Henderson Opportunities Trust — Is a bird in the hand really worth two in the bush?

HOT has been managed consistently for many years by two experienced investment managers, James Henderson (since 2007) and Laura Foll (since 2018) of Janus Henderson Investors (JHI). In turn, they are supported by the broader resources of the JHI equity team (see page 13). The trust aims to achieve capital growth in excess of the broad UK market from a portfolio of primarily UK investments, with a secondary objective of delivering dividend growth over time. The trust’s all-cap focus gives it the flexibility to seek growth opportunities from across the market, including those listed on AIM, underpinned by a value-driven style that invests in out-of-favour or under-researched companies. At its core, the HOT portfolio is a blend of what could be tomorrow’s leading British companies, across a wide range of activities and market caps, at different stages of their life cycle, from promising early-stage businesses to established businesses reinventing themselves. ‘Tomorrow’s leaders’ are complemented in the portfolio by investment in ‘stabilisers’. These are often larger, mature but still growing businesses, with more predictable cash flows, as well as natural resources companies that provide a hedge against unexpected developments in commodity markets.

Faster-growing smaller companies have outperformed their large-cap counterparts over the long term and this is reflected in HOT’s outperformance of its broad UK equity market benchmark over the past 10 years. Over shorter periods, smaller companies are more volatile but have tended to rebound strongly from market setbacks, typically led by larger caps.

Exhibit 3 shows how the Numis Smaller Companies Index excluding investment trusts (NSCIEXT)1 has outperformed the broad market over the past 10 years. We also show the same index but including AIM shares (NSCIAEX), which modestly underperformed the broader market. The main purpose of the AIM market is to encourage younger, smaller, more entrepreneurial businesses, some of which will succeed – often spectacularly – and many others will fail. While this has limited the long-term performance of the AIM index, it remains the case that selective, long-term investing in AIM-listed companies can be highly rewarding so long as the risks are well managed. We discuss below how this has been the experience of HOT and its managers at Janus Henderson, creating long-term value despite the sharp sell-off of AIM stocks in the past two years.

Given HOT’s significantly greater focus on smaller companies compared with its all-market benchmark (Exhibit 1), marked divergence in net asset value (NAV) total return performance over shorter time periods is inevitable.2 Resulting primarily from small-cap weakness over the past two years, and especially among AIM-listed companies, HOT’s NAV total return performance relative to the benchmark is negative over one, three and five years, but remains positive over 10 years. Portfolio ‘stabilisers’, including larger company and commodity exposures and stock selection, have provided positive offsets, with NAV total return performance ahead of the NSCIAEX over three, five and 10 years.

The greater volatility of smaller company performance can better be seen in HOT’s returns on a discrete calendar year basis. HOT has tended to outperform the index when the market is rising, and this was clearly the case in 2020 as the market recovered strongly from the pandemic low point.

Three key issues have negatively affected the recent performance of smaller companies:

The investment managers firmly believe that there is a strong opportunity to benefit from a recovery in smaller stocks. This is based on several observations and expectations, including:

Looking at price to sales ratios (P/sales) rather than using earnings, a less reliable indicator of underlying value, the small-cap index trades at a lower level than larger companies. While this is not unusual, at c 0.5x on a trailing basis it is at the lower end of its historical range. This is equally the case relative to larger companies.

HOT’s portfolio includes a number of early-stage companies (7% of the total), typically with a high P/sales ratio, reflecting valuations that anticipate very strong future sales growth from a low base. Nonetheless, on a blended basis, including its larger company exposure, HOT calculates its end-H123 P/sales ratio at c 0.6x, a five-year low, and well below the long-term average of little under 1x.

Although AIM-listed companies cover a wide range of market caps (several companies have market caps of more than £1bn and up to c £2bn), it is within the AIM market that HOT’s investment managers expect to find most of what they hope will be tomorrow’s leading businesses. Correspondingly, the bulk of HOT’s small and early-stage company investments are AIM-listed. Over the longer term, HOT’s investments in AIM stocks have created significant value, driven by a combination of stock selection and risk mitigation. For example, during the past 10 years,3 HOT’s investments in AIM-listed Serica Energy, Blue Prism Group and Keywords Studios have provided exceptional returns of c 1,400%, 1,500% and 1,200% respectively.4 In aggregate, the top 10 AIM performers have contributed more than 50% to performance, more than offsetting a negative aggregate return of c 18% from the bottom 10 AIM contributors. While liquidity can often be restricted in smaller AIM stocks, risk exposure is highly diversified and actively guided by a strict valuation approach under which strongly performing investments are incrementally reduced.

