Jonathan Brown and Robin West are fundamental stock pickers, with a strong valuation discipline. The team were taking profits in more highly rated stocks in the year to the end of Q3 2018, and from Q4 were adding exposure to companies previously viewed as too expensive, post significant share price falls.
The managers aim to achieve above average returns (relative to peers) through the cycle with lower volatility. The strong performance so far in 2019 YTD with NAV returns +11.7% isn’t necessarily expected, given the historic pattern of returns where the managers typically lag very strong markets. We hazard that the strong relative performance over the past six months has been largely a result of the team’s focus on valuation and their trading activity.
Jonathan and Robin aim to identify companies which have a sustainable competitive advantage, a compelling proposition in a growing market, as well as good management and balance sheet strength. They look for businesses that have the potential to double in size over the next five years, and in typical Invesco Perpetual style, hold for the long term (valuations aside) – their typical annual turnover is 25% (the latest figure from Morningstar is 27.9%).
IPU’s portfolio typically comprises around 80-90 holdings, with no position allowed to get much bigger than 3% of NAV – an approach that the managers say means they can sleep at night. However, the current uncertain political environment has translated into a desire to invest in only those companies they have a high degree of confidence in. As a result, the number of holdings in the portfolio has dropped to only c 71 holdings currently.
The team usually take profits in stocks which they believe are over-valued, and which trade on very high multiples. Their approach has stood them in good stead since the start of Q4 2018. The portfolio has been performing especially strongly recently, and over both the short and medium term, the trust is currently in the top decile relative to peers over most periods.
Over the past five years, the trust has delivered a NAV total return of 62.3%, relative to the benchmark’s return of 30.3%, and has beaten the index in all of the past five calendar years. The managers have an alpha score of 4.6% pa over the same time frame. The degree of outperformance of the index over five years is significant, particularly so when you consider that the manager has achieved this without the use of leverage.
The dividend, which equates to a yield of 4.3%, is achieved by distributing all the available income arising from the portfolio, boosted by a small proportion from capital profits. This compares very favourably with other small company funds and trusts, but also those in the equity income sector. The fact that a proportion of the dividend comes from capital means that the managers have not had to tilt their investment approach to achieve this level of income for shareholders.
Relative to the index (and some peers) the trust continues to have more of a value angle, prompted by a view that Brexit has led to a global aversion to domestic UK exposure which means stocks are attractively valued. UK sales of the portfolio are currently estimated at c. 55%, relative to the benchmark of 65-70%. Reflecting their caution, the team has around 5% cash in the portfolio currently.
That the trust's longer term outperformance is largely a result of stock-picking skill is reflected in the 5-year alpha score of 4.3% pa. The recent performance through Q4 and YTD shows the benefit of the manager’s valuation-led, generally cautious approach. As a result, IPU continues to deliver top quartile returns, but with lower than average volatility.
The discount is currently fairly negligible, which does present a potential risk for shareholders should risk appetites recede. However, over time, the trust has developed a solid following particularly with retail investors, and since the 2015 enhanced dividend policy was implemented, has commanded a premium rating relative to peers based on the strong and consistent performance from the managers but also the high dividend yield, currently 4.3% on a historic basis – the highest in the UK Small Cap investment trust and open-ended sectors.
IPU offers exposure to a top-rated management team, with a significant yield premium relative to peers. Importantly, this yield is achieved without compromising the long-standing investment process, which has delivered such excellent long-term results.
|Consistent investment process delivers strong results through cycle, with lower volatility
||Dividend paid from capital may not be tax efficient for some investors
|Highly stable and experienced team – currently top quartile in investment trust peer group
||Trades at a premium rating to peers, and narrow discount in absolute terms
|Attractive dividend yield
||Often, lags peers when the market is “hot”, although has kept up well YTD
Jonathan Brown and Robin West are the co-managers on Invesco Perpetual UK Smaller Companies Trust (IPU), who sit within the broader UK team at Invesco. As is the case with their colleagues, they are fundamental stock pickers, with a strong valuation discipline. For Jonathan and Robin, fund management is as much about finding high quality businesses that are growing profits, as it is buying them at what they see is the 'right' valuation. As we discuss in more detail in the performance section, the strong relative performance over the past six months has been largely a result of the team’s focus on valuation.
