Henderson Smaller Companies Investment Trust — A compelling option for UK small and mid-caps

Investors are preoccupied by the major themes of the war in Ukraine, rising inflation, the associated potential path for higher interest rates, and the Chinese government’s COVID-19 policies, which are all contributing to slowing global economic growth. So far in 2022, these concerns have seen global markets sell off by around 10%. The broad UK equity index has outperformed global markets, albeit still posting a negative return of c 4%, although UK smaller- and mid-sized companies have underperformed larger companies in this risk-off environment returning -18%, while AIM has lost around 26% in 2022 (Exhibit 1, all returns in pounds sterling, year to 26 June). The UK’s short-term outperformance can be attributed to the valuation support offered by UK equities relative to other regions (according to JHI, UK equities are trading at the widest discount to global equities in 25 years) and the mix of industries. The broad UK equity market as at the end of May had a 21.9% weighting in financials, which is expected to benefit from rising interest rates, 20.0% in basic materials and energy, which have benefited from strong commodity prices, and only 1.3% in technology.

It is possible that global growth will slow with the current macroeconomic headwinds and that the drivers are not short lived or easily overcome. Higher food, energy and input prices are a substantial burden on consumers and corporates alike, so it will become even more important to be able to identify those companies with defendable barriers to entry, strong recurring cash flows, solid balance sheets and talented management teams that are able to navigate this landscape.

Despite the macro headwinds, the long-term attractiveness of UK smaller companies remains intact. Often these businesses are faster-growing companies, managed by entrepreneurial-aligned management, operating in areas of disruptive technology and new business models. They can be the beneficiaries of mergers and acquisitions as larger companies are attracted to their growth and positive fundamentals and they tend to be under-covered by brokers and analysts compared with larger companies, which can lead to an informational advantage for those willing to do the primary research. As shown in Exhibit 2, historically UK smaller companies have outperformed the broader UK market. In addition, UK smaller company funds (as defined by the Morningstar UK Small-Cap Equity category average) have outperformed the Numis Smaller Companies Index (Exhibit 3) illustrating the alpha that good active managers can deliver in this under-researched part of the market.

HSL under longstanding manager Hermon has achieved significant (3.2%) annualised outperformance (to the end of May 2022) of its benchmark over his tenure. This outperformance is over and above the opportunity set, which in itself as shown in Exhibit 2, has outperformed the broader UK equity market. Over the same period (December 2002 to the end of May 2022), the Numis UK Smaller Companies ex IT Index has returned an annualised 11.3%, while the largest 100 companies in the UK have returned an annualised 7.0%.

HSL’s portfolio is well spread with over a hundred positions. It is diversified by sector and industry (Exhibit 4), after being through HSL’s investment process. The fund is built from the bottom up, so themes are not really prevalent in the portfolio, although the managers are benchmark aware when constructing the portfolio.

The single largest absolute and relative industry position is in industrials. This heterogeneous category includes a wide array of end users and industrial applications including longstanding positions in aerospace and defence company Ultra Electronics, engineering and construction business Balfour Beatty and business services company RWS Holdings. Within the consumer names there are again a wide range of types of companies, such as Watches of Switzerland (a primary play on demand for Rolex and other luxury watches), housebuilder Bellway and restaurant and pub group Mitchells & Butlers. Within financials, there are specialist lenders (OSB Group and Paragon Banking), niche and alternatives asset managers, such as ESG specialist Impax Asset Management and Gresham House with their higher-margin alternatives business and private client managers, Brewin Dolphin (which has agreed to a takeover bid from Royal Bank of Canada) and Rathbones. Technology is one of the largest relative overweight positions (Exhibits 4 and 5); Oxford Instruments has been a long-term position in semiconductor manufacturing, but there are also holdings in software and technology services via GB Group and Computacenter.

