Henderson Smaller Companies

HSL has an extensive track record of outperformance...

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Henderson Smaller Companies

Summary

Henderson Smaller Companies (HSL) invests in UK small- and mid-cap companies, seeking to generate total returns. Managed since 2002 by Neil Hermon of Janus Henderson Investors, HSL typically owns around 100 companies which the manager and his analyst team believe offer superior growth potential at a reasonable valuation.

Neil builds his portfolio primarily through bottom-up stock analysis, looking for companies which are attractive on his ‘4 Ms’: Model, Management, Money and Momentum (which we explain in the Portfolio section). This is balanced with valuation considerations (and we note Neil presently thinks the UK market looks attractively valued, with earnings set to be strong in the current financial year too).

Returns over the long term have been very strong, HSL significantly outperforming the benchmark index under the current manager’s tenure and over the past five years. As we discuss under Performance, this outperformance has been consistent, with HSL having outperformed on average in both positive and negative markets (though the trust did underperform in the market sell-off of Q1 2020).

Whilst the investment focus is on small- and mid-cap companies, which tend to yield less, HSL has an extensive track record of dividend growth. The current yield (as at 31/05/2021) of 1.9% on an historic basis is not particularly high but, as we discuss in the Dividend section, HSL has a track record of growing its dividend over the previous 18 financial years.

Kepler View

HSL has an exceptional long-term track record of consistent outperformance, and a relatively balanced approach that may suit as a more ‘core’ UK small- and mid-cap allocation. Returns in recent months have remained strong, and stock selection appears to have been a consistently positive contributor to returns over previous financial years. Despite the post-vaccine rally posing some stylistic headwinds to a growth-focussed investment approach, we note that the manager has nonetheless managed to remain ahead of the benchmark over this period. With a consistent investment process and a stable team, we see no reason why stock-picking should not continue to be a positive contributor going forward. Investors looking to access the smallest companies in the UK market should, however, consider the sizeable (currently majority) allocation to mid-cap, which is likely to feature consistently.

Whilst an historic yield of 1.9% is unlikely on its own to hold significant attractions to income seeking investors, the strong track record of dividend growth potential may alter this calculus. However, the severe challenges to income generation posed by COVID-19 necessitated the deployment of revenue reserves in the previous financial year to support the dividend, and it seems likely to remain necessary if the dividend is to again grow. Having narrowed significantly in recent years, there currently appears to be limited discount opportunity here.

Bull bear
Exceptional and consistent track record of outperformance driven by stock-picking Underweight allocation to GBP revenues could prove a near-term headwind given recent GBP rally
Long-term track record of dividend growth Relatively structural gearing can exacerbate downside as well as amplify upside
Large trust offering economies of scale, seen in low management charges Board likely to have to draw further upon revenue reserves to support dividend

Portfolio

Henderson Smaller Companies (HSL) aims to maximise shareholders' total returns (capital and income) by investing in smaller companies that are quoted in the United Kingdom. Managed since 2002 by Neil Hermon, stock selection is driven by the investment analyst team’s bottom-up research, and sees the trust typically consist of around 100 UK small and mid-companies (108 as at 30/04/2021) which meet their ‘4 Ms’ criteria.

Selecting stocks from across the UK market, the team usually focuses on a market range of roughly £200m-£1.5bn, with any stocks entering the FTSE 100 subsequently sold within six months. Sector allocations are a byproduct of stock selection, but are limited to a 10% relative deviation from the benchmark Numis Smaller Companies Excluding Investment Companies Index; this, however, affords the manager wide latitude in sector allocations still. Stock positions have a maximum deviation from benchmark weighting of 4%, but in practise larger positions will be beneath a 4% absolute level (let alone 4% overweight).

top ten positions

Holding
%
Impax Asset Management
2.8%
Bellway
2.7%
Future
2.4%
RWS
2.3%
Team17 Group
2.2%
Mitchell & Butlers
2.1%
Oxford Instruments
2.1%
Clinigen Group
2.0%
Learning Technologies Group
1.9%
Gamma Communications
1.8%
TOTAL
22.3%

Source: Janus Henderson, as at 30/04/2021

Portfolio construction is primarily driven by bottom-up stock analysis, though the team will incorporate top-down considerations into position sizing. Idea generation comes from numerous sources, with the team reading broker research and recommendations, watching for company-specific announcements or macroeconomic data that may alter operational conditions or dynamics for certain companies. Meetings with company management teams, a key part of the stock analysis process, also on occasion serve to drive idea generation.