Having spoken to Jonathan and Robin recently, they commented that during the summer when valuations were getting very full, they were taking profits on many of their best performing stocks in the technology sector as wall as others such as CVS. With the proceeds, they had been building up cash levels and buying less highly rated companies. In the Q4 market retreat, valuations became much more acceptable once again, and so they have deployed capital back into many of the same stocks such as Keyword Studios and CVS. However, other businesses that they had met with and liked, but had too demanding valuations suddenly became available at acceptable prices. The team initiated positions in several companies at much lower valuations than last summer, including Learning Technology Group (provides on-line training to companies) and Scapa Group (adhesive manufacturer, moving from industrial applications into healthcare). As we discuss in the performance section, this activity has helped the trust weather the downturn, but also perform strongly so far in 2019 – so much so, that it is amongst the better performers in the sector YTD with NAV returns +11.7%. Given the historic pattern of returns, where the managers typically lag very strong markets, this wasn’t necessarily expected. We hazard that the strong performance relative to peers is down to the repositioning activity undertaken by the managers. It is worth noting, that at the margin such activity will count against the trust in the perverse way that the KID RIY costs are calculated, despite the trading activity directly leading to a superior outcome.
Jonathan and Robin try not to take macro views, and rely on fundamental bottom-up stock analysis. They have a wide remit across UK stocks (including AIM), and complete around 350 meetings with companies per year. The team have a self-imposed market cap limit of not investing in a company worth less than £100m. As such, in terms of market-cap exposure, the trust tends to sit in the middle of the pack relative to peers – neither particularly heavily weighted to mid caps, nor to micro caps.
MARKET CAP BREAKDOWN
The companies that the managers tend to invest in have both 'quality' and 'growth' characteristics. Jonathan and Robin aim to identify companies which have a sustainable competitive advantage, with a compelling product or service in an attractive and growing market. Importantly, the company should have good management (with a meaningful stake in the business) and have balance sheet strength. They look for businesses that have the potential to double in size over the next five years, and in typical Invesco Perpetual style, hold them for the long term – their typical annual turnover is 25% (latest figure from Morningstar is 27.9%).
Overall, Jonathan and Robin aim to have a portfolio with exposures to a range of sectors, but also exposed to different growth themes. The graph below illustrates the current exposures. 'Self-help' are companies which are growing thanks to a recovery initiated by management, 'roll out / roll up' are businesses that can roll out successful concepts or act as consolidators, 'structural growth' businesses are exposed to a strong and growing market, and GARP represents companies which have good growth characteristics, but have valuations which the team find attractive on a relative or absolute basis. The totals in the graph below add up to more than 100%, given the fact that several companies in the portfolio fit in more than one category. The managers' focus on higher quality businesses that tend not to ‘boom and bust’ means that, as we discuss in the performance section, the trust has historically outperformed in more difficult market conditions.
Jonathan and Robin are cautious managers, and hence their aim to achieve top quartile returns but with lower than average volatility. Part of the manager’s caution is reflected in their desire to have a relatively diversified portfolio. IPU’s portfolio typically comprises around 80-90 holdings, with no position allowed to get much bigger than 3% of NAV – an approach that the managers say means they can sleep at night. However, the current uncertain political environment has seen the managers reduce the number of holdings in the portfolio, increasing concentration. This is driven by the managers’ desire to invest in only those companies they have a high degree of confidence in. As a result, Jonathan and Robin tell us that the portfolio currently has only c 71 holdings.
TOP TEN HOLDINGS as at 31st Jan 2019
|Fisher (James) & Sons
Future Media has been a very strong contributor to performance, having delivered a share price return YTD of c 57%. The team have been top-slicing the holding as the price has risen, but it remains the top holding well north of the self-imposed limit of 3% of NAV. IPU has been a long-term holder, and it is a constituent of the 'self-help' bucket. The company bought a number of specialist magazine titles such as What Hifi? and Techradar, and transitioned them from a print-based businesses to an online model. The management team has executed a similar strategy successfully at AutoTrader, and continue to find ways to further monetise their position. They have proprietary technology, and scalable platform to enable price comparisons on thousands of lines, from hundreds of retailers.
4imprint, a supplier of promotional merchandise, continues to deliver double digit sales and profit growth for the team. The company fits within the 'structural growth' theme. The team believe the company has huge potential given the fact that it is the second-largest in its industry but only has a 3% market share. Jonathan and Robin believe one key to its success is the quality management, with the CEO joining the business in 1991, and being responsible for the core business since 2004.
Keywords Studio fits within the 'roll out/roll up' theme, and having been sold down by the managers when its price to earnings (P/E) rating reached near 49x. Following the Q4 correction, the share price came back to below it’s long run average, which has seen the managers start adding again. The company provides services such as translation to computer games creators and is benefitting from a growing trend to outsourcing in the industry. The company has a strong management team in Jonathan and Robin’s estimation, with a long-standing, committed CEO with a significant equity stake, and is executing successfully on a strategy of earnings-accretive acquisitions, with its growing scale proving increasingly advantageous.
