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26% and 16% EPS growth forecast for 2013 and 2014. Positive progress so far in H2 clearly gives scope for upside in the near term, while if storage sales progress to plan, we should see operationally geared upside in the longer term as well. Following a strong run, the 16.2x 2014 P/E is a premium to peers, which we feel is merited by these prospects. We estimate that 30% growth in storage in 2015 to £18.1m would generate 38p of earnings, and put the company on a low double-digit P/E multiple. If SATA progresses to plan, such growth would not be unrealistic.

Storage: PATA and SATA on track Within storage, demand for the company’s industrial PATA storage products has remained robust. Customer qualification and commercialisation of CML’s SATA products, where the company is working with a number of existing PATA customers to bring product to market, appears to be proceeding to plan, with initial shipments expected over the coming months. As a reminder, the market for SATA controllers is thought to be significantly larger than for PATA and growing more rapidly. In particular, the average price per controller chip is expected to be up to twice that of PATA. Thus, if customers start using CML for a significant proportion of volumes, it would not be unrealistic to expect storage revenues to more than double within three or four years. With the cost base expected to remain broadly stable, these incremental revenues should drop strongly through to the bottom line.

First chipset customer drives Wireless Following a muted start to the year, Wireless sales have rebounded, as expected in H2 as the first major chipset customer, a Tier One PMR manufacturer, commenced full production. Revenues per device from a chipset customer – where CML provides modem, RF and sometimes voice coding chips – can be 2x to 2.5x more than for just a modem.

CML’s IMS states that trading thus far in H2 has been ahead of management’s expectations. Both the Wireless and Storage business lines appear to have contributed to the robust trading. Customer commercialisation of products incorporating the company’s SATA chips appears to be on track, meaning that the prospect of an upwards inflection in growth and margins continues to draw closer.

Peer group comparison The 11 UK smaller cap investment companies that make up the peer group below encompass a range of divergent investment styles and SEC’s investment approach is unique within the peer group. SEC ranks tenth of 11 funds over one year. The principal reason for this may be SEC’s weighting to ‘smaller small caps’ and AIM companies, which, as we noted on page 7, underperformed FTSE small cap ex-IC stocks in 2012. SEC’s analysis of performance in Q412 highlights falling share prices for KCOM (disappointing results), Lavendon (which SEC believes may be shorted by hedge funds) and Tyman (on profit taking); these three stocks reduced the NAV by 2% over that period. SEC is sixth of 11 funds over three years and tenth of 11 over five years in terms of total shareholder return. SEC’s ongoing charges are the second-highest of the peer group and its discount is the second-widest. It is among the lowest-yielding UK smaller company funds.

Dividend policy and record The directors expect shareholder returns will derive primarily from capital appreciation and intend only to declare final dividends to the extent necessary to maintain SEC’s investment trust status (not retaining more than 15% of income). SEC did not declare a dividend in two of the seven accounting periods since launch. The dividend for the period ended 30 June 2012 was substantially higher than for the previous year and the highest paid since launch, but this should not be taken as any indication of likely future dividend payments.

There are 64.6m ordinary shares in issue and no other classes of share capital. Borrowing 25% of net assets is permitted, but a £5m loan facility with RBS expired in July 2012, and the board decided not to renew it since it was not being used. Ongoing charges for the year ended 30 June 2012 were 1.3% (2011: 1.5%). The management fee is the lower of 1.0% of the adjusted NAV of the company and 1.0% pa of the company’s market capitalisation (to prevent double counting, the holding in SRF II is excluded from the calculation). There is a performance fee of 15% of the outperformance of the FTSE Small Cap ex-IC Index plus 2% pa, with a high-water mark. The performance fee is capped at 1.75% of NAV, with the excess that is deferred to future periods payable if that period’s cap has not been exceeded and the NAV is still above the high-water mark. Shareholders can vote on whether the fund should continue as an investment trust at each AGM.