Basic materials (Exhibits 4 and 6) and energy have been a structural underweight in the portfolio. Some of these companies do not lend themselves to consideration within the investment process (as described in the Investment process section on page 10) as cash flows and earnings are largely dependent on volatile commodity prices, which tend to be cyclical and difficult to predict. There can also be ESG factors that present an issue for some managers, and finally the constituents of the investable universe are quite different from the major oil and basic material producers such as Shell and BHP Group in the large-cap universe. The managers are benchmark aware and will look to find suitable opportunities here, although in these two sectors they acknowledge that by not holding some of the more leveraged and speculative companies in the index, performance could be adversely affected when commodity prices spike, as they have done recently.

HSL’s investment process accentuates the long term, so portfolio turnover is relatively low with an average holding period of five years. Through 2021, the fund participated in seven initial public offerings (IPOs) including private equity house Bridgepoint and card and gift retailer Moonpig. There were also eight takeovers in the portfolio, with stocks such as John Laing and Marshall Motors leaving the portfolio, with six of these being private equity transactions, a theme that seems to be ongoing given the discrepancy of valuations in UK equities versus global peers, and the weight of cash available for investment in private equity funds. Through 2022 to date, the fund has seen bids for healthcare technology business EMIS from US-based UnitedHealth Group, a private equity approach for the B2B information services and data provider Euromoney and the previously mentioned purchase of private client manager Brewin Dolphin.

Transactions in 2022 to-date have been diverse but generally focused on adding to the existing portfolio rather than introducing new positions, although there have been four new additions: in land and property regenerator Harworth, security and defence contractor QinetiQ, private client wealth manager Rathbones and Workspace, which provides London-centric flexible office and light industrial business space. Examples of adding to existing positions, which have seen some share price weakness, include the housebuilders Bellway and Crest Nicholson, the gaming developer Team17 and consumer retailer Halfords.

Over the last 10 years, HSL has been more volatile in terms of its standard deviation of returns compared with the benchmark and peers. Historically, investors have been well rewarded for this extra risk with higher risk-adjusted returns than the benchmark (which excludes AIM-listed stocks). HSL’s sensitivity to market moves or beta is modestly higher than one over this period with a tracking error of around 7%. This is an active fund seeking to find the best opportunities, which we feel plays into the manager’s strengths and experience.

UK smaller companies can clearly be a volatile asset class. The combination of nascent/immature companies, developing technology and lack of liquidity all contribute to this. It is also considered to be an inefficient market with less analyst coverage per stock (if at all) when compared to larger companies. For those willing to carry out the fundamental bottom-up research, market-beating returns should be possible. It is thus pleasing to see that in a majority of recent financial years stock selection has been the primary driver of HSL’s returns relative to the benchmark (Exhibit 9, right-hand side).

Over the medium term (three and five years to the end of May 2022), the fund is ahead of the benchmark index by 0.7% and 2.4% annualised, respectively, and since Hermon started managing the portfolio in November 2002, the annualised net outperformance of the benchmark has been 3.2% to the end of May 2022.

In the year to the end of May 2022, the portfolio returned -17.7% in NAV terms versus -9.5% for the benchmark index and -13.1% for the wider UK small-cap universe. Smaller companies underperformed the broader market in what have been less benign economic conditions, as described earlier in this report. The portfolio is focused on holding companies capable of superior and persistent growth (Exhibit 10). In a rising interest rate environment, growth stocks were derated (Exhibit 11) as the duration of their long-term cash flows were discounted at higher rates. Operationally the portfolio companies overall continued to perform well. The use of gearing through the period also detracted from performance (although over Hermon’s tenure its use has been accretive to returns) and ended the period at 11% (24 June 2022: 12%). Value stocks performed relatively better, which is not where the portfolio is structurally positioned. HSL’s underperformance has not dented the exceptional long-term record in which it has outperformed the index in 16 of the last 19 financial years. In addition to the stylistic headwinds, there is also a lack of energy or basic materials in the portfolio, which have outperformed in a year (to the end of May) when the price of Brent crude oil rose from around $70 a barrel to $115. The manager’s investment process focuses on companies with enduring quality at the right price, with much of the available opportunity set in either of these two sectors failing to justify inclusion on environmental and quality (the ability to reinvest recurring cash flows into consistently higher-returning assets) factors. AIM, in which the portfolio has 29.2% (May 2022) invested, has been very weak in the calendar year-to-date. AIM stocks are not included in HSL’s Benchmark index, Numis SC ex IC.