These various sources are qualitatively filtered through the team, using their experience of stocks or sectors. With a long-established team, they also have long-standing relationships with many of the brokers serving to generate ideas and can factor their knowledge of the broker’s knowledge and expertise into any idea. Quantitative screens are also used to filter out stocks with undesirable characteristics.

Stocks passing this stage are then subject to bottom-up stock analysis, using the team’s ‘4Ms’ analytical framework. The ‘4Ms’ in question are:

  1. Model: What is the business model? The team are primarily looking for companies with strong competitive advantages and industry-leading franchises. Such companies will often retain significant pricing power (and be able to pass on any rise in input costs to end consumers), and scalable business models. However, Neil and the team are willing to consider companies where such advantages are weaker if they foresee a period of superior growth ahead.
  2. Management: This involves looking at factors around the management of a business, such as assessing the strength of corporate governance, management strategy, management track records, and alignment of management and shareholder interests (amongst others). The team conduct over 300 management meetings a year as part of understanding this aspect of a company, as well as providing more context for the other aspects.
  3. Money: An assessment of a company’s finances. The team look for companies with high free cash flow, where expansion can be self-financing. They also prefer companies with strong and robust balance sheets. Operating conditions over 2020 obviously presented some challenges to assessments of cash flow in recent history, but the team look to longer-term history for context.
  4. Momentum: Seeking to identify companies with positive earnings momentum, which are consistently beating earnings expectations. Neil notes that positive business momentum can often be sustained for longer than the market discounts.

With this process, the team are primarily looking for opportunities for growth in companies. As an output, stylistically unsurprisingly HSL is tilted more towards ‘quality’ and ‘growth’ factors and underweight towards ‘value’ factors on a quantitative basis. However, the team are value cognisant, and will seek to assess the valuation of a position passing their ‘4M’ criteria prior to initiating a position.

This is not an attempt to pick the cheapest stocks, but to contextualise a company’s valuations. Typically they use measures such as Price/Earnings, EV/EBITDA, Free Cash Flow Yield, or Dividend yield, but are flexible and pragmatic on which metric may be appropriate (often depending on what industry a company operates within). Assessments of valuation look at the valuation of a company relative to its competitors, in the context of their relative industry position and growth outlook. The team assesses what degree of growth may be priced in, and whether this underestimates what they believe the company can achieve.

Tactical positions with slightly shorter than usual timeframes may be taken in companies where they believe there to be nearer term catalysts, but most companies are introduced with a long-term outlook of over five years and a preference for lower turnover. Once introduced, positions are monitored on an ongoing basis, to see how business operational strategies develop and whether the companies are meeting their expectations. The team also target at least two meetings p.a. with the management teams of any company they own.

Positions are sized partially upon the ongoing perceived relative opportunity to other holdings, though so long as operational improvements keep up with share price outperformance the team are happy to ‘run their winners’. The investment team behind HSL also manage further open-ended and segregated mandates; portfolios and trades are replicated pari passu across all strategies. Given HSL itself has considerable scale (presently c. £966m assets as at 31/05/2021), these further assets mean liquidity of underlying stock positions is considered key. Along with seeking holdings for the long-term and the team’s preference for ‘running their winners’, this tends to see HSL hold a significant proportion of its assets in mid-cap stocks.

current exposure by market index

Source: Janus Henderson, as at 31/03/2021

Although the team prefer to run their winners and to keep turnover low, they will exit positions if they observe the fundamentals deteriorating. This will typically be driven fundamentally by companies displaying traits which are the inverse of those that would lead them to buy. Negative changes to a business model (or failure to adapt to changing circumstances), changes in company management, a deteriorating financial position, or negative earnings surprises, for example, will all cause a re-evaluation and likely exit of a position. Similarly, Neil and the team will exit positions where movements in the share price are sharp and unexplained by developments, where valuations have become too demanding, or simply where outperformance has led to outsized stock-specific risk.

Presently the team observe that the UK market is cheap relative to history, and that they anticipate a sharp rebound in corporate earnings over 2021 and 2022 after a sharp drawdown in 2020. IPOs continue to offer some ideas, with the team initiating positions in various IPOs in recent months such as Moonpig, the online card and gift retailer, and Bytes, an IT solutions provider. They have also taken part in placings, such as Restaurant Group, noting that the management had improved the quality of the business and are now generating higher operating margins. Neil and the team also foresee a greater growth trajectory, in part catalysed by the exit from lockdown policies initiated in response to the COVID-19 pandemic. The equity raise that the team participated in helped to improve the balance sheet quality, and they think leaves the company in a stronger position to take market share going forward.

