Aberforth Split Level Income Trust (ASLIT) is a high yielding smaller companies fund with a disciplined value approach, offering a historic yield of 4.9%. This is the highest natural yield on offer from a pure smaller companies trust.
The trust is in its second year, having launched on 3 July 2017 (as a rollover vehicle for Aberforth Geared Income Trust). Relative total return performance has been held back by the value style being out of favour, particularly in the second half of 2018 – although Q1 2019 was much more positive in performance terms.
The trust met its first-year dividend target of 4p, supplementing that with 0.6p of specials in a bumper year for those. The first interim dividend of 2018/19 saw a slight increase over last year, while income received from specials on the portfolio has been considerable, though lower than in 2017/18.
The trust has built up a revenue reserve already, holding back 0.8p last year, or 20% of the full-year dividend. This is consistent with the approach taken by the antecedent trust AGIT, which built up substantial reserves in the first few years in order to provide greater security to the dividend – we would note that three of the six board members of ASLIT, including the chairman, previously served on AGIT.
The trust is team managed, with decades of experience between its members. The two remaining founding partners, Alistair Whyte and Richard Newbery, have been part of the team managing the trust since 1990. Richard retires at the end of this month (April 2019), leaving a committed team of six experienced investors who follow the same philosophy and approach.
Being contrarian and value investors, the managers have built up an overweight to UK domestic stocks on a bottom-up basis. They are also biased to the small end of the market and do not buy AIM stocks, meaning the exposures are different from the average smaller companies fund.
The managers aim to have ASLIT near fully invested at a portfolio level at all times. The company has structural gearing in the form of zero dividend preference shares (ZDPs), which means that the ordinary shares are 28% geared, considerably higher than most smaller company trust peers, most of which do not have any gearing at all.
The Aberforth approach, the income mandate and the company’s structure mean that ASLIT is highly differentiated to its peers. ASLIT has the most extreme positioning towards value (according to Morningstar data) in both the closed- and open-ended sectors. Relative to peers, the ordinary shares of ASLIT have the highest gearing to equities of peers thanks to the ZDP shares.
The trust’s discount has been volatile. The current discount of 9.9% is wider than the sector average of 7.4%. The board is able to buy back shares, but has not done so to date, with the trust’s limited life representing a hard form of discount control.
ASLIT offers a rare opportunity to diversify an investor’s sources of income into the small cap market. The gearing from the ZDPs means that the yield is highly attractive, at 4.9%, and is likely to remain high, in our view. The trust also offers exposure to a disciplined value approach.
The Aberforth team have generated substantial outperformance using the value style in the past, and we would back them to do so again when the decade-long outperformance of the growth style finally ends. This might need a resolution to the Brexit process, or it might be a consequence of resumed optimism about the US economy and the course of its interest rate cycle, which has been a key determinant of the relative performance of growth and value investment styles even in the UK.
We would highlight that the portfolio currently represents value on many levels, and is something of a contrarian’s dream: UK stocks are currently out of favour, small caps have underperformed large caps since the referendum, value has underperformed growth since the financial crisis, and the trust is trading on a discount to the sector average as well as NAV.
|High dividend yield
||Structural gearing will amplify volatility for ordinary shares
|Experienced team, who have generated alpha over the long term
||A no deal Brexit would likely significantly dent sentiment
|Value stocks, in a deep value area (domestically exposed UK smaller companies)
||No discount control mechanism, beyond the limited life
Aberforth Partners is a committed and disciplined value investor, which aims to find attractive businesses at a time that they are unloved by investors. According to Morningstar data, ASLIT has the largest weighting to value of all of the AIC and IA UK Smaller Companies sectors, at 65% of NAV. This compares to an average of just 17% for the closed- and open-ended UK smaller companies sectors. This is mainly due to the consistent application of a value approach in a sector which is mainly populated by growth managers, but also to the extra value tilt that comes from the objective of providing ordinary shareholders with a high level of income.