The portfolio stocks that performed the strongest in the 12 months to end-May 2022 were Serica Energy and Ultra Electronics. Not owning Petropavlovsk, Trustpilot and Cineworld,all significant underperformers in the benchmark, was also beneficial to relative returns versus the benchmark index. Serica Energy is a North Sea oil and gas provider that is benefiting from the rise of oil and gas prices. It is well capitalised and is generating significant cash flow. Ultra Electronics supplies the defence and security industries specifically in the marine, aerospace and communications sectors, where it has significant intellectual property. The company received a bid from Cobham in August 2021 that is currently being reviewed by the UK government, given the strategically sensitive role that Ultra Electronics plays in UK defence.

The largest detractors within the portfolio to relative performance were Future, Team17, Bellway and Gamma Communications (not owning benchmark index outperformer Energean was also a relative detractor). Future is a media platform focusing on consumers and business to business, which monetises content through subscriptions and advertising. The company has guided to increasing earnings through its last financial year, but its share price has derated as the market has become more negative on the outlook for commercial advertising spending. Team17 develops video games for PCs, consoles and mobile devices. Post IPO in 2018 it has delivered good top-line growth and is well capitalised, although more recently its share price was weak as growth stocks underperformed over the period. Bellway is a UK national housebuilder, which has benefited from rising house prices (over and above input costs). Its shares were weaker in response to a required provision that it has set aside for remediating fire safety deficiencies on all of the buildings it has built (over 11m in height) over the past 30 years. In addition, the sector was weighed upon by rising interest rates and slowing UK economic growth. Gamma Communications supplies voice, data and internet services to pan European small and mid-sized businesses. The company has been highly successful in moving customers onto more flexible cloud-based solutions and has a success record in organic and acquired growth. Again, the share price was affected by the declining sentiment towards growth stocks.

The AIC UK Smaller Companies sector is one of the largest and most diverse peer groups with 24 constituents; these funds span a range of investment styles and approaches, reflecting that the investment trust structure provides a permanent pool of capital that allows investment managers to take long-term positions in stocks that may be less liquid, and is free from the obligation to return cash to investors at very short notice, as is the case for open-ended structures such as OEIC or unit trusts.

The average market cap of HSL’s portfolio holdings is c £1.1bn, which is higher than category peers or the index (Exhibit 13) and is a function of where Hermon and the team have historically found opportunities with a broadly underweight defensive, overweight growth tilt. The investment approach is one of low-turnover (average five-year holding period) and a willingness to run winners to gain the full compounding advantage of the growth potential within the portfolio. The manager has six months to sell holdings that are promoted into the FTSE 100 and there are currently two portfolio holdings in this index. Despite the permanent capital base, the managers still have an eye to liquidity and tend not to invest in those companies with a market cap below £150m. There is a range of market caps in the portfolio from Howden Joinery at £3.5bn, which was first bought in 2018, and Harbour Energy (£3.4bn, April 2021), both of which entered the FTSE 100, in March and May 2022, respectively, to stocks such as Access Intelligence, which was first acquired in August 2021 and has a market cap of £127m. AIM-listed companies are also a sizeable feature in the fund with 29.2% invested here at end-May 2022.

HSL has a number of notable features that stand out within the AIC peer group. Hermon has an exceptionally long tenure managing this fund for more than 19 years, with the average tenure for all small-cap investors in the peer group being less than nine years. The trust is the oldest in its category, having been incorporated in December 1887, and its fees are also very competitive with ongoing charges for FY21 of 0.39%, which makes this trust the second cheapest in the sector. The fee structure has provision for a performance fee to be levied if the fund outperforms, which may reduce the relative competitiveness of the fee investors pay here in the event of outperformance.