Relative to the index (and some peers) the trust continues to have more of a value angle, prompted by a view that Brexit has led to a global aversion to domestic UK exposure which means stocks are attractively valued. UK sales of the portfolio are currently estimated at c. 55%, relative to the benchmark of 65-70%. This is a view shared widely across the Invesco team in Henley (see Keystone, Edinburgh , Perpetual Income & Growth).
The trust continues to be underweight financials, consumer goods and basic materials, and overweight technology, industrials and healthcare. The industrials sector – the trust’s highest weighting - is a very broad sector, with a lot of variety and on a fundamental basis, there is little overlap between stocks. Given the high levels of leverage in developed economies and ageing population, they have positioned the portfolio towards resilient companies that they believe are able to sustainably generate profitable growth ahead of the wider economy through market share gains, exposure to higher growth niches and re-investment of cash flows.
In terms of outlook, Jonathan and Robin retain their customary caution given the continued economic and political uncertainty in the UK. They believe that any visibility on a final Brexit deal that politicians can give will be good for sentiment and share prices. Reflecting their caution, as we discuss in the gearing section, the team has around 5% cash in the portfolio currently.
The managers have authority to gear the trust to the lesser of 30% of net assets or £25m. However, this is a relatively conservative strategy, and it is therefore not surprising that the managers expect to use gearing rarely. Indeed, as we discuss in the portfolio section, reflecting their current cautious outlook, the managers have around 5% cash on the balance sheet at present. Historically, the trust has nearly always been ungeared, and as such has carried lower gearing than the average for the investment trust peer group. The low levels of gearing make its performance over the last five years especially impressive, as it now appears in the top decile of peers over most time frames without using leverage.
For those that follow IPU’s performance over time, over shorter time frames it will be clear that the team can struggle to perform relative to peers in very strong upward-moving markets. In some part, this is thanks to their reluctance to using gearing. However, the main reason for this, we believe, is the team’s natural caution and value driven approach to picking growth stocks. As we discuss in the portfolio section, the team are usually sellers of stocks which they believe are over-valued, and which trade on very high multiples.
The managers’ caution is expressed in their aim to achieve above average performance with below average volatility. As the graph below shows (a rising line indicates outperformance, falling line is underperformance), Jonathan and Robin struggled relative to more 'growthy' peers and the index up to the end of Q3 2018. As 2018 developed, they had been selling down strongly performing holdings, recycling capital into less expensive stocks as well as building up cash levels. During Q4, the team were rewarded for their caution, and had the opportunity to build back up positions they had previous sold, at attractive valuations. Following a more difficult January, the portfolio has been performing especially strongly recently.
As the table below illustrates, the trust is now in a very strong position relative to peers on a historic performance basis. Over both the short and medium term, the trust is in the top decile over most periods.
NAV performance over selected time periods
|Small Companies Trust Peer Group Rank
Source: JPMorgan Cazenove
Over the past five years, the trust has delivered a NAV total return of 62.3%, relative to the benchmark’s return of 30.3%, and has beaten the index in all of the past five calendar years. The degree of outperformance of the index over five years is impressively large, particularly so when you consider that the manager has achieved this without the use of leverage.
We believe that this longer-term outperformance is largely a result of stock-picking skill (over 5 years, IPU has demonstrated alpha of 4.6% pa), but also of the manager’s generally cautious approach. IPU has developed a track record of delivering among the better risk/reward profiles of the peer group. In the graph below IPU is marked in red, delivering high returns relative to multiple peers, while keeping a lid on volatility.
5 YR NAV RISK AND RETURN (UK SMALLER COMPANIES PEER GROUP - IPU HIGHLIGHTED RED)
Source: Morningstar, Kepler Partners
The managers’ aversion to highly-geared, lower quality stocks has been a consistent feature of their stockpicking process over the years. In performance terms, this is reflected in recovery years, periods typically characterised by weak businesses with weak balance sheets being re-rated upwards when it becomes more clear that they aren’t going to go bankrupt. As we discuss above, the trust has achieved five consecutive years of outperforming the benchmark, illustrating the manager’s strong value-add and outperformance over the benchmark over time. Since 1st January 2019, IPU is very marginally behind the benchmark despite having been hit by a small (0.6%) write off in Patisserie Valerie.
DISCRETE CALENDAR YEAR NAV PERFORMANCE
A board-led initiative in 2015 saw the dividend level rise materially – supported by capital reserves. Currently the shares yield 4.3% on a historic basis, and as such IPU has the highest yield in the AIC smaller companies sector.
