abrdn UK Smaller Companies Growth Trust — End of an era but successful strategy remains

While outperforming over the long term, the shares of UK small-cap companies have significantly lagged the performance of the broad UK market since Q421 (Exhibit 1, left-hand side). This may provide an opportunity for long-term investors who are prepared to weather periods of higher volatility in small-cap stocks as, in general, smaller businesses have superior growth prospects compared with their larger peers. Investor risk aversion is currently high, which is unsurprising given the difficult macroeconomic backdrop, characterised by rising inflation, exacerbated by the war in Ukraine, and higher interest rates that are piling more pressure on already-stretched consumer budgets. The recent UK political upheavals have also been unhelpful with regards to both consumer and business confidence.

The current uncertain environment is reflected in UK company valuations, which have been out of favour with global investors since the Brexit vote in 2016 (Exhibit 1, right-hand side). The Datastream UK index is trading on a modest 9.3x forward P/E multiple, which is a 30.1% discount to the Datastream World index and considerably wider than the 12.0% average discount over the last decade (range of a 3.1% premium to a 30.1% discount).

Harry Nimmo and Abby Glennie have a high degree of confidence in the quality, growth and momentum approach of investing in UK small-cap companies, noting that while there have been periods of volatility, the strategy has been very rewarding for AUSC’s shareholders with significant long-term outperformance versus the index, the broader UK market and the trust’s peers. According to the managers, the Matrix screening process has changed very little over the last 19 years, and valuation is a secondary consideration as ‘cheap stocks tend to be cheap for a reason’.

They explain that 2022 has seen a flip from growth to value stock market leadership and some high-quality growth companies have become so inexpensive that they are now classed by some investors as value stocks. Nimmo and Glennie say that it has been disappointing that there has been a lack of interest in quality factors this year, especially given the consensus view that we are heading into a recession. While the oil & gas and mining sectors are seeing positive earnings estimate revisions, the managers comment that in ‘small-cap land’ these companies are not steady cash generators as they are often single-project businesses, so are inherently risky. Nimmo and Glennie suggest that during the 2007–09 global financial crisis, investors did indeed care about quality and earnings momentum factors but their behaviour in H122 was ‘irrational’; as an example, Watches of Switzerland issued a series of positive trading statements, but its shares derated due to widespread concern about consumer discretionary stocks. However, they note that investors’ behaviour has been more ‘rational’ so far in H222.

Nimmo suggests that people should have at least a five- to 10-year time horizon when investing in UK small-cap stocks and according to the manager the average annual total return over the long term is more than 10%. It is a volatile sector, ‘so hang in there and be ready to get involved when the market reassesses the outlook’, he opines. Nimmo suggests that the bottom of the UK market is likely to be when we are at the worst point of economic pain and small-cap stocks are starting to outperform the broader market. The manager says that the UK has been out of favour with global investors since the Brexit vote. However, investors should remember that the UK stock market is not representative of the UK economy, as 45% of the revenues of UK-listed companies are generated overseas. Nimmo comments that JTC Group (funds administration) and Kainos Group (multi-utility services provider) are examples of successful businesses that are expanding overseas, while YouGov (market research and data analytics) is a global leader listed in the UK. He says that AUSC’s portfolio is a balance of domestic and international operations.

At end-August 2022, AUSC’s top 10 positions made up 33.8% of the fund, which was modestly more concentrated than 32.5% a year earlier; four positions were common to both periods. Nimmo reports that the fund’s top 10 holdings have an average current-year earnings growth of c 10%. Six have a recent trend of higher earnings and four are flat, while nine pay a dividend. However, the manager cautions that ‘things are getting tougher across a range of sectors, and there are new and evolving headwinds’.