Despite the focus on growth, by virtue of the process seeking quality profitable and cash-generative businesses, HSL has increased its dividend each year, even in FY21, when dividend revenue from investee companies had declined. The FY21 dividend per share was 23.75p and was funded from portfolio income (13.86p), the revenue reserve and a small amount from the capital reserve. At the end of FY21, revenue reserves were 16.2p or 70% of the FY21 dividend. The fund has considerable capital reserves available for distribution if required. The current yield is 2.9%, which compares with the Morningstar peer group average of 0.66%. Since 2003 HSL’s dividend has grown at an annualised rate of 23.9% versus the broad UK market at 4.1% (source: JHI).

HSL’s board regularly monitors the share price discount to NAV and has shareholder permission to buy back shares. However, this facility has been historically sparingly used and no shares have been either bought back or issued over the past five years. The discount has fluctuated over the past five years from a slight premium to almost 20%, with an average over this period of around a 9% discount, which makes the current discount of 17.2% look somewhat of an overaction by the market in light of the excellent long-term returns together with the solid team and robust investment process. HSL’s performance has been challenged in 2022 with its growth style and lack of energy stocks. Historically performance has been more challenged in periods of market/economic weakness, but has rebounded strongly. This makes the current discount and recent underperformance potentially a good entry point for long-term investors. As is evident from Exhibit 18, investor demand for UK smaller companies has been in decline of late, which no doubt has also been a contributor to HSL’s currently wide discount, as shown in Exhibit 17.

HSL aims to maximise shareholder total returns by investing in high-quality, growing smaller companies in the UK. The benchmark is the Numis Smaller Companies Index (excluding investment companies), which is the bottom 10% of the UK Main Market by value, consisting of around 400 companies. The managers can also invest in AIM-listed shares, which increases the investment opportunity set by a further c 800 companies. The team generally avoid stocks with a market cap of less than £150m, which reduces the investable universe and helps mitigate liquidity concerns. New investments are limited to the Numis or AIM indices, and the managers are not afraid of running their winners and will continue to hold positions, when deemed appropriate, as they grow out of either index, although they will sell within six months if a stock reaches the FTSE 100 Index. Stock positions are limited to ±4% relative to the benchmark with sector positions ±10% versus the index. Equities can account for 80–100% of total gross assets with fixed income or cash limited to a range of 0–20%. No more than 5% of the gross assets of HSL can be invested in a single holding or into more than 10% of an investee company at the time of purchase (in exceptional circumstances and with board approval this may be increased to 10% and 20% respectively). No more than 15% of HSL’s portfolio will be invested into other listed investment trusts and net gearing is limited to a maximum of 30% of shareholders’ funds.

The investment universe is, at over a thousand companies, large and so to reduce this to more manageable levels the team uses broad-based screening on preferred metrics including liquidity and market cap and utilises its accrued knowledge over multiple cycles together with financial statement analysis. It will also draw upon its network of c 30 brokers with which it has built up long-term relationships to reduce the potential opportunity set to around 200 companies. The team can then carry out fundamental research on these companies, carrying out further in-depth due diligence including competitor analysis and meeting with company management (the team meets with over 300 a year). The investment process is based around the team’s well-established ‘4Ms’, which are used to assess a potential investment’s merits. This incorporates focusing on the companies’ models, management, money and momentum. It also serves as a process to review the ongoing merits of the investment thesis and deteriorating scores can result in a reappraisal of the buy case and can lead to an exit from the portfolio.

At this stage, the team also factors in valuation using measures such as P/E and EV/EBITDA multiples, free cash flow yield and dividend yield, depending on the most appropriate measure; ESG factors are also considered. With regard to valuation, the managers will reassess if they believe that the valuation has become too demanding, if there are violent unexplained movements in the price, if the price appreciation results in an outsized position, if there is a change in perceived risk or in the degree of upside potential. As already mentioned, any investee company entering the FTSE 100 will be sold within six months.

