Henderson Opportunities Trust — Staying the contrarian course

Investors continue to be preoccupied by an extensive list of major negative themes: rising inflation, central bank tightening, a global economic slowdown, the Chinese government’s COVID-19 policies, the war in Ukraine and a deepening cost of living crisis in developed economies. Despite the severity and duration of these factors though, 2022 global equity markets have only sold off by around 4.4%, with the broad UK equity market performing marginally better, delivering a return of -2.3% (to 14 September 2022). This can be attributed to the valuation support offered by UK equities (according to Janus Henderson Investors (JHI), with UK equities trading at the widest discount to global equities in 25 years) relative to the MSCI ACWI on a 12-month forward price to earnings basis. The broad UK equity market has a weighting of 22.4% in financials, which is a sector expected to benefit from rising interest rates, 19.2% in basic materials and energy, which have been lifted by robust energy and commodity prices, and only 1.5% in technology (all at the end of August 2022). More pertinently for HOT, small caps trade on a 12-month forward price to earnings multiple of 10.2x, compared to the largest 250 UK companies, on 12.3x on a similar basis and the largest 100 UK companies on 13.2x (JHI: September 2022). Morningstar estimates that HOT is itself currently trading on 10.5x forward price to earnings multiple compared with its Morningstar UK small-cap peers on an average of 16x and Numis Smaller Companies (including AIM, excluding IT) of 10.2x. Exhibit 1 illustrates the relative value on offer in the UK versus other global markets.

HOT is well placed to navigate this difficult landscape that confronts investors. The wider equity team at JHI are highly resourced and have some of the industry’s most experienced UK investors; Director of UK Investment Trusts and portfolio manager James Henderson has been at the helm since January 2007 and has worked with co-portfolio manager Laura Foll since 2009 and on this fund since October 2018. The two also co-manage Lowland Investment Trust (LWI), and although LWI has an income focus it is also multi-cap in nature. At July 2022, HOT and LWI shared 46% commonality. There is also some more modest similarity (14% commonality at April 2022) of holdings with Henderson Smaller Companies (HSL), which is managed by Neil Hermon and team, and 14% commonality with JHI UK Alpha fund, managed by Neil Hermon and Indriatti van Hien. There are tangible benefits of the collegiate investment environment at JHI across the whole UK desk, which adds to the well weathered combination of Henderson and Foll’s management of HOT. Their combined experience, expertise and interaction with the wider JHI team is likely to be even more important for investors over the coming years.

The portfolio is diversified by allocations to six distinct buckets. These buckets provide a broad framework for the managers to create a portfolio with varying drivers of returns, which provides the portfolio a broad opportunity set designed to add balance to what otherwise would likely be an unconstrained small-cap growth portfolio.

The majority of the portfolio will usually consist of ‘Tomorrow’s leaders’, which includes small/mid (SMID) compounders, Growth small-cap, Early-stage and Recovery/special situations. These higher-growth, but potentially riskier opportunities are balanced with potentially less volatile ‘stabilisers’, which include Growth large-caps and Natural resources, which ensures that the portfolio is always exposed to the energy market.

The Early-stage bucket is potentially the highest risk part of the portfolio as these companies are often at an early stage of their development but are likely to have the potential of a large addressable end market, which gives them a long runway of possible growth. Ceres Power, a leader in the development of clean energy, is a current example of an early-stage company, and has been in the portfolio since September 2018. Growth small-cap companies are more established than early stage, but still relatively nascent. They will have some track record of fast earnings or sales growth and will be focused on new markets or in disrupting and taking market share from incumbents. A current example is Tracsis, which was initiated in March 2013 and provides specialist software in the transportation industry. SMID compounders are likely to be market leaders with a good historical record of sales and earnings growth. They are thus likely to have good management teams and given their merits may well be at a premium valuation to peers. Given the long-term attraction of these businesses they are likely to be a material element of the portfolio. A current example would be RWS, which is a market leader in translation services and has been in the portfolio since October 2007. Recovery/special situations, as the name infers, are often former market leaders that are in the process of reinvention or seeing recovery in end markets. It is likely they will be troubled by a number of factors that if resolved may lead to a re-rating and positive reassessment by the market. A current example is Marks & Spencer.

Growth large-cap holdings are likely to have experienced and effective management, with a good track record in delivering sales and earnings growth. The reliability and consistency of the earnings should lead to a market premium dividend, which with the large-cap nature leads to very high levels of liquidity. This allows the managers to use these holdings as a source of funds for investing into small-cap growth opportunities even in times when market sentiment is weak. Tesco is an example of this type of holding. The final category is Natural resources, which provides a hedge to other part of the portfolio that may struggle in inflationary squeezes driven by rising commodity and energy prices. Because of the difficulty of forecasting movements in spot prices, it is often an area where active managers fear to tread. However, because there is a requirement to hold at least 5% of the portfolio in this bucket, there will always be some exposure to these markets.

While Natural resources is in the ‘stabilisers’ element of the portfolio there is likely to be a significant exposure to smaller companies, which may exhibit high levels of volatility depending on what is happening with spot prices. A current example is North Sea oil and gas company Serica Energy (market cap c £1bn), which is a top 10 position and has been in the portfolio since June 2014. Serica has been extremely buoyant over the last 12 months in response to the strong energy market. Shell (market cap c £170bn) is also held in this bucket, but to illustrate how Serica, despite being in the same sector, differs, in 2022 to date Serica has returned 125% (to 5 September) versus 69% for Shell, and has a five-year standard deviation of returns of 88% versus 27% for Shell. Another constituent of this bucket is also a North Sea operator; Jersey Oil & Gas (market cap c £80m) has provided a similar return in 2022 to date, but with twice as much volatility as Serica. Investors should be aware that some holdings in the ‘stabiliser’ category can exhibit volatile but differing characteristics to other parts of the portfolio.

2022 has been an uncomfortable period for shareholders in HOT. The material weightings to AIM, and smaller companies in general, have been a hindrance to performance. Despite share price weakness, much of the portfolio is performing relatively well from an operational perspective, with the managers highlighting Surface Transforms, which is in the autos sector and provides brake components to high-end manufacturers such as Tesla and Audi. Likewise, Next Fifteen Communications is seeing good results coming through, but little corresponding positive recognition in the share price. With the cost-of-living crisis there can be little doubt that the consumer is in a tough position, with limited visibility on the six months ahead. While the portfolio does have some cyclical consumer exposure, through longstanding positions in Hollywood Bowl and Gym Group and the newly initiated Halfords, these are also balanced with larger-cap growth consumer ‘ballast’ via holdings in Reckitt Benckiser and Tesco. The managers believe that, over the next 12–18 months, inflation is likely to moderate, releasing the pressure on consumers in what will be a slowing economic environment. It may be uncomfortable, but the managers are using weak equity market days to incrementally add to some of these unloved, smaller capitalised consumer and more generally cyclical or out-of-favour growth names. In Exhibit 3, it is discernible that the weighting to growth stocks has just started to tick up.

The portfolio is truly all cap (Exhibit 4), with a mix of varying market cap holdings. These vary from mega caps, such as HSBC and GSK, to mid-caps, such as IP Group, and small and micro caps, such as Jersey Oil & Gas. The blend gives the portfolio the ability to balance faster growing, more volatile companies with more stable large caps. This mix gives the portfolio less correlated drivers of return than one focused on any one part of the market.

A key point to the investment strategy is that there is a long list of nearly 100 companies in the portfolio, with an average position size of 1.2% and with around 20 positions at half a percent or less (May 2022). This allows the managers the freedom to dip their toes into unloved and volatile areas of the market and reduces the effect on the portfolio of failure in any one stock. For a strategy of this nature, we believe this to be an eminently sensible approach. We also like the discipline that the ‘stabilisers’ bring to the process. The allocation of up to 30% in Growth large-caps (largest UK listed stocks) and up to 15% in Natural resources gives the portfolio the ability to ride out periods of volatility in small caps and to effectively hedge the main input into upward inflationary pressure. It means that the portfolio will always have at least 10% and 5% in these camps respectively, which gives the fund an added level of diversification and differentiation to many of its peers.

The portfolio has seen an increase in the weighting to energy and financial stocks and a reduction to those in industrials and technology (Exhibit 7). At the same time, the average market cap within the portfolio has been increasing, the exposure to UK derived earnings tailing off (Exhibits 5 and 6) and the exposure to stylistically value stocks increasing. The investment process focuses on the bottom up rather than the top down, and so the weighting to various sectors and parts of the market are a product of the process and the available opportunities, rather than a forecast on the economy. These movements have largely been passive in that they have been driven by market movements rather than aggressive buying and selling. Energy, financials and larger companies have all performed better than small caps, AIM and technology, which accounts for these moves. Incrementally the managers are seeking to halt and reverse these previous trends with the direction of travel being incremental investment into more cyclicality, less large cap, more out of favour growth and more UK domestic earnings.

The portfolio has quite a pronounced exposure to what Morningstar labels as cyclical and sensitive sectors, with only limited exposure to what Morningstar defines as defensives. Given the investment process, which focuses on identifying contrarian, out-of-favour stocks on attractive valuations, this split should be of little surprise. Cyclical sectors are defined as those that are exposed to industries significantly affected by economic expansion and contraction, including basic materials, consumer cyclicals and financial services. Key holdings in this area include Springfield Properties, Barclays and Anglo American, with Halfords and Marks Electrical Group examples of more recent additions. Sensitive sectors are those that are affected by economic expansion and contraction, but not to the same magnitude as cyclicals. Industries in this group include industrials, technology and communication services. Key positions in this area include Serica, Next Fifteen and Tracsis, with i3 Energy being an example of a recent addition. The portfolio has less in defensives, which as the name suggests focuses on industries that are relatively dislocated from the economic cycle. Industries here include consumer defensives, healthcare and utilities. The exposure here is limited to around 10 names, with GSK, Tesco and Creo Medical group being the largest positions. A recent addition here is Finsbury Food Group.

New holdings in 2022 include a diverse list, with two additions to the Natural resources bucket in i3 Energy, which has North Sea and Canadian oil and gas assets, and integrated oil major Shell. There were two consumer defensive stocks added, one to the Growth large-cap bucket (Reckitt Benckiser) and one within the SMID compounders allocation, which was Finsbury Food Group, which is involved with producing supermarket cakes and speciality breads. Renold is a precision industrial engineer with applications across a range of end uses and is held within the Growth small-cap bucket. Lastly a position in Halfords Group has been added within the Recovery/special situations bucket.

There have been no outright sales of note, although the managers have been using share price strength in some of the energy positions such as Serica Energy and Shell that have been beneficiaries of buoyant energy prices to fund more cyclical and out-of-favour opportunities in the market.

The AIM market has been a focus of the portfolio over many years. The managers see it as offering higher, more interesting growth ideas than those on the Main LSE market and a market where tomorrow’s leading British businesses can be found. The current allocation is 51.6%; however, over the past 10 years it has been as high as 64% and as low as 28%. Given the expectant tilting within the portfolio away from Growth large cap to Growth small cap and Early stage, investors can expect the weighting to AIM to increase at the margin over the coming quarters. While AIM is rich in potential opportunities, it is often especially affected by investor sentiment, with risk-off environments particularly difficult. It is less liquid in general than the Main Market, which requires a patient approach to building up and divesting positions. Patience is, however, built into the process, with the average 10-year portfolio turnover, as calculated by Morningstar, equating to 24% or around a four-year average holding period, versus 55% or a less than two-year average holding period for the Morningstar UK small cap category. The material exposure to AIM-listed stocks is certainly a differentiator to both the AIC peer group and the mainstream investment community in the UK in general. For those investors willing to be patient and turn over enough opportunities, the historical returns from AIM have been well worth the effort.