Gearing

HSL undertakes gearing through a combination of structural gearing (£30m 20-year unsecured loan notes paying interest of 3.33% p.a.), and a more flexible tactical facility (a £60m revolving credit facility). Together, these amount to c. 9.3% of current net assets (as at 31/05/2021), well within the board restrictions on gearing (30% max). HSL last reported a gearing ratio of 10% on 30/04/2021, and as such this suggests to us that the trust is currently employing all its gearing facilities (with subsequent NAV gains reducing the gearing ratio). Sizeable NAV gains have reduced the effective gearing ratio the managers can deploy, but we understand that generally gearing is employed at a fairly consistent level, similar to that currently seen.

Returns

Neil has run HSL since November 2002, and over this period to 31/05/2021 has delivered NAV and share price total annualised returns of c. 14.3% and c. 17.5% p.a. respectively, strongly outperforming the benchmark Numis Smaller Companies Ex Investment Companies Index’s annualised returns of c. 12.5% p.a.

Over the five years to 31/05/2021 HSL has delivered NAV and share price total returns of c. 105.4% and c. 135.6% respectively, the latter boosted by a significant narrowing in the discount. This represents significant outperformance of both the unweighted peer group average (NAV and share price total returns of c. 70.8% and c. 85% respectively), and the benchmark (c. 58.8%).

nav returns vs peers and Benchmark

Source: Morningstar

Past performance is not a reliable guide to future returns

As we can see below, relative returns have tended to be stronger in periods where the market was positive over the previous 12 months, as opposed to negative. In part, we think this likely reflects the relatively structural deployment of gearing. However, we note that the median relative return of HSL was superior to both the peer group average and the benchmark over both types of period during this time. Structural deployment of gearing perhaps explains some of the additional upside capture, but Neil has managed to overcome the disadvantage of gearing in periods where the market fell. The portfolio is built from bottom-up stock selection as the key driver, but the stock analysis process balances different stylistic elements and the manager seeks to ensure that the primary driver of portfolio relative risk is stock specific factors.

median ROLLING 12-MONTH RETURNS RELATIVE TO BENCHMARK AND PEERS

MEDIAN RETURN
RELATIVE TO PEERS
RELATIVE TO MARKET
Benchmark positive
5.7%
9.7%
Benchmark negative
0.7%
3.1%



OCCASIONS OUTPERFORMED


Benchmark positive
95%
100%
Benchmark negative
56%
69%

Source: Morningstar, Kepler calculations; date range 31/05/2016 - 31/05/2021

Past performance is not a reliable guide to future returns

From the above, we note with interest the consistency of outperformance over the benchmark index in particular. Stock selection has been a consistent positive contributor in every financial year since at least FY 2012 (ending 31/05/2012) (Source: Henderson Smaller Companies annual reports). The trust has outperformed very consistently over an extended period of time.

We can see consistency of outperformance also when looking at discrete calendar year returns, with calendar years where the benchmark generated stronger returns generally seeing stronger relative returns from HSL, and vice versa. However, in calendar years such as 2014 and 2020, HSL still outperformed even though the benchmark index was negative for that year. Conversely, 2016 saw HSL trail despite positive benchmark returns.

Discrete calendar year returns relative to peers and benchmark

Source: Morningstar

Past performance is not a reliable guide to future returns

Having underperformed both the benchmark and peer group in the initial drawdown in Q1 2020, HSL subsequently started to recover in relative terms. The trust was relatively geared going into the crisis, but retained gearing capacity in the teeth of the sell-off to build positions in opportunities they were identifying.

We note with interest HSL’s relative outperformance since the initial Pfizer announcement that they had developed a successful COVID-19 vaccine in November 2020. This rally has been characterised more by outperformance by cyclicals and value stocks. Although the manager is cognisant of the value he pays for a position, much of the aim of the stock selection process is driven by looking at measures of quality and on potential growth outlook. HSL is, furthermore, underweight to GBP revenues, at a time when GBP has been rising. Despite this, the trust has outperformed; we would attribute this as likely due in part to gearing, but also substantially to good stock-picking.

nav total returns relative to benchmark and Peers

Source: Morningstar

Past performance is not a reliable guide to future returns

Dividend

HSL’s shares currently yield c. 1.9% (as at 31/05/2021) on an historic basis. The managers focus on total return opportunities from their underlying holdings, and typically this is skewed more towards capital growth. Nonetheless, the underlying investment process itself emphasises companies which can compound cash flow growth, and the excess free cash flow is often returned to HSL as dividends. At least 85% of this is, in turn, paid out to shareholders, and HSL has grown its dividend for the previous 18 financial years.

HSL has seen its dividend grow at a rate of c. 4.6% p.a. from FY (financial year) 2011 to 2020, notably in excess of the rate of inflation.

