Invesco Perpetual UK Smaller Companies Trust’s (IPU) managers have a simple aim: to achieve top quartile performance over a cycle with below-average volatility compared to their peers. Historically, they have achieved this and, whilst the current market conditions have seen the trust struggle relative to peers, nothing would indicate that over the medium to long term their pattern of top-quartile returns could not return.
Jonathan Brown and Robin West have worked together since 2014, and as a management team have applied the same investment philosophy consistently over this time. Looking to buy and hold companies which can double their profits over five years, they are unashamedly growth investors. However, they are perhaps more “valuation aware” than many competitors, tending to trim especially strong performers and recycle capital into more attractively valued opportunities.
Within the portfolio, the managers believe that any COVID recovery, if it comes, will be rapid, and so have been seeking out high-quality ‘self-help’ companies who would be beneficiaries. These companies represent just under half of the portfolio and constitute one end of the barbell approach that the team have adopted. At the other end of the barbell are the defensive growth companies which have long been a part of the portfolio.
IPU’s yield premium to peers and the market remains: the board have amended their dividend policy which will see a dividend of at least 15p this year (a yield of 3.7%), but also seek to increase dividends annually.
In our view, IPU’s discount is once again a significant attraction for investors. As we illustrate under Discount, IPU has long traded at a significant premium to peers. However, this year the trust has experienced a savage derating.
We believe, however, that the fundamental factors behind the historic premium rating have not changed. The trust continues to offer a relatively secure dividend stream (albeit lower than the previous trajectory) which offers a significant premium to peers. Certainly, the short-term performance since the market nadir has not matched some ‘growthier’ peers. However, investors mustn’t forget that this is likely a characteristic of the investment process which, in our view, has enabled the managers to deliver on their objective of top quartile performance but with below-average volatility over the long term.
We believe that IPU’s fundamental attractions are undiminished. The trust has now achieved six consecutive calendar years of outperforming the benchmark, in both up and down markets. We attribute this success to the cautious nature of the managers’ stock picking, their preference for high quality-companies, and their continual recycling of strong performers into better value opportunities.
IPU was issuing shares from treasury as recently as January, which in our view is testament to the attractive package that the trust presents. Yet now investors can buy this same package – in no way damaged by COVID-19 – on a 17% discount, which we view as an opportunity.
|Consistent investment process delivers strong results through cycle, with lower volatility||If current momentum continues, more growth-tilted peers will likely outperform|
|Highly stable and experienced team||Payment of dividend from capital means trust will remain smaller than it would otherwise
|Progressive dividend, offering a significant yield premium to the peer group||No-deal Brexit could mean UK equities remain out of favour relative to international markets|
Invesco Perpetual UK Smaller Companies Trust (IPU) aims to achieve long-term total returns by investing in small-to medium-sized UK companies. The management team has been in place for many years, with Robin West joining long-term manager Jonathan Brown in 2014.
The team have a consistent approach to investment which, compared to investment trust peers in the small-cap space, is more ‘valuation aware’ than many competitors. Nonetheless, Jonathan and Robin are unashamedly growth investors. Indeed, they look for companies which can double their profits over the next five years. However, whilst they are keen to run winners, they also tend to trim into especially strong performance and recycle capital into more attractively valued opportunities. It is this characteristic of their process which, in our view, has enabled them to deliver on their objective of top quartile performance over the long term, while demonstrating below-average volatility. At the same time, as we discuss in the Performance section, this has also led them to lag the peer group this year and may be one reason why the Discount has sagged so dramatically YTD.
When we met with Jonathan and Robin recently, they reported that their investment strategy was being hampered this year by what they see as an extreme bifurcation of valuations in the market. COVID-19 winners are seeing a wall of capital being allocated to them, whilst those perceived as losers are being hammered. The result is that some companies in their investment universe are trading at historically very high multiples (such as P/Es of 40-50x), whilst others appear extremely good value.
Many of IPU’s portfolio companies are in the former camp. However, Jonathan and Robin – following their investment process which has served them so well in the past and over the longer term, have been trimming those which seem most expensive. They believe that the COVID-19 recovery (or indeed Brexit) will be rapid if and when it comes and so have been seeking out high quality ‘self-help’ companies who will be beneficiaries of the recovery when it comes. These companies represent just under half of the portfolio and constitute one end of the barbell approach that the team have adopted. Jonathan and Robin believe that these companies have robust balance sheets that will enable them to last out the interruption to business, and will be able to retain (and grow) their industry-leading position once conditions return to some sort of normalcy. They believe that the prices they are paying for these companies are very attractive and so expect that, over the medium term, this part of the portfolio will experience a significant re-rating.
Companies in this part of the portfolio include Johnson Services, 4imprint and Churchill China. All of these companies are experiencing severe interruptions to demand. However, the team believe that they are of a high enough quality, with solid finances and good management, that they will be survivors. As such, when the recovery comes they will be able to take market share from weaker competitors and emerge significantly stronger. Jonathan and Robin recognise that it could take some time before these businesses stage a recovery. But in buying shares on what they view as huge discounts to intrinsic value, they are happy to wait.