As a means of controlling the discount, the board has instituted a series of semi-annual tenders for 4% of the issued share capital at a 10% discount. The first of these tenders took place in May 2012 and the two held to date have both been oversubscribed. The discount briefly widened to c 25% in September 2012, but has narrowed since and is now around 18.5%, in line with its average over the past year. SEC has powers to buy back 14.99% of its share capital, renewed annually at the AGM, but outside of the tenders, it has not bought back stock since June 2011.

Recent performance SEC’s concentrated portfolio and the managers’ emphasis on bottom-up fundamental research suggest stock selection will usually have the greatest impact on SEC’s performance. Recent performance has been good in absolute terms (in line with SEC’s investment objective), but poor relative to the FTSE Small Cap Index ex-IC and those investment companies that specialise in investment in UK smaller companies. On balance, larger stocks and fully listed stocks outperformed other small caps in 2012. The AIM market, which is about one-third of SEC’s portfolio, fell by 1.6%, while the FTSE Small Cap Index ex-IC rose by 35.8% in 2012. This may have inhibited SEC’s performance. The managers also believe Q412 saw a good performance from high-indebted, low-margin companies, stocks that are generally not present in SEC’s portfolio.

Current portfolio positioning While the investment strategy places no emphasis on monitoring weights relative to any benchmark, it may be interesting to note that relative to the UK market, the portfolio has a significant bias to industrials and is very underweight in a range of sectors, notably oil and gas, financials and consumer goods. This does mean performance diverges significantly from that of the market. The managers have been deploying some of the cash in the portfolio, topping up holdings in E2V after its share price fell in October, Goals Soccer Centres (taking SEC’s stake in that company over 5%) and Gooch & Housego.

Overview As at 31 December 2012, SEC held 18 companies. The top 10 holdings accounted for 85.2% of the invested portfolio and cash was 4.9% of the trust. All the investments were UK companies. The average market cap was £203m and the listed stocks were valued on 11.0x prospective P/E with a yield of 3.5% and a cash flow yield of 14.6%. By contrast, the average FTSE Small Cap (ex-IC) stock was trading on 10.6x prospective with a yield of 3.2%. SEC’s portfolio had much lower gearing than the market, with end-2013 forecast average debt:EBITDA of 0.5x vs 1.8x.

SVGIM does not want to be involved in the day-to-day management of investee companies, but seeks to engage with them constructively. The managers are looking for solutions to a company’s perceived problems that will benefit all shareholders, rather than cutting special deals for themselves and, to that end, SVGIM tries to build a consensus between the interested parties if seeking change. SVGIM avoids companies where one shareholder is dominant (ie owns more than15%). SVGIM does not use the press or threaten litigation, believing this can be counterproductive. Neither does it seek board representation, as it wants the freedom to deal in the stock without being an “insider”. SVGIM does not, typically, threaten to call EGMs to try to force its agenda on companies. It believes that, over time, 75% of its investment return has come from stock selection and 25% from constructive engagement with companies.

SVGIM invests with a time horizon of two-to-five years. While the portfolio is not invested with regard to any benchmark, SVGIM limits exposure to any one industrial sector to a maximum of 20% of gross assets. The maximum investment in any one company is restricted to 15% (at the time of investment). The investable universe comprises all UK-listed companies (excluding investment companies) with a market cap in excess of £50m (c 650 companies). SVGIM screens these, placing emphasis on cash flow and asset backing and reduces them to a watch list of c 250 companies, which it follows closely. SVGIM builds cash flow models for each potential investment. It also makes an assessment of the underlying quality of the target’s business (good returns on capital, high barriers to entry). This analysis is important; attempting to “fix” a strategically challenged business could be futile. With each investment, SVGIM tries to identify potential catalysts for change and an exit plan from the investment. SVGIM draws on its extensive network of contacts in industry and private equity to aid in this evaluation and the Industry Advisory Panel is involved at all stages of the investment process. The team talks to management, advisors and other stakeholders, ensuring that they meet senior management before making an investment. SVGIM says providing equity finance to good companies that are short of capital has proved to be a successful strategy in the past and this has accounted for c 40% of its investment activity.