While the market has been volatile, reflecting its long-term approach, AUSC’s recent portfolio turnover is not dissimilar from the c 15% per year long-term average. There is a relatively new position in Serica Energy, a highly profitable North Sea gas producer with 35–40% cash on its balance sheet. According to Nimmo, the company has a solid dividend yield and a good Matrix score. Gas prices are currently elevated and the manager expects robust demand for several years; he considers the company to be undervalued. Paragon Banking Group has been added to AUSC’s portfolio, despite having experienced operational issues in past economic cycles. The company provides buy-to-let mortgages but has diversified its businesses and sources of funding. Its margins are expanding due to the lag between raising loan rates and deposit rates. Nimmo suggests that Paragon is a ‘very different company now’ with an attractive valuation (c 7% dividend yield and c 5x forward P/E multiple). There is a new position in Coats Group, which is the world’s largest manufacturer and distributor of sewing thread and supplies, and the second-largest manufacturer of zips and fasteners. The company has an innovative product offering in sustainable threads, as well as pricing power and levers to pull to maintain margins.

Complete sales from the fund include companies with poor Matrix scores or that have grown too large such as Diploma and IntegraFin, while Gear4music was sold after a profit warning. Hotel Chocolat Group was recently divested following the news of its strategic review.

Recent portfolio top-ups include: Marlowe (a UK leader in business-critical services and software); Alpha Financial Networks (an example of a strong UK business that can be expanded overseas); Marshalls (a provider of hard landscaping products that has a 60% market share and is a quasi-monopoly); CVS Group (a veterinary services business that recently reported strong results); Telecom Plus (which is benefiting from the demise of alternative energy providers); and 4imprint Group (its North American business is very resilient, where it is the leader in a very fragmented market).

Nimmo explains that AUSC had too much exposure to alternative asset managers following a strong 2019–21, so the positions in Impax Asset Management and Liontrust Asset Management were reduced. Other partial sales in the portfolio include consumer discretionary stocks Future, Team17 Group and Motorpoint Group.

AUSC’s breakdown by sector and market cap is shown below in Exhibit 3. We are unable to provide a year-on-year comparison of AUSC’s sector exposure as the classifications have changed within the last 12 months.

In FY22 (ending 30 June), AUSC’s NAV and share price total returns of -27.3% and -34.3% respectively lagged the reference index’s -19.0% total return. The largest positive contributors to AUSC’s relative performance were: Telecom Plus (+118bp); Safestore Holdings (+90bp); Alpha Financial Markets (+77bp); Clipper Logistics (+51bp); and Hilton Food Group (+40bp). Conversely, the largest detractors were: Gamma Communications (-102bp); XP Power (-94bp); Future (-90bp); Impax Asset Management (-82bp); and GB Group (-80bp).

AUSC’s relative performance is shown in Exhibit 6. Unfortunately, a tough period over the last six months has negatively affected the trust’s longer-term performance. Its NAV is ahead of the reference index over the last five and 10 years, but lags over the other periods shown. Over the last decade, AUSC’s performance is notably ahead of the broad UK market.

In Exhibit 8, we show the 16 members of the AIC UK Smaller Companies sector with market caps above £50m. AUSC is differentiated by its use of the Matrix proprietary screening tool and disciplined focus on stocks that satisfy its quality, growth and momentum criteria. The trust’s performance has been negatively affected by the market rotation away from growth stocks and its NAV total returns rank 15th and 13th in the selected peer group over the last one and three years respectively. AUSC ranks ninth out of 15 funds over the last five years and eighth out of 13 funds over the last decade. On 21 October 2022, the trust’s discount was lower than average in a group where only one fund was trading at a premium. It has a competitive ongoing charge, a below-average level of gearing and, unsurprisingly given its focus on capital growth, a below-average dividend yield.

AUSC pays semi-annual dividends in April and October. The board aims to pay out around a third of the total annual distribution as the interim dividend with around two-thirds as the final dividend. In FY22 the trust’s revenue return was 9.07p per share, which was a 41.1% increase compared with 6.43p per share in FY21. This was the highest ever generated, exceeding 8.80p per share in FY19. Share repurchases contributed 0.26p per share (2.9%) but investment income of £11.1m was also £1.1m higher than £10.0m in FY19. Special dividends made up less than 1.5% of AUSC’s income in FY22.

