Aberforth Smaller Companies 03 December 2019
Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by Aberforth Smaller Companies. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
Aberforth Smaller Companies Trust (ASL) takes a disciplined value approach to investing in UK small-caps, which has generated market-beating returns since launch in 1990. Since the financial crisis, growth strategies have tended to outperform in the UK and globally, and ASL has not been spared.
However, in the past few months there has been a sharp rally in value stocks. This has seen ASL’s share price rise by almost 20% – with the NAV rising and the discount narrowing – illustrating the potential should the ‘elastic snap back’. The managers note that, in terms of the historical price-to-earnings (P/E) ratio, ASL’s portfolio is trading on the widest discount to the smaller companies index in its near 30-year history.
The trust is managed by a team of seven, five of whom are partners of Aberforth. The investment approach is long-term, and the managers are active shareholders behind the scenes. The partnership structure and the managers’ significant investments in their own funds mean that interests are strongly aligned with those of the shareholders, in our view.
Although ASL aims to generate total returns, dividends are viewed as an important part of that return and the value approach means that the portfolio often yields more than the market. The current historic yield is 2%, excluding special dividends. Revenue reserves are healthy, as discussed in the Dividend section.
As sentiment has shifted back towards value strategies since the summer, the discount has narrowed and ASL now trades on a 3.5% discount, compared to an AIC UK Smaller Companies sector average of 6.5%.
Despite the discount to NAV having narrowed materially over the past couple of months, there is still an interesting value opportunity in ASL’s underlying portfolio, in our view. The managers highlight that (as at 31 October) their holdings are trading on a P/E discount to the benchmark index that is well over two standard deviations wider than its long-run average.
The outperformance of value since mid-August shows how quickly sentiment can change in the market and how quickly significant gains can be made, given how extreme the valuation differential between growth and value has become. With growth having resumed its run, the question remains of what could lead to a more sustained period of outperformance. One of the brakes on value stocks over the past decade has been low interest rates, pushing investors into growth stocks. If the recent rate cuts by the US Federal Reserve are seen as a pause rather than a change of direction, and if the global economy continues to expand, then we could be entering a period far better suited for a value strategy such as Aberforth’s. At the same time, the valuation dispersion among stocks in the UK equity market offers opportunities (and of course risks) to active managers.
We think that ASL’s portfolio offers valuable diversification to most UK investors. The all-cap and small-cap fund, and investment trust sectors, tend to have high weightings towards mid-caps or the upper end of the small-cap market, whereas ASL remains tilted to the ‘smaller smalls’. This, the value strategy and the managers not investing in AIM, make it highly differentiated. In our view, investors could hold ASL to diversify their exposure to the most common biases in the market currently – growth, mid-caps and (in the small-cap world) AIM.
Whilst the discount has narrowed in absolute terms, ASL is a high quality, liquid investment trust. As such, a discount of 3.5% remains attractive in the context of a sector, which in some cases has seen discounts eliminated entirely (for now...).
|The underlying portfolio is trading on the widest P/E discount versus the benchmark in its near 30-year history
|Low rates are bad for a value approach, and recent rate cuts raise the possibility the economy could turn before rates are significantly raised
|The approach has generated market-beating returns over various cycles
|Gearing is cautiously applied, which can limit returns (although limiting losses)
|The partnership structure and long-term approach means management is aligned with shareholders
|A no-deal, or chaotic, Brexit could see appetite for UK assets crater in the short term