Aberforth Smaller Companies (ASL) is the only UK smaller companies trust with an unambiguous value approach, barring its income-focused sister Aberforth Split Level Income.
The long-term track record has been extremely strong, although returns in recent years have been below those of the peer group thanks to the managers’ diligent adherence to a value approach - a style that has been very much out of favour in what has been a growth or momentum driven market. The value approach and the concentration on the smaller end of the market (due to its lower valuations) differentiate the trust from its peers.
The value approach leads to a contrarian tilt to the portfolio, which has in recent years become overweight domestic earners and picked up exposure to resilient retailers that have been sold off on sentiment rather than fundamentals. These exposures have helped the trust in recent months.
The team of managers has extensive experience, with the two remaining founding partners having been involved in running the portfolio since 1990. One of them, Richard Newbery retires at the end of this month (April 2019), leaving a committed team of six experienced investors who follow the same philosophy and approach the company has had since the beginning. The team has significant shareholdings in the trust, and so their interests are well-aligned with the long-term interests of shareholders.
Although the trust aims for total returns, the value approach often leads the company into higher dividend-payers. The historic yield is 2.4% excluding non-recurring special dividends, which compares favourably to a sector average that does include specials of 2.5%. The board is committed to a progressive dividend policy, which has been supplemented by special dividends over recent years. With significant revenue reserves and high average cover for dividends paid by the portfolio holdings, the managers hope that the dividend can grow even through the next cyclical downturn.
The trust is trading on an 8.7% discount compared to a sector average of 7.2%. The trust did trade on a tighter discount than the sector briefly in Q1. In this period many investors bought back into the UK on value grounds, although after the date for “Brexit” was pushed back into the autumn the discount widened again.
The strict valuation discipline makes this trust unique in the smaller companies space. We believe it could be held on its own by investors who wish to harvest the value premium in small caps, or used to diversify the heavy growth biases in most small- and mid-cap focussed funds, open- or closed-ended.
Value has been out of favour for a while in small caps and in the wider market thanks to the low growth, low inflation environment, which has seen investors chase secular growth in the few areas they can find it. A period of rising rates and inflation could create a much more fertile ground for Aberforth’s approach, although we note that calling turns in the market is extremely difficult, so waiting for a regime change could be a risky approach to take. Thanks to the aversion to the value style, the trailing PE on the Aberforth Smaller Companies portfolio is towards its lowest at any time since launch, except during the early 1990s recession and immediately following the 2008 crisis.
Moreover, the 9% discount perhaps offers some comfort on the downside. A rebound in the performance of value versus growth could well see the trust trade on a premium versus peers as has happened in the past.
|A highly experienced management team, which has followed a consistent approach through multiple market cycles and takes a long-term view.
||It may be some time before we see a sustained period of value outperforming growth in small caps.
|A unique approach in the small-cap sector, which offers diversification benefits as well as the chance of outperformance when the economic regime changes.
||The risk to a value approach in small caps is that cheap stocks can go bust, although this is mitigated by the trust’s diversified portfolio.
|An active share buyback policy and a trust trading on a discount to peers thanks to its style being out of favour.
Aberforth Smaller Companies aims to generate long-term total returns from a value approach to investing in UK small caps. The basic philosophy is that buying good companies when they are cheap will be rewarded in the long term, so the management team looks to find attractive businesses that have fallen out of favour. This means uncovering why a company is cheap and deciding whether it is justified: is it being punished for previous management mistakes? Is the company out of favour because of macro trends?
The managers believe the market habitually over-rates winners and under-rates losers, and “there is a price for everything”, meaning that companies facing real difficulties can be good investments if they have been overly punished by the market and there is a clear route to a re-rating. This, and the strict valuation discipline that sees the trust sell stocks when price targets are met, also means that the team tend to buy into the same companies more than once: as sentiment is cyclical, the same companies return to attractive valuations if you wait long enough. This is a disciplined approach, therefore, which prevents the managers from being seduced by the stories behind stocks, which can often lead to investors paying too much for a company. Morningstar data show that turnover has averaged 22% over the past three years, implying a holding period of between four and five years. The managers tell us they would expect turnover to increase slightly when value investing returns to favour, but as re-ratings have been slower to come in recent years the rate has remained depressed as the portfolio has been recycled less frequently.
The approach and philosophy has been maintained over almost thirty years of investing (the trust was launched in 1990). Over time, some of the original founding partners have been replaced. Richard Newbery and Alistair Whyte are the remaining founding partners and were joined by Euan Macdonald in 2001 and Keith Muir in 2011. In 2016, Chris Watt joined from Jupiter and Peter Shaw from Kames. Most recently, Jeremy Hall joined from Nikko and Cartesian in October 2018, while Richard Newbery will retire at the end of April this year. The managers share out sector responsibilities, but decisions are made collectively, which helps ensure the trust’s style is consistent. It also ensures managers do not become advocates for their sectors, but are focused on finding the best areas of valuation in the market.
