abrdn UK Smaller Companies Growth Trust — New lead manager, same proprietary process

Looking at the 10-year chart below in Exhibit 1 (left-hand side), UK small-cap stocks had outpaced the broader UK market over a multi-year period. However, this outperformance has reversed since the beginning of 2022 as investors have become more risk averse during a period of rising inflation and higher interest rates. This may provide an opportunity for investors with a longer-term perspective that are prepared to ride out periods of small-cap share price volatility, as generally, smaller businesses have better growth prospects than larger corporates.

UK share prices performed well in recent months, having bottomed in October 2022, but the failure of two US regional banks, Silicon Valley Bank and Signature Bank, in early March 2023, followed by concerns about the much larger Credit Suisse bank, have added to the macroeconomic uncertainty and investors have once again become more cautious. With such a backdrop, selectivity is surely warranted. Seeking quality businesses that can grow regardless of the economic environment and that are trading on undemanding valuations would appear to be a sensible approach.

In general, UK stocks remain very attractively valued in both absolute and relative terms having been in a relative declining trend since the June 2016 Brexit vote. The 11.1x forward P/E multiple of the Datastream UK Index is around a 20% discount to its 10-year average. It is also a 28.5% discount to the Datastream World Index, which is considerably wider than the 11.8% average discount over the last decade.

When meeting with existing and potential AUSC shareholders, Glennie and Yeaman note that there is currently much interest in the macroeconomic environment. They say that there has been a modest change in sentiment towards the UK market, which had been out of favour since the 2016 Brexit vote despite attractive valuations and high international exposure. The managers attribute the change to the relative valuation of the UK versus other markets becoming really stretched, there is now more political stability since the mini-budget debacle and economic conditions are getting tougher in other regions. The UK economy is now looking stronger than feared, while c 50% of UK mid-cap companies’ revenues are generated overseas, providing a less-expensive way of accessing this growth than investing in larger businesses.

While not all holdings will be immune from macroeconomic challenges, Glennie and Yeaman expect resilient earnings from portfolio companies, and they highlight that fund flows from large to small-cap stocks have started. The managers believe that the majority of UK small and mid-cap companies (SMID) earnings estimate downgrades have already occurred, and that the UK is further ahead than other geographies in terms of downgrading estimates. They explain that during economic cycles stock markets typically bottom before earnings trough. The UK stock market bottomed in October 2022 and rallied strongly from this low point, until the recent concerns about bank solvency. There had been concerns about a consumer-led recession, but the managers report that discretionary spending has exceeded consensus expectations, evidenced by the results from retailers and travel companies for example. They also point to purchasing managers’ indices, which have also moved off their low points, saying that typically, this point in an economic cycle coincides with outperformance by SMID stocks.

Glennie and Yeaman suggest that stock market ‘pain’ in 2022 was due to macroeconomic uncertainty, highlighting that the biggest style changes occur when there is a change in macroeconomic factors. Last year saw inflation pick up and interest rates rose more than expected. They comment that there are also uncertainties this year, but believe that the inflation and interest rate paths are broadly known, so are expecting a more style-neutral market. The managers explain that this backdrop should be positive for AUSC, which is focusing on companies with the potential to meet or exceed earnings expectations. They add that inflation is moderating and following peak inflation stock markets tend to perform well. Glennie and Yeaman suggest that risks to this scenario are a recession, another pickup in inflation or interest rates that are higher than consensus expectations.

The managers believe that AUSC’s focus on quality, growth and momentum should mean the trust performs relatively well during an economic recovery. Investors paid up for growth companies during the global pandemic, but these stocks experienced a large derating in 2022, particular in the shares of small-cap businesses. Glennie and Yeaman also highlight that the UK was the region where small-cap growth stocks were at the widest discount to the broader stock market. They say last year investors did not care about quality it was all about value stocks. However, in October 2022, quality factors started to come to the fore and AUSC had a strong period of relative performance last October and November. The managers add that while market falls can be very painful, recoveries can be rapid.

At end-February 2023, AUSC’s top 10 positions made up 32.9% of the fund, which was modestly lower than 33.8% six months earlier; seven positions were common to both periods.

AUSC’s sector breakdown is shown below in Exhibit 3. The trust is exposed to all 11 of the broad market sectors except utilities. Over the six months to the end of February 2023, the largest changes are a lower real estate weighting (-3.9pp) and a higher allocation to industrials (+2.1pp).

Glennie comments that she and Yeaman are never short of investment ideas. In recent months, new additions to the fund are:

Three positions have been sold in recent months due to poor Matrix scores and changes in the investment cases: Alliance Pharma, Moonpig Group and Watkin Jones.

