The Small Cap Value Trust Trading On A PE Of 7.9x Earnings

Most UK small-cap investment trusts have a clear growth bias, but the top performer over the last three years is firmly in the value camp. If you think that interest rates and inflation will remain at higher levels than we have become accustomed to then it could continue to outperform, especially as the underlying portfolio is valued at just 7.9x historic earnings.

The £1.3bn Aberforth Smaller Companies (LON: ASL) has just released its annual results for the year ended 31 December 2023 in which it reported an NAV total return of 8.2%. This was behind the increase of 10.1% in the benchmark because of the manager’s preference for stocks at the smaller end of the small-cap spectrum.

ASL is significantly skewed in favour of the industrials and consumer discretionary sectors, whereas the main underweights are technology and real estate. Being positioned like this meant that the trust lagged its peers by around five percent during the Santa rally in the last couple of months of 2023, but since then it has pretty much matched the index.

Underlying Value

At the end of December the portfolio consisted of 78 stocks with an average market cap of £591m, compared to £957m for the benchmark. The PE multiples of the holdings are typically much lower than the index, reflecting the manager’s distinct investment style.

According to the accounts, the portfolio is trading on a PE of 7.9 times historic earnings, whereas the benchmark is valued at 12.8x. This suggests that it offers considerable value, as does the fact that six of its holdings were subject to takeovers last year.

In total there were a dozen takeovers in the small cap universe in 2023, of which the fund benefited from half. The deals were executed at an average premium of 66% to the pre-announcement share prices, with private equity houses being the bidders in seven of the twelve transactions.

Dividends, Discount And Buybacks

The Board has declared a final dividend of 28.55p along with a special dividend of nine pence, bringing the total pay-out for 2023 to 50.5p, a 6.8% increase on the year before. This is equivalent to a yield of 3.8%, with the dividends well covered by earnings and backed up by healthy revenue reserves of 42.55 pence per share.

Over the last 12 months the shares traded at an average discount of 13%, but that has narrowed slightly and they are currently available 11% below NAV. The downside risk is limited by the active buyback programme that last year resulted in 1.1% of the opening share capital worth £11.6m being bought back.

The managers say that the probability of a soft-landing has risen, but warn that the robust economic backdrop of rising government spending and high employment levels could mean that inflation continues to be an issue in 2024. If they are right it would tend to support their value style.

Outlook

They also point out that longer term equity returns are heavily influenced by the starting valuations. This means that the cheap portfolio rating should bode well and continue to support M&A activity.

The broker Numis says that the higher interest rate environment has been favourable for the fund’s distinct value style, which is reflected in the fact that it has been the best performer in the peer group over three years. They note that the managers have stuck to their approach through good times and bad, so investors know what they are getting.

It is impossible to predict how the macro-economic environment will pan out, so perhaps the safest strategy would be to pair Aberforth with one of the growth-oriented small cap funds. Even if value falls out of fashion, ASL is a large and liquid trust with an attractive 3.8% yield and an ongoing share buyback programme that should put a floor under the discount.

Nick Sudbury: