Standard Life UK Smaller Companies Trust — Success from delivering ‘what it says on the tin’

UK small-cap equities have outperformed their large-cap brethren over the long term and particularly so during the market recovery, having underperformed during the Q120 sell-off (Exhibit 1, left-hand side). It is encouraging that there have been many positive trading statements this year from smaller-cap companies across a broad range of sectors as the economy has reopened, and dividend payments have generally resumed.

In aggregate, UK shares look relatively attractively valued compared with other major markets, illustrated by the Datastream UK index, which is trading on a forward P/E multiple of 12.6x. This is a 26.9% discount to the Datastream World index and is considerably wider than the 14.8% average discount over the last five years and the 9.4% average discount over the last decade. UK stocks have been out of favour with global investors for several years, although a higher level of bid activity for domestic businesses in recent months may indicate an increased level of interest. There has also been a robust market for initial public offerings (IPOs) highlighting that the UK is capable of nurturing interesting businesses with long-term growth potential. In an environment of post-pandemic improving company fundamentals and below-average valuations, global investors may wish to consider initiating/increasing a position in UK equities with the understanding that the more interesting growth opportunities generally reside outside of the larger-cap companies.

Nimmo notes that the trust has enjoyed a very strong period of relative performance since mid-March 2021 following the ‘dash for trash’ value rally in response to positive vaccine news in early November 2020. The emergence of COVID-19 variants has caused investors to question the pace of economic recovery and they are once again favouring growth stocks. SLS’s recent performance has been ‘quite spectacular’ says the manager, and he believes that the backdrop for small-cap stocks remains positive. Nimmo explains that the start of a new economic cycle tends to be positive for the performance of small-cap versus large-cap equities; they have been very strong in both absolute and relative terms since the end of March 2020. The economy is still in a recovery phase, although there have been fits and starts; however, the manager cautions that the valuation for many quality, growth and momentum stocks is high. He suggests that companies trading on high multiples need to deliver earnings above expectations to justify their current valuations, and those that do not meet consensus estimates are seeing their share prices come under pressure.

Glennie comments that the re-opening of the new issue market has been positive for the performance of small- and mid-cap stocks. The managers undertake a significant amount of pre-IPO work on companies, and Glennie says there is always a range in the quality of companies coming to market, and notes that some of the companies listing are high-quality, family-run businesses that meet SLS’s investment criteria.

Nimmo believes that while inflation has risen, in some cases dramatically, the bulk of this is related to dislocation in supply chains, such as semiconductors; he is having discussions about input shortages with many companies. While wage inflation is also in evidence, the manager suggests that the end of the furlough scheme will mean that there will be more people looking for jobs. Although headline wage inflation is punchy, there has been a mix change in the economy with some older, higher-paid workers losing their jobs, so Nimmo says it will be important to watch wage inflation over the next three to six months to gain a clearer picture.

Going forward, the manager suggests that SLS’s investment process could be viewed as an ‘each-way bet’; he believes that defensive high-quality companies with strong balance sheets should outperform in a falling stock market, but if the market is strong, small-cap stocks in general should continue to perform well as we are still in the early stages of an economic recovery. Nimmo says that during the pandemic the disparity between strong and weak businesses widened and supply chain issues should provide the opportunity for high-quality firms with pricing power to continue to outperform their weaker peers.

At end-August 2021, SLS’s top 10 positions made up 32.5% of the fund, which was a lower concentration compared with 38.0% 12 months earlier; six positions were common to both periods. As shown in Exhibit 3, there was a notably higher weighting to AIM (+9.0pp) and a lower weighting to Numis Smaller Companies plus AIM (-6.7pp).

In terms of sectors (Exhibit 4), in the 12 months ending 31 August 2021, the largest changes were higher weightings in financials (+3.7pp) and consumer services (+2.4pp) with lower exposure to industrials (-3.6pp).

Nimmo explains that SLS’s portfolio companies are very rarely on the receiving end of bids given they tend to be highly rated quality businesses. However, Sumo Group has received a bid from Tencent and Sanne Group has received competing bids. The manager comments that ‘private equity firms are loaded up with money, as are trade buyers’ and suggests that the UK market remains relatively inexpensive compared with other major markets, which is supportive for further merger and acquisition (M&A) activity here.

Magazine publisher Future has been in the fund since 2018 and is now SLS’s second largest position. Nimmo is impressed by the company’s CEO Zillah Byng-Thorne; he says her clear-sighted and decisive character means she knows the correct businesses to acquire and what to pay for them. Future bought the comparison website GoCompare, which has proved to be very successful, and has recently paid £300m for Dennis Publishing, whose titles include The Week and the more niche publications IT Pro and Minecraft World. Future’s CEO is adept at getting people to pay for the company’s digital content, according to the manager, and there are still many paper magazine titles available, whose content can be monetised via online versions. Around a year ago, Future’s share price suffered following the publication of a negative report by a short-seller, the contents of which proved to be unfounded, and the shares have subsequently rallied. Nimmo likes to let portfolio winning companies run and Future’s market cap is now c £4.3bn; he refers to this company as a ‘fantastic story’.