In H123 (ending 31 December 2022), AUSC’s NAV and share price total returns of -2.2% and +3.3% respectively compared with the reference index’s -0.6% total return. The best performing stocks were: Kainos (resilient business and pricing power); 4imprint (strong demand and increasing share in a fragmented market, leading to consistent earnings upgrades); and Alpha Financial Markets (beating earnings expectations driven by both sector and geography growth).

Stocks that detracted most from AUSC’s H123 performance were: Hilton Food Group (earnings downgrades as the company was unable to fully pass through higher salmon pricing); Mortgage Advice Bureau (negative repercussions in the housing market following the UK’s mini budget); and Alliance Pharma (Chinese COVID-19 restrictions hindered exports, disrupted distributor orders, and a Competition Market Authority investigation – the position was subsequently sold).

Exhibit 6 shows AUSC’s relative performance. Unfortunately, an investor preference for value rather than growth stocks over the last 12 months has negatively affected the trust’s longer-term record. However, it remains comfortably ahead of the reference index and the broad UK market over the last decade. The managers explain that in October and November 2022, there was a market shift towards growth stocks. AUSC meaningfully outperformed the reference index over this period, which is clearly shown below in Exhibit 7. Glennie and Yeaman are also encouraged by the trust’s NAV outperformance in March 2023, which was a very volatile month due to concerns about the US and European banking sectors.

AUSC is a member of the AIC UK Smaller Companies sector. In Exhibit 8, we show the 18 largest funds with market caps above £50m; they follow a variety of mandates. The trust has a differentiated strategy, using the Matrix proprietary screening tool to highlight stocks that satisfy the managers’ quality, growth and momentum criteria.

Investors’ general preference for value rather than growth stocks since the beginning of 2022 has negatively affected AUSC’s relative returns. Its NAV total returns rank 16th and 17th out of 18 funds over the last one and three years respectively, 11th out of 17 funds over the last five years and ninth out of 14 funds over the last decade. The trust’s discount is narrower than average, and it has a competitive ongoing charge, a below-average level of gearing and a dividend yield that is below the mean. This is unsurprising given AUSC’s focus on capital growth rather than income.

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 H123, the trust’s revenue earnings per share was 5.32p, which was a 24.9% increase compared with 4.26p in H122, reflecting increased confidence from investee companies’ management teams. An FY23 interim dividend of 3.00p per share was declared, which was 11.1% higher year-on-year.

As shown above in Exhibit 9, having remained steady for three years, there was a step-up in AUSC’s annual dividend in FY22 despite economic uncertainty, which is testament to the resilience of investee companies’ earnings. The FY22 annual payment of 8.10p per share was a 5.2% increase compared with 7.70p per share in FY21.

AUSC’s shares are trading at a 13.6% discount to cum-income NAV, which compares to an 8.2% to 15.4% range of discounts over the last 12 months. It is wider than the 12.2%, 8.5%, 7.7% and 6.2% average discounts over the last one, three, five and 10 years, respectively. There is scope for a higher valuation if the trust’s relative performance improves or there is higher investor demand for UK small-cap companies.

The 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 H123, c 2.3m shares (c 2.5% of the share base) were bought back at an average 12.0% discount, which added 1.5p to the trust’s NAV. AUSC also has a discretionary tender mechanism in place, although no tenders have taken place 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 January 2023, the trust has been managed by Abby Glennie, who replaced long-standing lead manager Harry Nimmo; they had worked closely together since January 2016, and she had been AUSC’s co-manager since 17 November 2020. Amanda Yeaman is the trust’s deputy manager; she joined abrdn in 2019. Glennie and Yeaman aim to generate long-term capital growth from a diversified portfolio of UK smaller companies. The trust’s board stresses that the 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). 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:

Glennie and Yeaman 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 managements 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. Glennie and Yeaman 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.

In H123, AUSC entered into a new £40m revolving credit facility (RCF) with Royal Bank of Scotland International, which has a further £25m uncommitted accordion provision. On 1 November 2022, £25m of the RCF was drawn down and used to repay, in full, a former £25m 2.349% term loan. At 31 December 2022, £25m of the RCF was drawn down at an interest rate of 4.73% and at 31 March 2023, AUSC had net gearing of 2.9%.

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 forecast FY23 ongoing charges ratio is 0.94%, which is 12bp higher than 0.82% in FY22.

AUSC is a conventional investment trust with one class of share; there are 89.7m ordinary shares in issue, with 14.4m held in treasury. Its average daily trading volume over the last 12 months is c 140k 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).