HOT has over the last five years traded on average at a 15.8% discount to its cum income (debt at fair value) NAV. This compares to the AIC UK smaller companies average of 12.6% and the AIC UK All Companies category average discount of 8%. The current HOT discount is 15%, which is broadly in line with the five-year average. Despite a differentiated investment approach and a good long-term record, HOT trades on a wider discount to both the average AIC UK All Companies and AIC UK Smaller Companies peer group (Exhibit 10). This appears overall to be unjustified and presents an opportunity for building on or initiating long-term positions.

The board have used share buybacks sparingly, with the last occasion being in FY20, and consider their use within the objective of enhancing NAV returns for shareholders rather than controlling or managing a level of discount. There is also the consideration of fund size and liquidity, which may also be a factor that the board has to weigh up. As previously mentioned, UK mutual fund flows have generally been weak over the past eight years (Exhibit 11), which has been a structural headwind for many UK funds.

During 2022 to the end of August 2022 the fund has returned -19.3% (NAV with debt at fair value) compared with the broad UK equity market return of -2.1%, the Morningstar UK Small-Cap equity category return of -23.4 and the Numis Smaller Companies Index (including AIM, excluding IT) return of -20.9%.

Both sector and stock selection have detracted in the year to date versus broad UK equities, with both the overweight and stock selection within energy being accretive, whereas the overweight and stock selection within the broad industrials area proved to be weak. From a market cap perspective, the material allocation to small caps versus the benchmark was a key area of relative weakness with no respite to be had from stylistic (ie growth, value, blend) exposures.

Taking a longer 10-year view, HOT has returned 168.7% (NAV with debt at fair value) compared with the broad UK equity market return of 92.7%, the Morningstar UK Small-Cap equity category return of 157.7% and the Numis Smaller Companies Index (including AIM, excluding IT) return of 106.6%.

Given that HOT’s focus is on smaller companies and AIM, it is little surprise that the fund’s returns on a 10-year view have been a little more volatile than peers in the AIC and Morningstar UK small-cap equity category. The corresponding beta or sensitivity to market movements is also above comparators, however on a risk-adjusted basis the fund’s returns are competitive versus AIC peers.

HOT is not easily pigeonholed into any one category. It is a member of the AIC All Companies category, but the current average market cap of the constituents is c £1bn, which is less than half the average (c £2.7bn) of the peer group, while the average market cap for the AIC UK Smaller Companies category is c £600m. The material allocation to AIM-listed stocks is a differentiator both within the AIC category and the wider Morningstar UK small-cap peer group. The inbuilt Natural resources allocation within the ‘stabilisers’ allocation creates a larger position in the energy and basic materials sectors than in the AIC peer group and in the Morningstar UK small-cap equity categories. On average over the last three years HOT has been c 12pp and 11pp overweight respectively. At June 2022 the combined HOT weighting of c 18.5% in Natural resources was largely in line with the UK broad equity market weighting to this sector.

Looking closer at the AIC All Companies peer group, with a market cap of c £87m HOT is one of the smaller funds. This gives the managers a tangible benefit in the often illiquid markets in which they primarily operate. It therefore stands to reason that HOT should be better able to capture the illiquidity premium available in the smaller and less liquid end of the equity market. A key element of the attractiveness of HOT, aside from its contrarian unconstrained approach (active share of c 80% with broad UK equities at July 2022 – active share is the indication of similarity between two funds, with 100 indicating complete divergence of holdings), is the experience of the managers. The average tenure of Henderson and Foll is one of the longest in the sector and gives comfort as to their ability to harness the diverse available investment opportunities. As a result of the investment approach, HOT has historically low portfolio turnover, as discussed earlier in the note. Long holding periods of undervalued but fundamentally sound companies allow the fund to capture the full cycle of recovery or compounding earnings within its holdings. It also helps keep transactions costs low, especially in less liquid markets.