The first and third largest positions in SLS’s portfolio are Kainos Group and Gamma Communications respectively, both of which were initiated when the companies first listed. While there is a need to be selective, these companies illustrate that participating in IPOs can be very lucrative when investing in high-quality businesses. Kainos’s IPO was in July 2015 at £1.39 (the current share price is c £18) and Gamma Communications’ IPO was in October 2014 at £1.87 (the current share price is c £18). Kainos is a software company that develops technology solutions for businesses and organisations particularly in the public, healthcare and financial services sectors. It is benefiting from the trend towards digitisation as forms that used to be paper based are now online. Nimmo suggests that ‘there is loads more to go for’. The managers recently had a meeting with telecom company Gamma Communications. It has benefited from the trend towards working from home and is expanding overseas. Nimmo explains that the UK has more advanced online telecom services than many other European markets, so Gamma has first-mover advantage in countries such as Germany and Spain.

In the portfolio, there is a relatively new position in Auction Technology Group (ATG), where Nimmo and Glennie participated in the February IPO (priced at £6 per share versus the current price of c £13 per share). The company focuses on curated art, like Sotheby’s, along with industrial auctions. It undertook a fund-raising a few months ago to acquire its largest competitor, so there are monopoly hurdles to overcome. However, if the deal is successful, ATG would become the global leader.

The position in high-level language translation company RWS Holdings has been sold. The managers said that the company had been in SLS’s portfolio for six to seven years, during which time the business grew successfully both organically and via acquisitions. However, they now fear that the company is somewhat of an ‘acquisition junkie’, as they believe that its recent purchase SDL is a ‘pedestrian’ business. RWS’s CEO resigned a few months after the transaction and Nimmo suggests that the company is running out of growth, which was reflected in a weak Matrix score. Nevertheless, the manager says ‘the position did its job, entering the portfolio at c £500m market cap and exiting, after a couple of fund raises, at c £2.5bn’.

Nimmo and Glennie participated in the July 2021 IPO of Big Technologies. The company owns the Buddi brand and provides products and services to the remote and personal-monitoring industry. It listed at £2 per share (the current share price is c £3.20). The managers explain that increased use of electronic tagging, which avoids the need for jail sentences, has positive effects for both offenders and taxpayers as it is a lower cost, more effective approach and leads to reduced levels of reoffending, and Big Technologies’ high-quality products mean that there are less false readings. The company has worldwide operations, long-term contracts and a high percentage of recurring revenues. It is a founder-run business; its CEO Sara Murray also founded Confused.com.

SLS’s turnover in Q121 was high at an annualised rate of c 40-50% as Nimmo explains that ‘the trust was a victim of its own success’ ending up holding too many larger-cap stocks, which were not included in the benchmark. These were sold with the proceeds reinvested in part in some IPOs. Annualised portfolio turnover is now back down to a more typical c 10–15% pa.

In FY21 (ending 30 June 2021), SLS’s net asset value (NAV) and share price total returns of +41.9% and +46.9% respectively lagged the reference index’s +52.3% total return. The managers explain that while the trust has a long-term record of outperformance versus the reference index, the process typically struggles to keep up during a market recovery phase, which occurred between early November 2020, when there was positive news about COVID-19 vaccine trials, and mid-March 2021, when concerns re-emerged about the pace of economic recovery. The largest positive contributors to SLS’s total returns in FY21 were Future, Kainos Group and Impax Asset Management Group, while the largest detractors were Hilton Food Group, Trainline and RWS Holdings.

SLS’s relative performance is shown in Exhibit 7. Following a return to form since the middle of March 2021, illustrated by the trust’s very strong relative results over the last six months, SLS is behind the reference index over the last year but is meaningfully ahead over the last three, five and 10 years. The trust has noticeably outperformed the broad UK market over all periods shown except over the last month.

Nimmo explains that since the middle of March this year the largest positive contributors to SLS’s relative performance include Future (by a wide margin), Kainos Group, Impax Asset Management Group and discoverIE Group, while the largest detractors include Trainline (position now sold due to increased competition from the government), AO World (the manager is giving the company the benefit of the doubt given the perceived market opportunity) and FD Technologies (formerly First Derivatives, position now sold locking in significant profits).

In Exhibit 9 we show the 19 members of the AIC UK Smaller Companies sector with market caps above £50m. The peers follow a variety of investment processes; SLS is unique with its use of the Matrix proprietary screening tool and its intense focus on quality, growth and momentum stocks.

Following a period of underperformance in late-2020/early-2021 as there was a ‘dash for trash’ with investors focusing on value/cyclical stocks that had underperformed during the pandemic, over the last 12 months, SLS’s NAV total return ranks 18th out of 19 funds (16.0pp below the mean) due to its lack of exposure to more cyclical areas of the market. The trust’s performance over the other periods shown is above average: fifth out of 19 (+11.9pp) over three years, sixth out of 17 (+23.2pp) over five years and seventh out of 14 (+20.5pp) over the last decade. SLS’s discount is below average, and the trust has a competitive ongoing charge. It has an above-average level of gearing and unsurprisingly given its focus on capital growth rather than income, a dividend yield that is below the peer group mean.