The managers take a bottom-up approach and aim to rotate capital from companies that are priced toward the top of the EV/EBITA range (enterprise value as a multiple of a stock’s earnings before interest, taxes and amortisation) into undervalued stocks trading at a wide EV/EBITA discount. This means that the trust invests in companies which are out of favour and sells out of them when they are back in vogue, and in many cases the team have bought and sold the same companies a number of times. The focus on EV/EBITA allows the team to consider companies with different capital structures on a level playing field, while EBITA is a reasonable proxy for the cash-generative powers of a business. The team has different approaches in some sectors, such as property and energy, which are asset-based, however.
The positioning tends to be contrarian, therefore. For example, in 2017 and 2018, the team found an increasing number of opportunities in domestic earners. These businesses, more dependent on the UK for their cash flows, have been generally out of favour since the June 2016 referendum and the devaluation of sterling thereafter. The bias still remains, although when we met with the mangers recently they told us that the valuation gap was less obvious than it had been thanks to the Q1 2019 recovery in markets. Currently 64% of the portfolio’s revenues are generated in the UK compared to just 58% for the index. It is important to emphasise that, as the team are bottom-up stock pickers, this positioning is not driven by a top-down view and so does not represent a view on the outcome of the Brexit process. Indeed, a certain Brexit outcome is not even necessary for some of the stocks to re-rate. Dunelm Group, for example, at 3.7% the trust’s largest individual holding, posted strong results in February and was rewarded with a rallying share price. This was validation of Aberforth’s view that the business was of a higher quality than recognised by the market, and sentiment to UK domestic earners and the retailing sector had seen it unfairly penalised.
We reproduce the top ten holdings below, with the domestic focus evident. Along with Dunelm, the list includes UK van rental company Northgate, Go-Ahead, the rail and bus operator, a housebuilder and a bricks manufacturer. However, this is a bottom-up value fund and not a UK domestic earners fund, and Spirent Communications is one stock which proves this. The telecoms testing equipment manufacturer derives 86% of its revenues from the Americas or Asia. Meanwhile, metal flow engineering company Vesuvius generates 4% of its revenues from the UK.
Structurally, one of the key differentiating factors from other small cap funds is that the company does not invest in AIM but restricts itself to the Numis Smaller Companies ex IT index. This compounds two of the key elements of its style: its value tilt and its bias to the smaller end of the small-cap market. The top end of the AIM market is home to some large mid-caps which fit into the “growth” bucket most naturally. Over the past five years this area has been a key area of focus for many small cap managers, with stocks such as Fevertree, ASOS and Boohoo trading on high valuations. These high growth stocks have undoubtedly benefitted from a low interest rate environment. With benchmark rates low, the rates used to discount future earnings in stock valuations have been low and produced disproportionately higher prices for “long duration” stocks – i.e. those with a greater weight to the future.
Indeed, on valuation grounds, the team has been overweight the “smaller smalls” since at least the 2008 financial crisis. Another contributing reason to the valuation gap is that since then investors have been more averse to the illiquid area of the market, and the larger end of the Numis index has also received more attention from ETFs and trackers as it qualifies for inclusion in the FTSE 250. The below table shows this valuation advantage persists: stocks under £250m in market cap are substantially cheaper than the larger members of the index and ASLIT has 24% in this part of the market compared to just 8% for the benchmark.
|Up to £100m
||£101m - £250m
||£251m - £500m
||£501m - £750m
On a sector basis, the current positioning is overweight in the cyclical industrial and consumer services sectors, reflecting those areas as being relatively out of favour as concerns about the implications of Brexit affect markets, However, cyclical areas are always likely to make up a large part of the portfolio given the relatively few companies in the “defensive” areas in the small-cap universe.
Fundamentally, the investment process used is the same as that used for the total return focused Aberforth Smaller Companies, which Aberforth launched in 1990. This is facilitated by the ZDPs, which contribute to a high yield for ordinary shareholders. Of course, there is still a yield requirement from stocks in the portfolio, which has led to the greater exposure to “value” as a style and to a greater concentration. As of the end of March, the trust had 66 holdings compared to 80 for Aberforth Smaller Companies Trust.
The team is happy to run up significant holdings in companies across its funds where it has confidence in its investment thesis, and currently 27% 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.
The managers aim to have ASLIT near fully invested at a portfolio level at all times. Given the company is structurally geared through its Zero Dividend Preference shares, the company only expects to use bank borrowings for short-term working capital purposes, which are not expected to exceed 2.5% of total assets, and at no point more than 5%.
