on businesses and households, and inflation, though still elevated, seems like it may have peaked. Though the conflict in Ukraine continues and the associated geopolitical risks remain, a more stable domestic political environment has helped calm UK markets and improve sentiment.

Portfolio performance was strong during the period and more details can be found in the Portfolio Manager's review regarding the drivers of this performance. There are many reasons to be optimistic about the outlook for UK mid caps and the Company's portfolio. The portfolio contains many companies with strong balance sheets which have been resilient through a challenging period, continuing to grow earnings and margins. Many of these companies' unique offerings have allowed them to pass through costs to their customers enabling them to thrive in an inflationary environment. The UK stock market remains cheap relative to many other global markets on traditional valuation measures. Given these clear valuation opportunities, it is unlikely that elevated interest from foreign buyers, such as Private Equity funds, will abate anytime soon, with domestically focused mid caps being particularly attractive. While investors should never be complacent given the complex international situation, still sticky levels of inflation and the risk of higher interest rates in the UK, the overall outlook has improved from the beginning of the financial year and the Board remains optimistic that the Portfolio Managers can continue to find attractive investment opportunities with the prospect of long-term returns for shareholders.

Robert Talbut

Chairman

27 June 2023

Portfolio Manager's Review

Market Background

UK equities rose over the period helped in part as the country emerged from its self-inflicted crisis, when the former prime minister ("PM") and chancellor announced huge fiscal stimulus, with little regard to how it would be funded. Many of the policies announced with September's  2022 'mini-budget' were reversed and the new chancellor Jeremy Hunt used the Autumn Statement to emphasise fiscal discipline. These developments supported a strong recovery by domestically focussed areas which also bounced back as it transpired the UK economy had performed resiliently during the energy crisis. Data from the Office for National Statistics revealed that the UK economy had not contracted in Q4 2022, contrary to consensus expectations. As a result, the economy dodged a technical recession by dint of avoiding two consecutive quarters of decline following the contraction recorded for Q3 2022. More broadly, economically sensitive areas of UK equities outperformed in line with other markets. This occurred amid hopes that the US Federal Reserve might be in a position to 'pivot' to cutting interest rates in late 2023.

Portfolio Performance

The portfolio NAV achieved a return of 18.5% during the period, outperforming the Benchmark by 3.5%. Similarly, the share price returned 18.7%, and so the discount, which began the period at 11.4%, widened slightly to 11.5%. Gearing was a positive factor.

Stock-picking in the Consumer Discretionary sector, alongside our underweight in the Real Estate sector, contributed strongly to performance. Healthy absolute returns in Consumer Discretionary were driven by a combination of stock selection and more resilient consumer spending than the market anticipated. Pressure on the Real Estate sector has been relentless in what we must admit is a more normal interest rate environment.

At a stock specific level, homewares retailer, Dunelm, continued to bounce back from its oversold position at the end of September 2022, when concern around consumer-focused stocks was at peak levels. Dunelm has continued to trade strongly, taking market share in both its core homewares sector and in furniture. The company is continuing to benefit from people spending increased time in their homes, partly driven by more home-working, and also, presumably, because of a desire to save money, now that the excitement of being able to eat in a restaurant again has receded. The announced 40p special dividend emphasises both the momentum in the business and its cash generative nature.

Share buy-backs were a common factor amongst some of our top performing holdings, including commercial vehicle fleet operator, Redde Northgate, and UK specialist bank, Paragon Banking Group, which is exposed to the residential buy-to-let market, and proving very resilient. Games Workshop, the company behind the Warhammer franchise, performed very well on the back of news it had struck an agreement in principle with Amazon to develop its intellectual property into film and TV productions. We have long seen scope for the company to selectively licence its intellectual property to grow the fan base and create a truly global franchise. The Amazon deal has brought this potential to the attention of the wider market.

4Imprint, the promotional products business with over 98% of revenues coming from North America, continues to enjoy rapid post-pandemic growth. 2022 results revealed 45% revenue growth and record operating profit. With just 5% market share of an industry that is transitioning online, 4Imprint's leading digital marketing skills position it well for further market share gains.

The largest detractor to performance was cyber security business, NCC. In the second half of its financial year 2023, NCC experienced softening demand for its services, as large US West Coast technology customers deferred buying decisions. Margins are also being squeezed from cheaper, overseas competition, although the resilience of NCC's profitable escrow business is mitigating some of the pressure.

Payments specialist, PayPoint, underperformed as the market digested its acquisition of multi-retailer redemption product provider Appreciate Group. However, the company has, in early June 2023, reported a positive year-end trading update, stating that "profit before tax for the financial year ended 31 March 2023 will be at the top end of the range of market expectations, driven by the strong momentum across the business." Mining royalties business, Ecora Resources, delivered results that fell marginally short of expectations. In the last two years, the business has begun to move away from being a predominantly coal weighted business, using the supernormal profits from this commodity to pivot towards commodities that will enable the energy transition.