The main valuation metric used is enterprise value to EBITA (EV/EBITA – or enterprise value as a multiple of a stock’s earnings before interest, taxes and amortisation). The team tracks the metric for 98% of their investment universe by value and believes it gives them an advantage over those who use the more common price to book or price to earnings measures. The metric considers companies of different capital structures on a level playing field, while EBITA is a reasonable proxy for the cash generative powers of the business.
As of the end of March 2019, the portfolio was trading on a significant discount to the universe, as highlighted in the below table. Using historic numbers, the valuation gap narrows when the 48 “growthiest” stocks are removed from the index. However, forecasts for 2019 and 2020 show a valuation wedge opening up again, reflecting the fact that these are quality companies whose likely growth is being underestimated or overlooked by the market.
EV/EBITA OF PORTFOLIO VERSUS ABERFORTH UNIVERSE
|(48 growth stocks)
|(234 other stocks)
Source: Aberforth, as at 31.03.19
Aside from cheaper valuations, another key long-term feature of the trust’s portfolio is its persistent overweight to the “smaller smalls”. The average market cap of the trust is £591m compared to £842m for the index. While the Numis index contains many companies which qualify for the FTSE 250 on size grounds, Aberforth Smaller Companies has a persistently higher weighting to the small-caps proper. This area of the market has been cheaper since the financial crisis, which the managers attribute to fears of illiquidity following the punishment taken in illiquid investments in 2008. This exposure tends to compound the contrarian nature of the portfolio: when UK stocks are in favour, the inflows tend to go to the more liquid areas of the market, which in the smaller companies universe means the “larger smalls”. The consequence of this is a tendency for higher valuations, as can be seen in the table below. Aberforth is overweight the smaller end of the market which sits on considerably lower valuations than the larger end.
VALUATION ON MARKET SEGMENTS
|Up to £100m
|Aberforth Smaller Companies
Source: Aberforth, as at 31.03.19
We think this tilt is an advantage from the point of view of investors and allocators. Allocating to mid-caps tends to be the preferred route for all cap or large cap managers to generate alpha, so those picking a “small-cap” fund with a high weighting to mid-caps are likely to be doubling up exposure and maybe even stock picks. Given the value discipline of the managers there can be no certainty as to how long the tilt to smaller smalls will remain, although given the mid-caps tend to be more growth-oriented businesses, it could well persist until the next sustained period of outperformance for value. The managers do consider the current situation a value anomaly which will be eventually rectified, however.
The current key sector exposures on a sector level are overweights to industrials, which make up 33% of the portfolio, and consumer services, which make up 29%. Although these are not typical “value” sectors, this is the nature of the index, which has low weightings to traditional value sectors such as energy and materials, healthcare, telecoms and utilities. Financials are a major part of the index, but without the large banks which are responsible for the dividend-paying, “value” tilt of the sector. Sector weightings reflect stock selection rather than industry-level views, however, although the management team necessarily consider the sector and economy-wide contexts when forecasting earnings and valuations multiples.
The value approach can lead to contrarian positioning. After the depreciation of sterling following the 2016 Brexit referendum, the team found more and more opportunities in businesses facing the UK domestic economy, as overseas earners re-rated relative to their peers. When we recently met the managers, they told us that they view the relative valuations as now being much more balanced, however, after a relatively stronger period for domestic earners which boosted the trust’s returns. Currently, 62% of sales are generated domestically compared to 58% of the index, they estimate.
They have also found opportunities in quality retailers which are out of favour, thanks to the belief that traditional retailers are fighting a losing battle with online sellers. Dunelm Group is one such company to have recently reported good results and seen its share price respond positively. As of 31 March, the stock was the largest holding.
The strict valuation discipline brings along with it a high level of active share as well as this contrarian positioning. At the end of the first quarter, active share was 78%, above the self-imposed minimum of 70%. We would note this is a “purer” figure than the numbers quoted by many managers as the Aberforth team limit themselves to the constituents of the Numis Smaller Companies ex IT index rather than investing up to 20% in off-benchmark stocks as many funds do.
The team is happy to run up significant holdings in companies across its funds where it has confidence in its investment thesis, and currently 31% of the portfolio is invested in companies in which Aberforth’s clients own more than 10% of the equity. This gives the team a certain amount of influence with boards of investee companies, and at any one time the managers are 'engaged' with the boards of a number of their investments. This engagement is constructive in nature and is never made public.