Having been held steady at 7.70p per share for the last three years, the board has proposed an annual dividend of 8.10p per share in respect of FY22, a 5.2% year-on-year increase. The manager reports that during COVID-19, 45% of portfolio companies cut their dividends but most of them have subsequently returned and some firms have increased their distributions. Around £1.1m was added to the trust’s revenue reserve (c £8.8m at end-FY22 and equivalent to c 4.0p per share after the payment of the final dividend). Given the challenging outcome for the UK economy, the board is mindful not to increase AUSC’s annual dividend to an unsustainable level.

Based on its current share price, the trust offers a 2.0% dividend yield.

AUSC is trading at a 13.3% discount to cum-income NAV, which is significantly wider than the 5.6% to 10.1% range of average discounts over the last one, three, five and 10 years. There is scope for a higher valuation if the trust returns to its long-term trend of outperformance or if investors become less risk averse. AUSC’s board employs a discount control mechanism, targeting a maximum 8.0% share price discount to cum-income NAV in normal market conditions. Renewed annually, it has the authority to repurchase up to 14.99% of the trust’s share capital. During FY22, c 4.7m representing c 4.7% of the share base were bought back at a cost of c £29.7m at a weighted average discount of 9.1%; this added 2.9p per share to the trust’s NAV. AUSC also has a discretionary tender mechanism in place, although none has been undertaken since June 2015, as share buybacks are the primary method to manage the trust’s discount.

Launched in August 1993, AUSC is quoted on the Main Market of the London Stock Exchange. Since 1 September 2003, the trust has been managed by Harry Nimmo at abrdn. He aims to generate long-term capital growth from a diversified portfolio of UK smaller companies. On 5 September 2022, it was announced that Nimmo would be retiring on 31 December 2022. Abby Glennie will become AUSC’s lead manager having been co-manager since 17 November 2020; she will be supported by Amanda Yeaman as deputy manager. The board stresses that a change in personnel will not lead to a change in investment process.

AUSC’s portfolio is made up of 50–60 of the managers’ highest-conviction investment ideas. The trust’s performance is measured against the Numis Smaller Companies plus AIM ex-Investment Companies Index (the Numis Smaller Companies ex-Investment Companies Index before 1 January 2018). To mitigate risk, at the time of purchase, AUSC may hold no more than 5% of total assets in a single position, no more than 5% in companies with a market cap below £50m and the managers tend not to invest in ‘blue sky’ (not yet profitable) companies, although up to 5% is permitted. Up to 50% of the portfolio may be invested in companies that are constituents of the broad AIM index. The managers may vary the trust’s level of gearing between a net cash position of 5% and net gearing of 25% of NAV (at the time of drawdown). At 14 October 2022, net gearing was 1.6%. To provide some context, over the last decade, the financial year-end position has ranged from 4.6% net cash to 8.8% net gearing.

AUSC started life as Edinburgh Smaller Companies in 1993, with Standard Life Investments (now abrdn) assuming management in 2003. The trust merged with Gartmore Smaller Companies Trust in 2009 and with Dunedin Smaller Companies Investment Trust in October 2018. With effect from 25 October 2021, the trust’s name was changed, following shareholder approval, from Standard Life UK Smaller Companies Trust (ticker: SLS) to abrdn UK Smaller Companies Growth Trust. The board deemed that the addition of ‘growth’ better reflects what the trust is seeking to achieve.