This yield is based on the 20.8p dividend for the last financial year. Each year, the board pays three equal dividend installments, followed by a balancing final dividend for the year which is approved by shareholders at each AGM (typically held in June). Dividends are paid quarterly in September, December, March and June. Interim dividends this year are being paid at a rate of 3.65p per quarter, representing an increase of 2.8% over the previous year. Although they have not formally guided what the dividend level might be for the financial year ending 31st January 2019, since 2015 the board have historically set the dividend so that it represents 4% of the share price as at the 31 January year end.
At the time of the interim results (31st July 2018), revenue return per share was up by 30% over the same period in the previous year. The balance of the dividend is paid from capital reserves, meaning that last year a contribution to the dividend was made from capital of 1.8% of net assets (2017: 2.1%). Paying a dividend from capital is seen in some quarters as possibly controversial, but the board argues that this represents only a small proportion of a year’s returns (based on the annualised returns over the last ten years). As we illustrate in the discount section, this change continues to have a material impact on appetite for the trust, which has remained on a significantly narrower discount than peers.
The board believes that this approach allows them to make a higher proportion of total returns available to shareholders payable through an enhanced dividend. Importantly, this is achieved without compromising the integrity of the portfolio or changing the manager’s investment process. On a historic yield of 4.3%, IPU therefore offers a highly attractive yield relative to the wider sector, where the weighted average yield for the UK smaller companies investment trust sector is 2.5%, and the (unweighted) average for the open-ended sector is 1.03%. We continue to believe that IPU stands apart from peers and other income funds in that the managers' investment process (and the quality of the portfolio) is not being compromised for the sake of a higher yield. As such, we continue to believe that for income investors the trust offers valuable diversification from 'the usual suspects'. It has the added benefit of being highly reliable (given a proportion is being paid from capital).
Having been part of the Invesco equities team in Henley for more than a decade, Jonathan Brown started co-managing the trust in 2011. After the retirement of Richard Smith in 2014, he was joined by a deputy manager in the form of Robin West, who re-joined Invesco after a period as a UK smaller companies manager at Aviva Investors. They are assisted by Susan Gallagher and run around £1bn in total.
The team has employed the same approach and investment philosophy throughout their tenure. They believe in buying financially strong businesses that can deliver growth independently of the wider economy. They believe in running winners – and will continue to own companies even after they have become constituents of the FTSE 100 (although they are not allowed to add to stocks once they reach these lofty heights).
At Invesco’s Henley office, each manager is responsible and accountable for his/her own performance and so, with no house view, stock selection is the sole responsibility of the two managers. Macro views they glean from colleagues are helpful, but not a driver of decisions. We understand that Jonathan or Robin will always meet the managers of a company before investing.
As the graph below shows, IPU has attracted a premium rating relative to peers. The catalyst for this came with changes the board made to the trust's dividend model in March 2015. This had a decisive impact on the discount, with IPU having historically traded at a wider discount than the peer group, it now consistently trades more narrowly, currently 2.8%.
There are several features to IPU that the board has designed to try to protect the trust’s rating. At the time of a tender offer (at NAV less costs in 2017, which was undersubscribed), the board committed to a “further range of options” being put to shareholders at or around the time of the AGM in 2020. In the immediate term, the trust continues to pay an enhanced level of dividends to shareholders, meaning it has a historic yield 4.3%, relative to the weighted average yield for the smaller companies trust sector of 2.5% (Source: JPM Cazenove). The board has also stated that it will continue to monitor the discount level and may “seek to limit volatility through the prudent use of share buy-backs” – which have so far not been needed.
With an OCF of 0.82% for the last financial year (ending January 2018), IPU is broadly in line with the average for the investment trust sector average, but considerably cheaper than the wider OEIC peer group, which has an average OCF of 1.07% (according to data from Morningstar). According to Morningstar, Jonathan and Robin’s OEIC has an ongoing charge of 0.92%.
A small point, but perhaps one worth being aware of, is that 85% of the management fee and other costs are charged to capital. In addition, the board last year paid out capital of 1.8% of NAV per year to augment the distributable income earned by the portfolio. So whilst it hasn’t been a problem in the past given the excellent capital growth delivered by the managers, in a sustained period of negative NAV growth, the trust’s capital will be eroded if the current distribution policy is maintained.
In common with many smaller company investment trusts, the managers are entitled to a performance fee. IPU’s arrangement is that the managers are due 12.5% of any outperformance of the Numis Smaller Companies index (excluding investment companies), but this figure may not exceed 1.0% of the value of the investment trust’s average funds under management in any one year. 100% of the performance fee is charged to capital. The latest KID RIY cost (as at 1st October 2018), which includes performance fees was 1.41%, with ongoing charges of 0.84%, 0.06% of transaction costs, and 0.51% for performance fees.