HOT’s strong returns from AIM investments come despite the sluggish long-term performance of the AIM index (Exhibit 10), which in part reflects considerable ‘churn’ among its listed constituents. More than 4,000 companies have joined AIM since it launched in 1995 compared with c 800 listed today. Promotion to the Main Market or acquisitions account for much of the churn, but so too does company failure. Over shorter periods, AIM performance has been anything but sluggish (Exhibit 11). When investors are confident, the market has performed strongly, but, with risk aversion currently high, the sell-off has been sharp and broadly based, giving up most of the strong gains generated following the peak of pandemic uncertainty in early 2020. While taking a long-term approach to investment, the managers do take an active approach to the portfolio and during 2021, taking advantage of rising prices, and where valuations were becoming elevated, the portfolio was tilted away from growth stocks (‘tomorrow’s leaders’) and more towards portfolio ‘stabilisers’. While directionally this was a positive move, the benefits to performance were tempered, first by the impact of petroleum revenue tax on oil and gas producers, and subsequently by the emergence of investor concerns over the banking sector following several failures in the United States and Credit Suisse.

Investor enthusiasm for AIM companies remains low, to a large extent reflecting the greater exposure of companies to the domestic economy. While international investors have been buyers of UK equities, driven by relatively low valuations, this has been focused on large, global companies and does not extend to smaller companies or AIM. International investment has been met by UK institutional sales while domestic funds continue to see outflows. Within open funds, exposures to less liquid investments have been reduced to protect investors in periods of stress. Morningstar data show consistent monthly outflows from UK small-cap funds since the beginning of 2022, representing 13% of total UK equity fund outflows, well above the small-cap index weighting. We believe that retail investor sentiment is an important driver of AIM performance. Although somewhat dated, the Office for National Statistics estimated that in 2020, retail investors owned 24% of AIM and unit trusts a further 9%.5 While this current lack of investor enthusiasm for AIM investment may sound negative, for the contrarian investor, as is the case with the investment managers, this is just the sort of environment that throws up opportunities at attractive valuations.

The portfolio managers are focused on long-term returns, with investment decisions driven by a selective, bottom-up approach. They are looking for the best capital growth opportunities, with no specific sector or size remits, although these are most often found among smaller companies, particularly those at an early stage. Their experience is that by staying close to companies, they can invest with conviction and better add value than would be the case by relying on top-down macroeconomic forecasting. As a result, there is no common theme to stock selection other than that the managers are seeking to identify the next generation of leading companies across a wide range of activities. Interactions with companies are a key part of the stock selection process, with the managers undertaking several hundred meetings and site visits each year. They firmly believe that company management is one of the most important factors in identifying possible investments, noting that a good management team can navigate a difficult economic backdrop, while poor management can get it wrong even in the good times. Although the managers do not use specific quantitative screens to whittle down the large number of stocks in their investment universe, their focus on buying good companies at attractive prices means they employ a range of valuation criteria, such as P/E ratios, price/book value and enterprise value to sales. By way of example, they note that the small-cap end of the spectrum often offers superior earnings growth whilst trading at an attractive P/E discount to the wider market, albeit with the risk of lower liquidity and greater volatility of returns. Diversification is key to managing smaller company risk. As we have shown above, successful smaller companies can deliver exceptional growth and investment returns, but others will struggle or even fail, while liquidity constraints limit the opportunity to react. The managers take an active but measured approach to topping up and reducing holdings, to lock in gains and mitigate the possibility of future losses.

At 31 May 2023 there were 98 holdings in HOT’s portfolio, towards the top of the 70–100 stock range. Six of the top 10 names were AIM stocks, with three banks (Barclays, Standard Chartered and HSBC) and the miner, Rio Tinto, accounting for the balance. Together, the top 10 holdings accounted for a little over a quarter of the total portfolio.

The managers expect banking stocks to continue to benefit from rising interest rates which benefit interest margins. Meanwhile, balance sheet and lending profiles are much healthier than they were ahead of the global financial crisis, providing protection against lending risk. Share prices have begun to recover from the negative impact on investor sentiment of US bank failures earlier in the year.

The AIM stocks are a diverse group, by activity and size (market caps shown are as at the date of publication):

For completeness, we show the portfolio sector weightings in Exhibit 15. These are an output of stock selection rather than a target or input into the investment process, but nonetheless show a broad spread of exposures.

To help investors make sense of the trust’s broadly diversified, stock-driven, all-cap portfolio, HOT’s managers look deeper than the basic distinctions of small-, mid- and large-cap, instead classifying their holdings under one of six classifications or ‘buckets’: early stage, small-cap growth, small- and mid-cap (SMID) compounders, large-cap growth, recovery/special situations and natural resources. To clarify the process even further, the buckets are grouped under two broad headings: ‘tomorrow’s leaders’ (the three small/mid-cap buckets and recovery/special situations) and ‘stabilisers’ (large-caps and natural resources). Each bucket has an indicative weighting range and, while HOT may choose to have no exposure to early-stage or recovery situations, it is a feature of the trust that natural resources must always be represented. The investment managers comment that the indicative exposure ranges provide them with a useful challenge, asking themselves ‘is there a good reason that we have a lower or higher exposure?’