The ZDPs mean that ASLIT’s ordinary shares are 28% geared. The ZDPs are a form of gearing that incur no interest costs, but the principal that the company must repay at the end of the fixed term (in this case, 1 July 2024) increases by a predetermined rate of 3.5% per annum and has a prior call on the company’s assets, over and above the rights of equity shareholders.
The advantage to the company of ZDPs is that they do not have any material covenants and are a capital cost to the company - therefore boosting the income distributable to ordinary shareholders. The drawback is that to any extent that the company’s assets do not grow in excess of what is required to repay the final entitlement of the ZDP (holders are entitled to 127.25p a share on 1 July 2024), then ordinary shareholders' capital will be eroded. This amounts to 0.95% per annum on the issue price.
The trust has seen a period of outperformance in Q1 2019, which has not been enough to offset the effects of a poor second half of 2018. Since launch in July 2017, trust has underperformed the index and peer group, with NAV total returns of -2.93% (excluding launch costs the return is slightly positive at 0.52%). Over that period the index has returned 3.21%.
It has been a “story of two halves”, however, with the NAV total return matching the index until June 2018, and relative performance deteriorating since then, as can be seen in the graph below.
PERFORMANCE SINCE LAUNCH
Since last summer, the market environment has been highly unfavourable to a value style, which has led to the underperformance. Within the UK, their value approach, which is compounded by the yield requirement, has led the team to invest more in UK-facing domestic earners. These underperformed as concerns mounted about the outcome of the exit negotiations. However, a key influencing factor has been market expectations of US interest rates. In Q4 of last year, the market began to question the ability of the Fed to stick to its hiking plans without sparking a reduction in economic activity and potentially a recession. This led to rate expectations lowering and therefore boosted long-duration growth stocks at the expense of value stocks once again. The first half of 2018 appears to have been another “false dawn” for value investing, therefore, and the more growth-oriented peer group has therefore outperformed.
It is interesting to note the relative outperformance of the trust in Q1 2019. In this period, we saw many active managers begin to allocate to the UK on value grounds, and UK value managers more broadly do better too. Is this another temporary phenomenon? The two most likely reasons we see for a sustained rebound of value are first, a resolution to the Brexit impasse – the BoE has stated that rates would be higher were it not for Brexit uncertainty and wages are rising substantially higher than inflation at the last count. Secondly, the raising of interest rate expectations in the US (due to an improving economic outlook and/or higher inflation) could well lead to a re-rating of value as it would decrease the present value of forecast future earnings, bringing down the valuations of high growth stocks disproportionately.
The company pays dividends twice a year, and taking the last two regular payments, i.e. on a historical basis, the shares are currently yielding 4.9%. This high yield is one of the key draws of the trust. In the AIC Smaller Companies sector the only trust to offer a higher yield is Montanaro UK Smaller Companies, at 5.2%, although this is partly paid from capital. ASLIT, on the other hand, offers an entirely natural yield. While it has the ability to pay out of capital, we believe it would be highly unlikely ever to do so. By contrast, the high yield is facilitated by the ZDP shares. The ZDPs have a predetermined level of return, which is rolled up and paid as capital at the end of their fixed term (see Gearing section). This introduces capital gearing (and risk) to the ordinary shares, but with the ZDPs having no entitlement to income or interest payable, the ordinary shares benefit from a higher distributable income.
Last year, the company’s first, ordinary dividends of 4p were supplemented by a 0.6p special dividend. This was paid from the special dividends on the portfolio companies. The managers prefer this way of allocating the payments, as specials are likely to be volatile and underlines that it is only the ordinary dividends which they expect to grow year-on-year. In 2017/18, the company received roughly £1m in income from one-off dividends. The managers tell us that the four specials that have benefitted the portfolio so far in 2018/19 have delivered £400,000 in income already, so we believe there is the prospect for a further special dividend this year. The first interim this year was 1.45p, 0.05p higher than 2017/18’s first interim.