The 4Ms process generates a portfolio of around 100 companies, constructed with position sizes dependent on conviction, risk considerations such as benchmark and liquidity measures (authorisation is required where JHI owns more than 10% of a stock or where 20% of a fund is made up of positions where JHI owns more than 5% of a company) and upside potential. The portfolio is primarily built from the bottom up, with sector weightings a resultant feature. However, occasionally top-down and more regularly risk considerations can have an impact upon sector weightings as per the sector and stock relative limits as set out above. In addition, there is a weekly compliance sign-off process applied to the portfolio and pre-trade compliance monitoring via Charles River and a formal quarterly review meeting with the independent risk team. HSL has a high active share (the difference between the fund and the index, with 0% indicating 100% commonality and 100% zero commonality) versus the benchmark (76.2% at end-May 2022) and a historical holding period of around five years. The tracking error is not targeted but has historically been in the 3–7% range. The managers invest across the full range of UK smaller companies, including those listed on AIM (May 2022: 29.2%) and it has a bias to mid-caps (May 2022: 63.4%) when compared with the Numis ex IC Small Companies Index.

The process lends the portfolio a growth bias when compared to the index, with higher forecast earnings, sales growth and profit margins. It is also a higher-quality portfolio in terms of return on equity and lower debt-to-capital (Exhibits 19 and 20). For this growth the managers are paying slightly more in terms of free cash flow yield, price to book and P/E multiples (Exhibits 21 and 22).

Hermon began his career at Ernst & Young as a chartered accountant before joining General Accident and becoming head of UK smaller companies. He subsequently joined Henderson in 2002 as head of UK smaller companies, becoming director of UK Equities in 2013. Hermon was appointed as manager of the Henderson Smaller Companies Trust in November 2002. Van Hien began her career at PricewaterhouseCoopers, where she qualified as a chartered accountant. She joined Janus Henderson Investors as a UK equity analyst in 2011 before becoming a portfolio manager in 2016 and deputy fund manager on this fund in June 2016. She was appointed deputy fund manager in June 2016. The third member of the team is Sedani, who joined the team in 2017. All three are qualified accountants, which we feel is a particular strength in smaller companies investment, allowing a more in-depth and rigorous analysis of a company’s balance sheet and financial strength. The team also manages the open-ended variant of this strategy, which has a similar approach, the UK Alpha fund (c 50% overlap) and several segregated portfolios totalling around £1.5bn in assets.

The wider UK equities desk incorporates a further four people; this seven-person team has on average more than 22 years of industry experience. Hermon and his team can also leverage off the wider JHI Investment team including multi-cap investors such as James Henderson, Job Curtis, Laura Foll and David Smith. There is also a further three-person team at JHI who manage pan-European smaller companies mandates.

ESG factors are part of the stock and valuation analysis carried out by the managers. They believe that companies that take these considerations seriously will warrant a valuation premium over time. HSL does not rely on an explicit green mandate and no investments are screened out (apart from cluster munitions). It sees value upside in companies that are taking measures to address issues such as governance and environmental protection and its approach is to be an active custodian of investor capital and to use its influence to enact positive change in portfolio companies over time. In addition to its 4Ms investment process, which includes having access to key company management, the team can utilise the dedicated JHI governance and responsibility resource as well as external third-party ESG research providers such as MSCI.

During FY21, JHI voted primarily against director remuneration, director ‘overboarding’ and instances of concerns about director independence. It also voted against the payment of dividends by companies that had benefited from the Coronavirus Job Retention Scheme and not repaid it in the same financial year the dividend was announced. In total, JHI voted at 135 shareholder meetings during the year to 31 May 2021, which covered the portfolio in its entirety. On 16 occasions (11.9%), JHI voted against management or abstained. It voted against 27 resolutions in total, being 1.4% of all resolutions voted on during the year, and abstained on two further resolutions (0.1%). Overall, according to Sustainalytics the HSL portfolio scores significantly better on carbon risk when compared to the Numis Smaller Companies Index and has better sustainability characteristics than peers.

Aside from the formal voting process, the managers interacted with 352 companies through the course of the year, with ESG discussed at 225 of these meetings. Letters were sent directly to the chair of all portfolio companies setting out JHI’s expectations around employee incentives, environmental, diversity and inclusion targets with a view to voting against management if these were not met. This was a collegiate process with company management, which welcomed the guidance and ongoing discussions with JHI. Finally, there were quarterly engagements with companies including diversity and inclusion in the financials sector, supply chain sustainability in the retail sector, employee welfare in the travel and leisure sector and recycling in the technology sector.