Investment process: Disciplined and responsible activist investing SVGIM aims to create a concentrated portfolio for SEC of 10-15 listed UK companies, with market caps below £300m at the time of acquisition. SVGIM is a value investor, which tries to identify undervalued companies and act as a catalyst to unlock the latent value in them. Where appropriate, the managers look to engage constructively to bring about strategic, operational or management change. When appraising companies, the managers emphasise cash flow and asset backing. SVGIM

SEC is managed by SVG Investment Managers (SVGIM), a division of SVG Capital. It was launched in 2005, raising £70.4m from investors. Adam Steiner and Stuart Widdowson, the investment managers of SEC, have been involved in its management since launch. They together with Jonathan Morgan, the Chairman of SVG Investment managers, own 3% of SEC. Adam Steiner and Stuart Widdowson also manage SRF II, a limited partnership vehicle launched in 2007 with holdings in common with SEC, using the same private equity investment ethos. SEC had a difficult time as the credit crisis unfurled, because a number of investments turned out to have been overleveraged. Two members of the SVGIM team who had been closely involved with the management of SEC’s portfolio left around this time and Steiner and Widdowson took a more hands-on role, reappraising the investment process with a greater focus on potential downside risk. SVGIM believes the strategy could accommodate AUM of up to £170m.

SEC is trading at an 18.3% discount to net asset value, a little wider than its average over the past 12 months of 17.9%. This is towards the wider end of the range of discounts for its UK smaller cap investment company peer group. In mitigation, the board has instituted a series of semi-annual tenders for 4% of SEC’s issued share capital at a 10% discount.

UK companies are benefiting from low interest rates, but battling economic headwinds. SEC can outperform by favouring companies that have defensive market positions, significant overseas businesses and robust balance sheets. We observe that SEC’s portfolio has, on average, much lower Debt:EBITDA than the average UK smaller company (0.5x vs 1.8x) and the portfolio is more expensive than the average UK small cap in price-to-book (2.2x vs 1.3x) and price-to-sales terms (1.0x vs 0.4x), which could reflect a bias to quality..............

SEC’s portfolio, constructed without reference to any benchmark, is focused on a narrow group of stocks that the manager believes are undervalued. SEC takes meaningful but not controlling stakes in these companies and attempts to influence their strategic thinking through a process of constructive engagement, sometimes alongside other stakeholders in these companies. The aim is to generate absolute returns by enhancing value over the medium term, targeting an IRR of 15% across the cycle. The core of the strategy is SVG investment Managers’ (SVGIM) proprietary research, which draws upon the manager’s extensive network of contacts in the world of private equity and in industry. It is also aided by an Industry Advisory Panel of leading figures with hands-on experience of managing UK companies. The portfolio is comprised of listed companies with market caps at the time of investment of less than £300m

Strategic Equity Capital (SEC) invests in a focused portfolio of smaller (typically less than £300m market cap) UK companies. It holds for the most part listed companies, but SEC’s managers apply a private equity ethos to the selection of investments. The managers aim to identify companies they believe are both undervalued and would benefit from strategic, operational or management initiatives. SEC seeks to bring about positive change by engaging constructively with these companies. Its performance relative to the UK market has been strong over the medium term.

the beauty of Chemring’s products is they’re expendable. So Chemring benefits from repeat orders, unlike defence suppliers of larger high-tech equipment. As is normally the case with British defence firms, the US and UK governments are Chemring’s biggest customers The long drawn-out invasions/liberations (call them what you want) of Iraq and Afghanistan have been very lucrative sources of business for Chemring. In the five years between 2006 and 2011, the company’s turnover quadrupled. The shares followed suit, rising from around 150p to over 700p................