Buying opportunity for this market leading small-cap trust

4 mins. to read
Buying opportunity for this market leading small-cap trust

One of the areas worst affected by Brexit was UK small and mid-cap companies, which sold off heavily in the immediate aftermath of the referendum. These sorts of businesses tend to be more reliant on the health of the country’s economy than the multi-nationals in the FTSE 100 and their share prices have recovered strongly in the last few months as the macro environment has held up better than many anticipated.

Despite the reasonable performance, many small-cap investment trusts have experienced a significant de-rating with their shares moving on to a wider discount to net asset value (NAV). A good example is Henderson Smaller Companies (LON:HSL), which is one of the Winterflood investment trust team’s recommendations for their 2017 model portfolio.

The fund has been run by Neil Hermon since 2002 with the manager using a ‘growth at a reasonable price’ approach to stock selection. He also puts a lot of emphasis on meeting company management, with the team visiting more than 400 businesses every year.

Hermon considers his investible universe to consist of all UK companies with a market value of at least £100m that are outside of the FTSE 100. His typical holding period is five years and any stocks that are promoted into the blue chip index normally have to be sold within six months.

Diversified portfolio

HSL provides exposure to a diversified portfolio which at the end of January consisted of 114 different stocks. The ten largest positions accounted for 24% of the assets and included the likes of NMC Health, Bellway, e2v Technologies, Melrose Industries and the Paragon Group.

It is interesting to note that the 30 biggest allocations make up about half of the assets, which leaves a long tail of small positions that each account for 0.6% to 1% of the fund and that complete the rest of the portfolio. The main sector weightings were Industrials, Financials, Consumer Services and Health Care.

About a third of the fund was invested in mid-cap stocks, which was partly a reflection of where the manager was finding the best opportunities and partly down to the fact that he runs his winners. Most of the rest of the portfolio was in small caps, with 9% at the micro end of the spectrum that includes AIM-listed companies.

Hermon looks for undervalued stocks with good growth prospects, sound financial characteristics and strong management.

According to the latest interim accounts, the NAV rose by just 1.1% in the six months to the end of November, which was well behind the 4.4% increase in the benchmark. The main reason for this was the underweight exposure to the mining and industrial metal sectors. These areas did well in 2016, but the fund typically has a lower allocation to them because of the volatile nature of commodity prices, the high levels of leverage in the industry, and the poor corporate governance.

Hermon looks for undervalued stocks with good growth prospects, sound financial characteristics and strong management. Recent additions include: Avon Rubber, a specialised product supplier for the defence and dairy markets; Burford capital, a litigation financing company; Hollywood Bowl, the operator of 10-pin bowling centres; and the smart meter operator, Smart Metering Systems.

Writing in the latest accounts he said that balance sheets are strong and dividends are growing in the companies owned by the fund. He also pointed out that if corporate confidence improves, merger & acquisition activity would increase, especially as cash earns next to nothing and the cost of debt is historically low. This was evidenced by the agreed bid for one of their larger holdings, e2v Technologies, that was announced in December.

Excellent long-term performance

Under Hermon’s stewardship HSL has built up an excellent long-term performance record and has outperformed its benchmark, the Numis Smaller Companies Index ex Investment Companies, in 12 of the last 13 financial years. It would seem reasonable to conclude that the manager has been able to consistently add value via his investment strategy and stock selection.

Over the five years to the end of January the fund generated a share price total return of 168.3%, which was well ahead of the 98.6% achieved by its benchmark and was sufficient to put it in second place out of eleven in the AIC UK Smaller Companies sector. It should be noted that part of the reason for the strong relative performance was that it tended to have a higher allocation to mid-caps than its peers.

Small-cap funds are not normally known for their dividends, but HSL has successfully improved its annual distribution for the last 13 years with the most significant increases coming in 2014, 2015 and 2016. Last year it paid an interim dividend of 4p and a final dividend of 11p, which gives the shares an historic yield of 2.37%. This is likely to increase as the interim dividend has just been raised to 5 pence per share.

Some small-cap funds can be quite expensive, but that is certainly not the case with HSL as it has one of the lowest ongoing charges ratios of its peer group with the figure estimated at 0.44%. This is due to its low annual management fee of 0.35% and the fact that its relatively large market value of £473m makes it more cost-effective in terms of its fixed costs. There is also a performance fee of 15% of any outperformance, although total fees are capped at 0.9% of net assets.

Henderson Smaller Companies along with the rest of its peer group has been considerably de-rated over the last year and its shares now trade on a discount to NAV of 16%. Unless you are expecting the Brexit negotiations to have a severe and immediate impact on the UK economy, this could be a decent long-term buying opportunity.

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