The Aberforth team have a cautious approach which could reassure those who are relying on their investment income for their living costs. The trust held back 0.8p of its revenue in reserve last year, or 20% of the full-year dividend. This is consistent with the approach taken by the antecedent trust AGIT, which built up substantial reserves in the first few years in order to provide greater security to the dividend – we would note that three of the six board members of ASLIT, including the chairman, previously served on AGIT, which gives us confidence that the same approach will be taken.
This cautious outlook extends to their views on the future for dividends in smaller companies. The Aberforth team observe that, at 9%, dividend growth has been very high since the 2008 crisis, well above the long-term average (since 1955) of 3%, and they expect a regression to the mean. The ongoing uncertainty around Brexit could be the catalyst or could at least mean that specials this year are below last year’s high number.
We note that the process employed by the Aberforth team has a strong track record of delivering dividend growth. ASLIT’s predecessor (AGIT) delivered significant growth in dividends over the seven years of the trust’s life. The board delivered 6p for the trust's first 14 months and managed to nearly double the annual ordinary dividend over the trust's life to the 11p paid in the trust's final year. We would caution that this growth in dividends is unlikely to be repeated by ASLIT, both because of the fortunate timing of the launch and the higher ZDP gearing than the current structure, which launched with an ordinary share/ZDP ratio of 4:1, relative to the predecessor’s ratio of 3:2.
Aberforth Partners constitute a highly-experienced management team with a total of c. £15m invested in ASLIT, showing very considerable 'skin in the game'. The team has decades of experience between its members, but the original partners have gradually been retiring, being replaced by a committed team of experienced investors. Alistair Whyte and Richard Newbery are the last of the original partners, having been on the team since launch in 1990. Richard, however, retires at the end of this month (April), leaving behind a team of six.
There is still a huge amount of experience on the team within the Aberforth ecosystem, so we are confident there will be no change to the strategy (this is one of the benefits of having a highly disciplined process). Euan Macdonald joined in 2001 and Keith Muir joined in 2011. Jupiter’s Chris Watt and Kames Capital’s Peter Shaw joined in the spring of 2016, and the newest recruit is Jeremy Hall who joined from Cartesian and Nikko in October 2018. 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.
Each of the investment managers has sector responsibilities, between them tracking 281 of the c.350 companies in the Numis Smaller Companies Index (ex ITs). Whilst EV/EBITA is one of the most important metrics used by the team to identify undervalued opportunities, price-to-book (P/B) and other metrics will also be used for certain business models. The managers do look for potential catalysts that will correct undervaluations, but are also believers in mean reversion, occasionally buying certain stocks just because the valuation has reached very low levels. In this way, they are often buyers of a stock following a profit warning and fully accept that, in many instances, 'it may get worse before it gets better' – and are willing to take a long-term approach.
The partners are fully aware of potential capacity issues in the small cap market and therefore they have a self-imposed ceiling on the business, meaning their funds under management (across all of their strategies) are capped at c.1.5% of the Numis Smaller Companies ex IT index’s total market cap. At the current time of writing, this means that they have further capacity of roughly £200m, relative to their current total AUM of £2.1bn. It is worth noting that their two investment trust mandates represent approximately 70% of funds managed.
For much of its short life, the trust has traded on a tighter discount than its peer group. This likely reflects the high income facilitated by the split capital structure, which is attractive given the widespread demand for income from diverse sources. However, as risk appetite returned to the stock markets in the first quarter of 2019, and the prospects for US interest rate hikes diminished, the average discount of the peer group has come in slightly, but on the other hand the trust’s discount has widened, albeit with considerable volatility (perhaps compounded by the high gearing levels from the ZDPs). The current discount is 9.9%, compared to a 7.4% sector average. Given the high structural gearing and the trust’s limited life, ASLIT’s board has not committed to use buybacks to manage the discount, and in our view is unlikely to do so.
DISCOUNT TO NAV
The trust pays Aberforth a management fee of 0.75% of total net assets, i.e. ordinary shares and ZDPs. This is equivalent to 0.92% of net assets on the ordinary shares, given the structural gearing. There is no performance fee. The OCF for the last financial year was 1.1%. This compares to the simple average for the UK smaller companies sector of 0.95%, and the OCF for the much larger (and much less geared) sister trust – Aberforth Smaller Companies Trust which stands at 0.79% (both figures from JPMorgan Cazenove).