Exhibit 16 shows the current portfolio positioning across the buckets, as well as its development over the past three years. Exposure to tomorrow’s leaders is currently lower than it has generally been over this period, and stabilisers lower, but this has begun to reverse. The changes over the period reflect a combination of capital allocation towards those areas in which the managers identify the most attractive opportunities, as well as performance. During 2021, the managers were reducing exposure to smaller growth stocks where they considered that valuations had become stretched, reallocating the proceeds to larger-cap stocks, recovery stocks and natural resources. Reflecting the sharp de-rating of small-cap stocks with continuing strong growth prospects, the managers expect the weighting to tomorrow’s leaders will continue to increase.

These companies are typically addressing potentially large end-markets but are at an early stage of commercialisation and yet to generate meaningful revenues and earnings. In aggregate, they offer significant upside potential, but individually they represent the highest element of risk in the portfolio. Share price performance is typically volatile, driven by the developments within these businesses and investor perceptions of their prospects, often with little correlation to wider equity market moves or the economy. These made up 7% of the portfolio at H123, around half the level at end FY20.

Example: Ceres Power is an investment in renewable energy and, specifically, a potential global leader in hydrogen fuel cell technology and the transition to green energy.

Although still at the beginnings of their life cycle, these are quality companies, more established than the early-stage companies, and forecast to grow sales and earnings at a fast pace.

Example: Tracsis, as described above with the top 10 holdings.

These are typically good-quality, well-established companies with strong management and a consistent record of sales and earnings growth, offering long-term compounding of returns.

Example: RWS Group is already established as a market leader in translation services, working with more than 80% of the world’s top 100 brands, more than three-quarters of Fortune’s ‘World’s Most Admired Companies’ and nearly all the top pharmaceutical companies, investment banks, law firms and patent filers.

These are typically out-of-favour companies, where the managers have identified a specific trigger for a re-rating, providing contrarian value opportunities. The triggers for unlocking this value may include a strategic repositioning of the business, management change or the prospects for a sales and earnings recovery. Exposure has more than doubled since end FY20, to 14% from 6%, including new investments across a range of market caps.

Example: Marks & Spencer has benefited from a range of self-help measures, despite a challenging consumer environment. The managers believe this process has further to go and that revitalisation of the business and the strength of the brand remains under-appreciated in the market.

These are generally large, well-managed and reliable companies where the managers expect continuing sales and earnings growth, albeit at a more modest pace than for those companies at an earlier stage in their life cycle. These can increase the liquidity of the overall portfolio and may also be an important source of yield. Exposure to this area is around 60% higher than it was at end FY20.

Example: Legal & General is one of the UK’s leading financial services groups and a major global investor, with a strong track record of earnings and dividend growth.

Commodity selection determines positioning within the sector, but the lower end of the exposure range has been deliberately set at 5% (not zero), meaning that there will always be some exposure, providing the managers with scope to benefit from unexpected developments in commodity markets. The managers have additionally sought to add value by paying attention to smaller companies in the sector.

Example: Serica Energy, the oil exploration and production business and a top 10 holding discussed above. Another top 10 holding, Rio Tinto, with good-quality assets across a broad range of resources, from a relatively low cost base, is also held within this category.

The managers continue to identify good-quality companies, with sound long-term business plans, trading at very undemanding valuations, and with the capacity to be tomorrow’s leaders. They have recently added to, or increased existing positions in, companies across each of the buckets and the investment managers highlight:

HOT is a member of the AIC’s UK All Companies sector, comprising eight member trusts, of which HOT is the smallest. Given there are separate sectors for UK Equity Income and UK Smaller Companies, in reality the UK All Companies sector is home to UK equity funds that do not have a specific income or small-cap mandate. Within the sector, HOT is the only trust that is truly UK and truly all-cap (noting the large percentage in AIM stocks, which come in a variety of sizes, and the broad spread of investments by market cap shown in Exhibit 2).

Looking at the constituents in greater detail, while there is undoubtedly overlap between investment strategies, there are also significant differences in emphasis. As their names suggest, JPMorgan Mid Cap and Schroder UK Mid Cap are mid-cap specialists, while Mercantile invests in small- and mid-caps. Aurora, with a concentrated portfolio of 15–20 stocks, and Baillie Gifford UK Growth Trust, both have a mid-cap bias (c 50% or over), while Artemis Alpha Trust and Fidelity Special Values both have significant (c 20–30%) non-UK holdings.