The managers follow seven principles for successful small-cap investing:

Nimmo and Glennie aim to generate long-term capital growth from a diversified portfolio of smaller-cap UK equities. They use the Matrix, which is a screening tool based on a series of 12 quality, growth, momentum and valuation factors including forecast earnings and dividend growth, earnings revisions, share price momentum, balance sheet strength and the level of directors’ dealing, to whittle down the investible universe of around 500 stocks to around 100 that are deemed worthy of further consideration. The most important factor, at c 40% of the Matrix weighting, is earnings revision momentum because back-testing shows this is the most predictive measure of future share price performance. Stocks are assigned a Matrix score between +40 and -40, with those between +10 and +40 deemed potential buy candidates and those between -10 and -40 potential sells. Companies considered for inclusion in AUSC’s portfolio are subject to further in-depth analysis and meeting company managements is an integral part of the research process. In keeping with other abrdn investment teams, the managers have a strong focus on a company’s ESG credentials.

Given the managers’ long-term perspective, the average holding period for AUSC’s investments is around six years, implying an average annual portfolio turnover of around 15%; although some names have been in the fund for more than a decade. Positions may be trimmed or sold if there is a deterioration in the Matrix score, the original investment thesis no longer holds true, they have grown to more than 5% of the portfolio, or there is a higher-conviction name identified. The disciplined investment process has been employed since abrdn took over management of the fund in 2003 and has delivered creditable performance through economic and market cycles.

abrdn has more than 800 investment professionals, including c 50 ESG specialists around the world. It encourages companies in which it invests to adhere to best practice in the areas of ESG stewardship. abrdn believes this can be achieved by entering into a dialogue with company management to encourage them, where necessary, to improve their corporate standards, transparency and accountability. By making ESG central to its investment capabilities, abrdn seeks to deliver robust outcomes as well as actively contributing to a fairer, more sustainable world. It considers ESG factors are financially material and affect corporate performance; companies that have higher standards tend to outperform those that do not.

The managers explain that for AUSC, ESG is really embedded at the core of the research process and is an important aspect of the focus on quality and the lower-risk approach. There is an ESG specialist on abrdn’s small-cap desk, and the managers also work closely with abrdn’s large and knowledgeable central ESG investment team. Nimmo and Glennie regularly engage with company management teams, including on ESG aspects. They say that it is important to highlight a couple of nuances for smaller companies. While external ESG data are used, it is not an ideal process because many of the companies are not covered at all, or are covered badly, providing a real opportunity for the managers to add value by conducting ESG fundamental research themselves. Also, smaller companies often have limited internal resources to focus on ESG, so many are keen to engage with the managers, who are able to help advise them and encourage them towards those ESG aspects required by shareholders.

AUSC has a £65m unsecured loan agreement with Royal Bank of Scotland International, maturing on 31 October 2022, made up of a five-year, fixed-rate term loan of £25m at 2.349%, and a £40m revolving credit facility (currently £15m is drawn), priced off SONIA. The board is currently considering refinancing options. At 14 October 2022, AUSC had net gearing of 1.6%.

AUSC has a tiered management fee structure: 0.85% per year up to £250m of the trust’s NAV; 0.65% per year between £250m and £550m; and 0.55% per year above £550m. Along with the investment management fee, abrdn also receives a fixed secretarial and administration fee of £75k pa plus VAT and a separate fee for the provision of promotional activities for AUSC (£246k in FY22 compared with £150k in FY21). The trust’s ongoing charges ratio (OCR) of 0.82% in FY22 was 6bp lower year-on-year and was the lowest in the company’s lifetime. The FY22 decline was largely due to a higher average NAV than in FY21, and the board expects a higher OCR in FY23.

AUSC is a conventional investment trust with one class of share; there are 92.4m ordinary shares in issue, with 11.8m held in treasury. Its average daily trading volume over the last 12 months is c 155k shares.

The board has had consistent membership since 2019 but its composition is regularly reviewed to ensure it has the right balance of skills, experience and diversity. AUSC’s board has participated in the Board Apprentice programme, which is dedicated to increasing diversity by increasing the pool of board-ready candidates. Jessica Norell Neeson is shadowing the board for a 12-month period from May 2022; she will attend all of AUSC’s board and committee meetings and will take part in discussions when invited to do so (the role is unremunerated).