Dividends are paid twice a year, with the first interim dividend for financial year (FY) 2021 paid in March. This matched the interim dividend from FY 2020. FY 2020 saw the dividend rise by c. 2.2% from FY 2019, despite a fall in revenue returns of c. -29.1%. With the current financial year running from 01/06/2020-31/05/2021, the board has previously noted the challenging backdrop for dividend generation, and that the final dividend will be determined when they have a better view of the trajectory of the economic recovery.

However, HSL has accrued revenue reserves in recent years. These amounted to c. £10.8m as at the interim reporting period (30/11/2020), which equated to c. 14.4p per share. Subsequently an interim dividend of 7p per share has been declared; when we account for this, and the difference between reported ex- and cum-income NAVs (as at 31/05/2021), we estimate that HSL currently has revenue reserve cover of c. 0.61x the FY 2020 dividend.

dividends and revenue returns per share

Source: Janus Henderson, The AIC

Past performance is not a reliable guide to future returns

Management

HSL has been managed by Neil Hermon of Janus Henderson since November 2002, when he joined Henderson as Head of UK Smaller Companies. Previously, he was Head of UK Smaller Companies for General Accident Investment Management, having begun his career at Ernst & Young as a chartered accountant. Neil is Director of UK Equities and a Portfolio Manager at Janus Henderson Investors, a position he has held since 2013.

Neil is assisted by deputy fund manager Indriatti van Hien, who joined Henderson as an UK equity analyst having previously qualified as a chartered accountant with PricewaterhouseCoopers. Indriatti was appointed a portfolio manager of UK equities at Janus Henderson in 2016. Shivam Sedani joined Janus Henderson in 2017, and serves as an equity analyst on the team. The team can furthermore lean on the broader UK equity team at Janus Henderson, and on input from various regional teams within the company. The managers also collaborate with the Janus Henderson Governance & Responsible Investing team to try and best integrate ESG considerations.

The HSL team also manage an open-ended UK smaller companies fund, and two segregated mandates. In total they manage over £1.6bn of assets, with the different portfolios effectively managed as one strategy.

Discount

HSL currently trades on a discount of c. 3.7 %, as at 31/05/2021. This has narrowed considerably relative to a five-year historic median discount level of c. 10.6%. A more ‘risk-on’ attitude prevailed over much of Q4 2020, which served to help drive a rally in NAV returns, and an even greater recovery in share price. The latter was further boosted by the agreement of a Brexit deal in late December 2020, with a sharp narrowing in the discount and a move to a narrow premium seemingly anticipating this announcement and consolidating thereafter.

HSL’s discount had, in any event, been trending towards trading close to NAV for much of the previous five years, as we can see in the chart below. This has been a result of net buying pressure in the market; the board retains capacity at this time to repurchase up to 14.99% of shares in circulation, but has not exercised this in recent years. As one of the largest trusts in the sector, with a large free float, we would suggest that HSL may have proven a primary beneficiary within the sector of return of ‘animal spirits’ to the UK market following the conclusion of a Brexit deal.

discount/premium

Source: Morningstar

Charges

HSL has an ongoing charge figure (OCF) of 0.42%, which is lower than the sector unweighted average level of c. 1.07% (Source: JPMorgan Cazenove). This includes a management fee, which equates to an annualised rate of 0.35% p.a. of net assets, charged quarterly in advance on the basis of the value of net assets at the end of the previous quarter. HSL also has a performance fee of 15% of any outperformance of the benchmark index on a total return basis over the trust’s financial year. Total management fees are, however, restricted to a maximum of 0.9% of the average net assets of HSL over the financial year. Any underperformance is carried forward. The Key Information Document Reduction in Yield figure is 1.11%, compared to a sector average of 1.89%, although we caution that methodologies vary. Fees are charged 30% to revenues, and 70% to capital.

ESG

The team note that ESG issues are incorporated into their ‘4Ms’ investment process. They believe that companies which score well on ESG issues and considerations warrant a valuation premium over time, and seek to adjust their understanding of what constitutes a reasonable valuation based on any premium that may be merited by their ESG characteristics. This process is not exclusionary, but instead about identifying appropriate prices for different companies. Thematically, the team note that companies offering solutions to issues such as ageing populations, cyber-crime, and urbanisation (amongst others) often have attractive growth potential.

Presently HSL has an ‘average’ rating from Morningstar Sustainalytics. We suspect that the output of the process will typically lead to reasonably ESG friendly outcomes, but may not meet the criteria of investors looking for ‘positive-outcome’ or more stringent ESG alignment.

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