Gearing is employed tactically, with a long-term view taken on the valuation of the markets and the opportunity. The last time the company took out substantial gearing was after the 2008 crisis, and it steadily wound down that debt, reaching an essentially ungeared state by the end of 2013. The other two occasions the trust has employed significant gearing were following the 1997 Long Term Capital Management crisis, when markets sold off on fears of systemic risks after a US hedge fund blew up, and after the UK recession of the early 1990s. The team tells us that they do not view this as an opportune time to gear up, though a severe sell-off triggered by a “hard” Brexit or a recession could be the cue for them to deploy debt again.
Currently the company has a £125m facility with RBS expiring in 2020, coinciding with the triennial continuation vote. The facility is worth 10% of NAV at the trust’s current size, although given the policy of the managers it is unlikely to be used fully except in extreme circumstances. Over the previous year, the facility has been used like an overdraft to manage day-to-day transactions and debt levels have not risen above 2% of NAV.
The trust has been run with the same value strategy since it was launched and has outperformed the benchmark by over two per cent a year, with returns of 12.7% to the end of 2018 versus 10.4% for the index. This has compounded into a huge difference in total return: 2,772.3% to 1,498.7%.
However, since the financial crisis of 2008, the trust has been facing a persistent stylistic headwind. An era of low growth, rock bottom interest rates and quantitative easing has led to high growth stocks being in favour, as investors look for secular growth stories. Over ten years, therefore, the trust has returned marginally less than the index, and the story is the same over five years, with the trust up 27.3% in NAV total return terms compared to 31.7% for the index.
The investment trust sector average has outperformed both Aberforth Smaller Companies and the index, with most other small-cap managers over-weighting high growth stocks, often those listed on AIM. In fact, many of the most successful consensus picks in recent years are listed on AIM. While this has been a good period for investing in that market, we believe there are a number of reasons to be wary that this will continue to be the case. First, in the case of the “story stocks”, which have been bid up despite low or non-existent earnings, the snap-back can be vicious. One recent example would be Blue Prism, the AI stock, which is down 37% since last August’s peak on sentiment rather than news. Investors also need to bear in mind that many stocks now stay on AIM until they are properly mid or large caps due to the favourable regulatory regime, so there is also the chance of style drift in AIM-heavy small-cap funds. Finally, and most importantly, the “normalisation” of interest rate policy could well lead to a significant rebound in the value style and a de-rating for high growth stocks.
Suggestions of this can be seen in the outperformance of Aberforth Smaller Companies immediately following the election of Donald Trump in late 2016, when expectations of rate hikes and inflation were high. The trust outperformed by 9% against the index between November 2016 and March 2017. This can be seen in the relative performance graph below, where an upward sloping line denotes a period of outperformance against the Numis index. Again in 2018, when a series of rate hikes seemed on the cards, the trust outperformed, delivering outperformance of 7% against the index between January and May 2018. However, concerns about a trade war and a more dovish Federal Reserve Bank have led to a rebound in the growth style since then. In this globalised economy, it is US interest rates which are having the most influence on the value / growth dichotomy in the UK, although the Bank of England keeping rates lower than they otherwise would have due to the Brexit process is undoubtedly a negative factor too.
RELATIVE FIVE-YEAR PERFORMANCE
As the graph below shows, the last period of sustained outperformance over the index came in 2012 and 2013, when value rallied in the small-cap market, and the trust outperformed the index. However, the trust also outperformed in 2017, which is impressive given that value underperformed over that year as a whole.
Style helped the fund at the start of 2017 as the “reflation trade” saw money leaving expensive defensives and bond proxies and flowing to hitherto undervalued areas, but as the reflation trade faded the value style suffered. The trust outperformed nonetheless thanks to overweighting the “smaller smalls”, which outperformed the more expensive “larger smalls”. Furthermore, the trust was boosted by, what was at that point, a higher overseas earnings exposure. Aberforth estimate that their portfolio companies generated 47% of sales from overseas at the start of 2017 compared to 41% for the index. This helped performance as the weak pound translated into higher earnings for these stocks.
In line with their value approach, this prompted the managers to shift their portfolio slowly into domestic earners after their de-rating, and currently the portfolio is overweight domestic earners. The team tells us that, so far in 2019, this shift has borne fruit, as valuations of the domestics have seen something of a recovery and therefore they think there is more of a level playing field on a forward-looking basis.