High performance polymer business Victrex underperformed on the back of full year results which revealed gross margin weakness. The company saw substantial inflation in raw material and energy costs, which it was only able to pass through at a lag. We continue to think the business is well-placed, with a 50% capacity share of the niche, high margin polyetheretherketone ("PEEK") market, a very solid balance sheet and a low valuation relative to its history.

After a strong run in the previous six months, defence business QinetiQ gave back some ground. However, post period end, the company reported strong operating results together with a significant upgrade to its long-term profit guidance, driven by increased opportunities in the Security and Intelligence markets.

Portfolio activity

We established a new holding in Babcock International, where we see growing demand for the company's defence and nuclear services combined with an improved balance sheet as a result of several disposals. We also added speciality chemicals company Elementis to the portfolio following the disposal of its chromium business, which should improve the company's balance sheet and sustainability profile. Following the disposals of its cigarette filters and packaging businesses, Essentra has emerged as a focused business concentrated on the attractive industrial components space. With a strengthened balance sheet, the business should be able to make smart acquisitions to consolidate a fragmented sector, while continuing to grow organically.

We purchased a stake in Senior, the British engineering company, which, we expect, will continue to benefit from the ongoing recovery in the commercial aerospace sector. This company's balance sheet has also improved significantly. The rationale for our WH Smith purchase is described above, and it is our main exposure to the Travel sector, where we expect to see a continuation of resilient consumer spend (as opposed to other types of consumer spend which may now be reaching exhaustion, post the re-opening bounce).

We disposed of oil services company Petrofac following news of the CEO's departure. We exited our residual position in PZ Cussons and reinvested the proceeds into drinks manufacturer and Irn Bru owner AG Barr, which made an interesting entry into the growing energy drinks market via its acquisition of energy, sports and protein drinks manufacturer Boost Drinks. This following the successful acquisition, several years ago, of 100% natural fruit cocktail mix manufacturer Funkin Brands. We sold engineer Weir following its promotion to the FTSE 100, in line with our stated policy.

We established a new position in oil and gas exploration business Harbour Energy which has a balance sheet about to swing to net cash and is delivering high levels of shareholder returns through buy-backs and dividends. In the short term, the shares have been weak, due to higher-than-expected levels of windfall tax on North Sea oil profits.

Outlook

Since the ill-fated mini budget in September 2022, we have experienced a period of relative calm, in addition to a welcome period of improved performance. However, there remains plenty to ponder, as ten-year UK interest rates have resumed their gentle curve upwards. We first wrote about "eye catching levels of inflation" in the 2021 Annual Report, and the fact is that although the UK economy has been more resilient than the vast majority of market commentators and forecasters expected, inflation remains stubbornly high. In the six-month period reviewed here, the 12-month rate of Consumer Price Inflation ("CPI") remained above 10%, a level unseen since the early 1980s.

Against this inflationary backdrop, a majority of the companies in the portfolio have fared remarkably well, demonstrating the pricing power we seek. Economic consensus suggests inflation will continue to fall as the year progresses, given lower energy and petrol prices, and it could even be that the suggestions in the media of price limits on certain commodity foods are enough to rein in this particularly sticky element of the inflation cocktail.

Our response, in this environment, is to stick to our strategy of choosing resilient businesses which can deliver high risk-adjusted returns with rising cash flows and earnings. We have maintained our focus on two categories of investment. First, those unique assets with scarcity value and franchise power that allow management teams to raise prices without noticeably impacting demand. The other category is more cyclical businesses or in industries that are undergoing some sort of change, or that might be at some form of a strategic crossroads. This could be industry consolidation, management change or supply retreating out of the market. As a result of this change, we believe these companies will deliver better returns on capital in the future, rewarding shareholders. Additionally, portfolio companies tend to be net cash, or to have low levels of debt. This is important as refinancing costs have increased sharply, hurting profitability, and increasing risks for equity holders.

Despite the consistently negative view presented in the media, there are a myriad reasons to be optimistic about UK mid caps. Consumer confidence is rebounding, with the highest reading for 15 months recorded in May 2023. In April 2023, 20 million adults saw a 10% increase in their incomes. This included over 12 million pensioners receiving the state pension, nearly 6 million receiving universal credit and over 2 million receiving housing benefit. The labour market is strong, and the housing market appears to have recovered from its near-death experience in September 2022.

Furthermore, the lowly valuation of the UK market continues to attract attention from Private Equity and trade buyers. Recent bids for UK mid caps Wood Group, Dechra Pharmaceuticals and Network International attest to this, and, if these valuation levels persist, the trend seems likely to accelerate.

We would also like to remind readers that we are fishing in an attractive pond. In terms of the long-term potential of UK equities, we suggest that investors willing to look beyond the ongoing negative headlines will find the UK punches above its weight. This can be seen in terms of multi-baggers relative to the US. (See "30-baggers": why the UK has more than its fair share), and this is why the Benchmark has beaten the S&P 500 return over the 25 years to 31 March 2023, when measured in local currency. In US dollar terms, it has very nearly matched the popular US index. This is despite the UK mid cap index suffering a substantial derating in the past 24 months. The Mid 250 is populated by multiple "unique" companies, with strong growth prospects, generating cash and delivering attractive returns on capital.