HOT’s exposure to the weakness of AIM-listed stocks in particular has significantly affected its short-term performance versus the peer group and this has fed through to the long-term performance data, although on a 10-year basis this remains solid and well ahead of the benchmark.

We consider that the above-average discount to NAV on which the shares trade in part reflects the recent performance of the trust and that of AIM stocks in particular. The positive NAV impact of a turn in sentiment for smaller stocks would be reinforced by the trust’s gearing, which is above the sector average. If followed by discount narrowing, this would represent a further benefit to shareholders. As noted above, although focused on capital growth, dividend growth has been strong and HOT provides the second highest yield in the sector.

Janus Henderson Investors’ fund managers follow a responsible investing framework that does not rigidly exclude either sectors or companies which score poorly on sustainability metrics, but instead tries to understand why some companies score poorly, whether it is material to the investment case and whether the company is improving.

That said, the managers see a role in the HOT portfolio for stocks that contribute positively to environmental, social and corporate governance (ESG), not simply those where there is the absence of a negative. This would include businesses that are involved in the transition to a lower carbon economy, such as clean hydrogen specialist Ceres Power and battery technology company Ilika, as well as those whose activities contribute positively to society, such as Deltex Medical, which manufactures systems to accurately manage blood circulation, reducing the risk of post-operative complications and the length of hospital stays.

For HOT’s full ESG statement, please see its entry on the AIC website.

Henderson Investment Funds, a subsidiary of Janus Henderson Investors and HOT’s alternative investment fund manager (AIFM) under the AIFM Directive, is paid an annual management fee of 0.55% of net assets. A performance fee (15% of any outperformance of the benchmark) may also be paid, subject to the NAV having increased in absolute terms, with a cap on total management and performance fees of 1.5% of average net assets. Any underperformance versus the index (or any unrewarded outperformance over the fee cap) is carried forward and set against outperformance or underperformance in subsequent years. No performance fee was paid during FY22, and none was accrued in the six months to 30 April 2023 (H123). Excluding performance fees, the ongoing charge ratio was 0.90% in 2022 (2021: 0.87%).

HOT has a £30m unsecured, floating rate loan facility which enables borrowing as and when the company deems it appropriate. It is priced at a margin the SONIA benchmark rate. The board has set a limit on net gearing of 25%. At 31 May 2023, net gearing was 15%. At end H123, net gearing was 14.9% and at 31 October 2022 (FY22) it was 13.9%.

HOT has one class of share, with 7.9m ordinary shares in issue (unchanged over the past 12 months) excluding 0.1m held in treasury. No shares were issued or repurchased during H123 or FY22. The trust is widely held by retail investors, with holdings via the platforms Hargreaves Lansdown, Interactive Investor and Halifax Share Dealing accounting for c 42% of shares outstanding. The volume of shares traded daily has averaged 7,000 over the past 12 months, with c 22% of HOT’s shares changing hands. A stock split being considered by the board would have the potential to enhance liquidity, although its main purpose would be to assist monthly savers and those who reinvest their dividends, or those who are looking to invest smaller amounts (such as younger investors). If the board decides that this is in the best interests of shareholders, it is likely to bring forward a proposal at the AGM in 2024.

A continuation vote is held every three years, most recently at the March 2023 AGM. A clear majority of votes cast (c 76%) were in favour of continuation, although this was lower than in 2020 (99%).

Board members are all independent and non-executive (NED). Wendy Colquhoun joined the board in 2018 and has been chairman since 2021. She was previously a senior corporate partner at international law firm CMS Cameron McKenna Nabarro Olswang and advised investment trust boards for more than 25 years. She is also a NED of Schroders Mid-Cap Fund and of Capital Gearing Trust. The other current directors are Frances Daley, Davina Curling and Harry Morgan. Detailed biographies can be found in the 2022 annual report.

James Henderson and Laura Foll are supported in the management of HOT by the deep resources of JHI, with its long and broad-ranging experience in active equity management. JHI has c £150bn of equity assets under management, with investment and research capabilities across a wide range strategies, sectors and styles. The investment team comprises more than 150 equity investment professionals, with an average of approximately 20 years’ financial industry experience, including specialist teams focusing on key sectors including healthcare, technology and energy. All JHI’s investment professionals, whatever their particular focus, combine insights gleaned from company meetings, generating the proprietary knowledge, which enables them to generate the original, independent views that shape investment strategy across the company. Specifically in relation to HOT, Henderson joined the industry in 1982 and the company in 1984, and Foll joined the industry and the company in 2009. They are both members of the JHI global equity team and work closely with the UK smaller and mid-sized companies teams.