As for the outlook, the trust stands to do best if the US recovery persists and rates rise further, in our view. Anything but a shock no-deal Brexit is likely to be positive for the company as it would improve the outlook for rate hikes. The Q4 2018 market slump is best viewed as a mid-cycle dip, the team suggests, and the valuations on the small cap market are below their long-term average, suggesting we are not late cycle. The trailing PE on the Aberforth Smaller Companies portfolio is towards its lowest at any time since launch, except during the early 1990s recession and immediately following the 2008 crisis.
The trust has a total return rather than income objective, although the board remains committed to growing the dividend over time. The shares currently yield 2.4% on a historic basis, excluding special dividends. The AIC Smaller Companies sector average is 2.5%, a number that does include specials and is affected by payments from capital. The managers’ value strategy naturally leads to stocks with higher dividend yields, though their influence can be diluted by positions in turnaround situations or sectors such as oil & gas where yields are low or zero. Over the long term, the portfolio yield has been on average 14% higher than that of the index.
Below we have included the total dividend paid each year, which since 2015 has included a special dividend. This was implemented thanks to the prevalence of specials from portfolio companies, which cannot be expected to be stable each year. Splitting this payment out into a special dividend makes it clear that it is only the ordinary dividend which the board has committed to grow each year.
Excluding specials the dividend grew by 5% between 2017 and 2018, in line with the five-year average. The trust did not increase the payout in the aftermath of the GFC, between 2008 and 2010, when the dividend was held at the same level.
The trust pays dividends twice a year, in August and March. It has not sought permission to pay dividends from capital but revenue reserves are 2.9 times the 2018 underlying ordinary dividend. These high levels give the managers confidence the portfolio will be able to meet its progressive dividend policy even through the next market downturn when plenty of small caps would be expected to cut their dividends.
Aberforth Partners constitute a highly-experienced and stable management team. After Richard Newbery retires at the end of April 2019, there will be six members: Euan Macdonald, Keith Muir, Peter Shaw, Christopher Watt, Alistair Whyte and Jeremy Hall.
Richard and Alistair are the remaining founding partners of Aberforth, who have managed the trust with the same valuation discipline since launch in 1990. Euan Macdonald joined in 2001 and Keith Muir joined in 2011. In 2016, Chris Watt joined from Jupiter and Peter Shaw from Kames, while the latest recruit was Jeremy Hall who joined from Nikko and Cartesian. The managers work collaboratively and are keen to avoid any single manager being named as ‘lead’ on the trust. Each one covers a number of sectors, but none are incentivised by their recommendations – which they believe would skew the portfolio toward the best ‘salesman’ – and instead remuneration is tied to the trust as a whole.
Aberforth runs two closed-ended funds, one open-ended fund and three other portfolios, with their total AuM at £2.1bn as of the end of March 2019. They have long stated their intention to limit themselves to hold a maximum of c.1.5% of the market cap of the Numis Smaller Companies ex IT index. The managers estimate they have roughly £200m in capacity left across their funds. In 2006 they closed their funds having reached this limit, reopening them when their share of the index’s market cap had fallen.
The trust’s discount to NAV currently sits at 8.7%, wider than the Morningstar IT UK Smaller Companies sector average of 7.2%. Since the start of 2015 the trust’s discount has been wider than the sector average the vast majority of the time, and as the graph below shows, during 2018 the gap was at its widest. In the first quarter of 2019, however, the discount to the sector narrowed and for a while the trust was trading on a tighter discount than the sector. We think this was a sign of the growing interest in the UK from a value perspective in Q1 as an increasing number of global managers and investors decided British stocks had overshot to the downside due to fears around the effects of Brexit. As we highlighted in a recent strategy piece, we agree with this assessment, and think that there is long-term value in the UK at this entry point, despite the short-term risks around the Brexit process. We view the widening of the relative discount since March as a reaction to the renewed Brexit uncertainty and the sense that any UK rebound has been postponed.
The board has the ability to use buybacks. It takes the view that they may help to close discounts, but the main motivations are to enhance the returns for shareholders who remain invested in the trust and to provide some extra liquidity for those wishing to exit. During 2018, 2.4m shares (2.6% of the Company’s issued share capital) were bought back and cancelled. So far in 2019, buyback activity has fallen. This reflects the recovery NAV, while “natural” demand for the trust’s shares has helped narrow the discount. There is a triennial continuation vote, with the next one due in March 2020.
The trust has an OCF of 0.79%, below the sector average of 0.95%. The management fee is 0.75% on the first £1bn of net assets and 0.65% thereafter. On the current net assets of £1.2bn, that amounts to 0.73%, which illustrates the fact that the other costs of managing the trust are very low. There is no performance fee, unlike a number of the funds in the sector. The KID RIY figure is 0.99%, significantly below the sector average of 1.65%, although we would caution that methodologies do vary.