Nimmo comments that there are now only a couple of SLS’s holdings that are not yet back on the dividend register: Jet2 and Hollywood Bowl, which is unsurprising given that leisure stocks remain under pressure. He says that 18 months ago, 90% of the trust’s holdings paid dividends and 10% did not, and due to the pandemic, 46% of the 90% cut their dividends. The manager explains that the percentage of portfolio companies not paying dividends has increased from 10% to 18%, as new issues generally do not make distributions. While ‘payments are back with a vengeance’ Nimmo expects SLS’s dividend to remain uncovered in FY22, with the board likely to again dip into reserves to keep the dividend unchanged. He notes that some of the trust’s larger holdings are growing their dividends at a rapid rate such as food processors Hilton Foods Group and Cranswick.

In FY21, SLS’s revenue return was 6.43p per share, 4.6% lower than 6.74p per share in FY20. However, dividend receipts are improving considerably as businesses are recovering from the coronavirus-led weakness in 2020; in the second half of FY21, the trust’s dividend income was 37% higher year-on-year. The board decided to maintain the annual dividend at 7.70p per year for the third consecutive financial year; it was c 0.8x covered by income. At the end of FY21, SLS had £7.5m in revenue reserves, which is c 1.0x the annual dividend.

SLS pays semi-annual dividends in April and October. The board aims to distribute around a third of the total annual distribution as the interim dividend with around two-thirds as the final dividend. Based on its current share price, SLS offers a 1.1% dividend yield.

SLS’s shares are currently trading at a 7.5% discount to cum-income NAV, which compares with the 0.5% to 9.2% range of discounts over the last 12 months. It is broadly in line with the 6.1%, 6.4%, 5.9% and 5.0% average discounts over the last one, three, five and 10 years respectively.

The board continues to operate a discount control mechanism, targeting a maximum 8% share price discount to cum-income NAV in normal market conditions. Renewed annually, it has the authority to repurchase up to 14.99% of SLS’s share capital. During FY21, c 1.4m shares (c 1.4% of the share base) were bought back at a weighted average discount of 6.1%, which added 0.5p per share to NAV. The trust also has a discretionary tender mechanism in place, although none have been undertaken since June 2015, as the board considers share buybacks are the primary method to manage SLS’s discount.

Launched in August 1993, SLS 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 17 November 2020, it was announced that Nimmo’s colleague Abby Glennie was appointed as SLS’s co-manager with immediate effect.

The fund is comprised of c 50 of the managers’ highest-conviction investment ideas. SLS’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 SLS 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 1 October 2021, net gearing was 6.6%. 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.

SLS 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. Following Standard Life Aberdeen’s name change to abrdn, SLS’s board is proposing that the trust’s name is changed from Standard Life UK Smaller Companies to abrdn UK Smaller Companies Growth Trust. It deems that the addition of ‘growth’ better reflects what the trust is seeking to achieve. The resolution will be voted on at the 21 October 2021 AGM.

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 13 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 35% 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 SLS’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 environmental, social and governance (ESG) credentials.

Given the managers’ long-term perspective, the average holding period for SLS’s investments is around six years, although a number of 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 1,000 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 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.

Glennie explains that for SLS, 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. Glennie says 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 doing 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 and they are able to help advise them and encourage them towards those ESG aspects required by shareholders.

Nimmo highlights portfolio company discoverIE, which he says has ‘an attractive ESG strategy’. There is improved reporting in its new annual report, it is following United Nations sustainability development goals and it has appointed a third-party ESG consultant to ensure that its strategy is focused on areas that investors consider to be appropriate. Areas that the managers would highlight for further improvement are discoverIE’s employee surveys and provision of more information about the company’s supply chain.

SLS has a £65m unsecured loan agreement with Royal Bank of Scotland International (RBSI), 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 (RCF), which was converted to be priced off Sonia in May 2021. The total £65m debt facility is currently fully drawn and matures on 31 October 2022. As at 1 October 2021, SLS had net gearing of 6.6%.

SLS has a tiered management fee structure: 0.85% pa up to £250m of SLS’s NAV; 0.65% pa between £250m and £550m; and 0.55% pa above £550m. Its ongoing charges ratio (OCR) in FY21 was 0.88%, down 3bp from a restated 0.91% in FY20. The FY21 OCR is the lowest in the company’s lifetime. Along with the investment management fee, abrdn also receives a fixed secretarial and administration fee of £75k pa plus VAT (capped at £150k pa plus VAT prior to 2021) and a separate fee for the provision of promotional activities for SLS (£150k in FY21).

SLS is a conventional investment trust with one class of share; there are currently 97.7m ordinary shares in issue, with 6.5m held in treasury. Its average daily trading volume over the last 12 months is c 160k shares.