As stock pickers, we are confident that the collective strength of our holdings' balance sheets will continue to provide resilience in a challenging economic environment. We are sticking to our sell discipline, avoiding companies whose business models are in danger of being disrupted while seeking out companies which have the ability to reinvent themselves, or which might be the next mid cap disruptor.

Schroder Investment Management Limited

27 June 2023

Half Year Report

Principal risks and uncertainties

The Directors consider that the principal risks and uncertainties faced by the Company for the remaining six months of the financial year, which could have a material impact on performance, remain consistent with those on pages 18 to 20 in the Annual Report and Accounts for the year ended 30 September 2022.

Going concern

Having assessed the Company's principal risks and uncertainties, the continuing impact of the war in Ukraine, climate change risk, inflation risk and increasing interest rates, its current financial position, its cash flows, its liquidity position and Financial Reporting Council guidance, the Directors consider it appropriate to adopt the going concern basis in preparing the accounts.

Related party transactions

There have been no transactions with related parties that have materially affected the financial position or the performance of the Company during the six months ended 31 March 2023.

Directors' responsibility statement

The Directors confirm that, to the best of their knowledge, this set of condensed financial statements has been prepared in accordance with United Kingdom Generally Accepted Accounting Practice, in particular with Financial Reporting Standard 104 "Interim Financial Reporting" and with the Statement of Recommended Practice, "Financial Statements of Investment Trust Companies and Venture Capital Trusts" issued in July 2022 and that this Interim Management Report includes a fair review of the information required by 4.2.7R and 4.2.8R of the Financial Conduct Authority's Disclosure Guidance and Transparency Rules.

Income Statement

For the six months ended 31 March 2023 (unaudited)

The "Total" column of this statement is the profit and loss account of the Company. The "Revenue" and "Capital" columns represent supplementary information prepared under guidance issued by The Association of Investment Companies. The Company has no other items of other comprehensive income, and therefore the net return/(loss) after taxation is also the total comprehensive income/(loss) for the period.

All revenue and capital items in the above statement derive from continuing operations. No operations were acquired or discontinued in the period.

Statement of Changes in Equity

For the six months ended 31 March 2023 (unaudited)

For the six months ended 31 March 2022 (unaudited)

For the year ended 30 September 2022 (audited)

Statement of Financial Position at 31 March 2023

Notes to the Accounts

1.       Financial Statements

The information contained within the accounts in this half year report has not been audited or reviewed by the Company's independent auditor.

The figures and financial information for the year ended 30 September 2022 are extracted from the latest published accounts of the Company and do not constitute statutory accounts for that year. Those accounts have been delivered to the Registrar of Companies and included the report of the auditor which was unqualified and did not contain a statement under either section 498(2) or 498(3) of the Companies Act 2006.

2.       Accounting policies

Basis of accounting

The accounts have been prepared in accordance with United Kingdom Generally Accepted Accounting Practice, in particular with Financial Reporting Standard 104 "Interim Financial Reporting" and with the Statement of Recommended Practice "Financial Statements of Investment Trust Companies and Venture Capital Trusts" issued by the Association of Investment Companies in July 2022.

All of the Company's operations are of a continuing nature.

The accounting policies applied to these accounts are consistent with those applied in the accounts for the year ended 30 September 2022.

3.       Taxation

The Company's effective corporation tax rate is nil, as deductible expenses exceed taxable income.

4.       Return/(loss) per share

5.       Dividends

An interim dividend of 5.5p (2022: 5.0p) per share, amounting to £1,902,000 (2022: £1,729,000), has been declared payable in respect of the six months ended 31 March 2023.

6.       Creditors: amounts falling due within one year

The bank loan is one-year term loan from Scotiabank Europe plc, expiring in February 2024 and carrying an interest rate based on the Sterling Overnight Interest Average plus a margin. This loan replaced the three-year term loan from Scotiabank Europe plc, which expired in February 2023.

7.       Called-up share capital



8.       Net asset value per share

Net asset value per share is calculated by dividing shareholders' funds by the 34,581,190 (31 March 2022: 35,066,190 and 30 September 2022: 34,581,190) shares in issue, excluding shares held in treasury.

9.       Financial instruments measured at fair value

The Company's financial instruments that are held at fair value comprise its investment portfolio. At 31 March 2023, all investments in the Company's portfolio were categorised as Level 1 in accordance with the criteria set out in paragraph 34.22 (amended) of FRS 102. That is, they are all valued using unadjusted quoted prices in active markets for identical assets (31 March 2022 and 30 September 2022: same).

10.     Events after the interim period that have not been reflected in the financial statements for the interim period

The Directors have evaluated the period since the interim date and have not noted any events which have not been reflected in the financial statements.