Companies that can mitigate or improve environmental and social factors in society and those that can directly address the United Nation’s 17 Sustainable Development Goals are likely to attract ongoing investor capital and prevail over those that do not. Within the portfolio there are a number of companies addressing environmental issues in the areas of clean energy (sms), energy efficiency (Victrex), environmental services (Foresight), sustainable transport (TI Fluid Systems) and water, waste and renewable energy management (Impax Asset Management). Social impact is addressed vis knowledge and technology (RWS), health (Dechra), safety (AB Dynamics), sustainable property and finance (Gresham House) and quality of life via the Gym Group.

HSL’s strategy is to use a moderate level of gearing to enhance long-term performance. The company has a combination of structural and flexible debt facilities: a £30m 20-year private placement (at an annual rate of 3.33%) and a more recently arranged £20m 30-year private placement (2.77%) and £85m of short-term bank borrowings. Hermon states that, over the course of the 19 years of his tenure, the use of gearing has been a positive contributor to investor returns. There are also a small number (4,257 of £1 each) of preference shares in issue.

Fees are a combination of a management fee of 0.35% of net assets levied per annum and a performance fee. 70% of the management and performance fees are charged against capital, with the remainder levied against revenues (which is the same for financing costs). The performance fee is calculated as 15% of any outperformance of the benchmark index, on a total return basis over HSL’s financial year with the combination of management fees and performance fees payable in any one year limited to 0.9% of the average value of the net assets during the year. The use of a performance fee has become an increasingly rare feature over recent years, although seven of the peer group of 24 currently have one in place. When structured appropriately with a commensurately low management fee, as is the case here, we think it provides alignment of interest with investors.

There are a number of checks and balances, which we think provides investors with safeguards such as a cap to the enhancement to NAV resulting from share buybacks. Any previous relative underperformance needs to be made good before a performance fee can be earned and a performance fee cannot be earned when the share price or NAV ends the year below where it started. For FY21, the ongoing charge was 0.39%, which is among the lowest in the AIC UK Smaller Companies sector. When the performance fee was incorporated, the overall ongoing charge was 0.98% for HSL, which was eighth lowest in the peer group of 24 funds. FY21 was a strong year for the trust with an NAV total return of 58.5% versus the benchmark total return of 54.1% and 52.8% for the universe of open- and closed-ended UK small-cap funds.

HSL is a conventional investment trust with a single share class. There is a continuation vote every three years, with the upcoming 2022 AGM in September the next opportunity for shareholders to vote. As shown in Exhibit 24 around 22% of the stock is held by retail shareholders via Hargreaves Lansdown and Interactive Investor, with a selection of institutional and private client investment managers also featuring in the list of the top 10 shareholders.

The board meets at least six times a year and the board members are all independent. They bring a wide range of salient skills including backgrounds in investment, smaller companies, ESG and marketing.

Penny Freer replaced outgoing chairman Jamie Cayzer-Colvin at the conclusion of the AGM in October 2021. Freer has investment banking experience specific to advising smaller companies and has sat on numerous corporate boards. David Lamb has marketing and business development experience, having been a previous managing director and board member at St James’s Place, and was previously an investment manager and chief research actuary. Alexandra Mackesy is the chair of the audit and risk committee and has deep experience at board evaluation and consultation. She has been a board member of numerous investment trusts and has previously worked in senior equity research roles. Victoria Sant brings extensive ESG experience as a senior adviser at the Investor Forum and was previously an investment manager at the Wellcome Trust. The newest members of the board are Kevin Carter and Michael Warren. Carter has been an investment manager and has held senior positions in investment businesses such as Watson Wyatt and Old Mutual. Warren has held senior positions in a variety of financial institutions and has led investment sales and marketing teams at Thames River, HSBC and Deutsche Asset Management.