At the other end of the barbell are the defensive growth companies which have long been a part of the portfolio. Where their share prices have been pushed too high, the team are trimming and taking profits. However, the trust still retains significant exposure to long term winners such as Future Media and CVS. The current top ten holdings can be seen in the table below.
top ten holdings
IPU’s portfolio typically comprises between 70 and 90 holdings, an approach that the managers say means they can sleep at night. These tend to be either companies that have great products or services, which can enable them to take market share off their competitors, or ones that are exposed to higher growth niches within the UK economy or overseas. The managers prefer to invest in cash-generative businesses that can fund their own expansion, although they are also willing to back strong management teams by providing additional capital to invest for growth. Jonathan and Robin rely on fundamental bottom-up stock analysis. They have a wide remit across UK stocks (including AIM) and complete around 350 meetings per year with companies. Sector weightings are determined by where the managers find attractive companies, rather than by allocating assets according to a top-down view of the economy. Industrials, financials, and consumer services together currently represent nearly 73% of the portfolio.
In terms of outlook, Jonathan and Robin believe that by focusing on the highest quality businesses, with distinct competitive advantages and strong balance sheets, will be in a good position should weaker competitors disappear. From their point of view, small caps are a good long-term place to build wealth, as they are often nimble companies within niches, whose managers are properly incentivised through inside ownership. By positioning a proportion of the portfolio for a post-COVID-19 normalisation, the team hope to ultimately continue their long-term track record of top quartile performance.
IPU’s managers employ a relatively conservative strategy. As such, whilst they have the authority to use gearing to take advantage of anticipated market strength or special situations, it has been rarely used in the past. This authority extends to the lesser of 30% of net assets, or £25m.
In order to help them decide when to use gearing the team employ an econometric model. They believe that it helps them get away from the market noise and make an objective decision. During the market selloff in March the model was flashing amber; indicating that we were getting close to a point at which gearing should be employed. As it was the market rebounded very strongly in April, and meant that gearing was not employed. At the time, going into the sell-off, Jonathan and Robin had net cash on the balance sheet of around 6%. They added to specific opportunities, but also kept some capital back to enable them to provide further capital for solid companies raising equity to survive the lockdown.
Historically, as the graph below shows, IPU has nearly always been ungeared and, as such, has carried lower gearing than the average for the investment trust peer group. This makes its strong performance track record compared to peers even more impressive, since that has been achieved without using leverage.
In our view one of the hallmarks of IPU is the strong performance achieved by the managers over the long term, but more especially the fact that this has been achieved with lower volatility when compared to peers. As we discuss in the Gearing section, part of the reason for this lower volatility is the managers’ hesitance to use leverage. However, in our view, the main reason is the managers’ preference for high-quality businesses, but also their philosophy of trimming winners and recycling into better value opportunities. These characteristics usually leads the managers to underperform on the way up but outperform on the way down – by definition, a lower volatility trajectory than peers. The graph below illustrates this, which shows the peer group (and IPU in red) in terms of NAV risk and return over the past five years. IPU is clearly on the ‘efficient frontier’ in terms of risk/return.
five-year nav risk & Return*
*UK Smaller Companies Peer Group - IPU highlighted in red
Source: Morningstar, Kepler Partners as at 31/10/2020
Over the short term, the pattern has also held true. The period since the start of the COVID crisis in stock markets can be seen in the graph below. IPU outperformed the benchmark and most of the peers on the way down, but as we discuss in the Portfolio section has underperformed on the way up. The managers’ ‘barbell’ approach has meant that IPU has lagged more ‘growthy’ peers, who have seen continued momentum.
nav performance since market started falling
Despite this short period of underperformance, the last five years has still been a period of strong relative performance for IPU, as the graph below illustrates. In absolute terms shareholders are now back at 2017 NAV levels, but over the five years, IPU has outperformed the benchmark, investment trust peers and open-ended peers. As we note in the Portfolio section, there are certainly challenges ahead, but the managers appear confident that, over the medium to long term, their companies will come out of the crisis in a stronger competitive position than they went into it.
Robin West joined Jonathan Brown as co-manager in 2014. As the graph below shows, the pair have outperformed the benchmark each year since then. 2020 has clearly been a challenge but, with two months to go, IPU is neck and neck with the benchmark.
discrete calendar year nav performance
Since 2015 IPU’s Board has been using the flexibility afforded by the investment trust structure to increase the dividend payable by the trust by boosting the amount paid out through a contribution from capital profits. Historically the dividend target under this policy was to pay a yield of 4%, based on the financial year end (31st January) share price. However, recognising the challenges that the pandemic was having on some companies’ dividends and capital values, the board changed the dividend policy, believing it to be no longer appropriate.
As we discuss in the Discount section, this move perhaps contributed to the discount widening relative to peers. In mid-July, when the pandemic was better understood, the board updated their dividend policy to target a dividend of at least 15p for the current year (representing a yield at the current price of 3.7%). The board also clarified their aim of delivering a more predictable level of dividend to shareholders and seek to increase dividends annually (although this is not guaranteed). The rate of increase will take into account the board’s expectations of income and capital returns.
In our view, the historic dividend policy was one of the reasons that had previously helped the discount to narrow. Whilst the new policy unarguably represents a cut, the new dividend policy gives greater clarity to shareholders on likely future dividends. With the peer group offering a weighted average dividend yield of 2.4% (source: JPMorgan Cazenove) the yield premium to peers remains significant, and is one of the reasons that we believe IPU’s discount relative to peers is unwarranted. We continue to believe that IPU stands apart from its 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 the higher yield that the shares pay. Dividends are paid quarterly in September, December, March and June.
Having been part of the Invesco equities team in Henley for more than a decade, Jonathan 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, who rejoined Invesco after a period as a UK Smaller Companies manager at Aviva Investors. They are assisted by Susan Gallagher, and run around £1bn of investments 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. Jonathan and Robin believe in running winners, and are theoretically allowed to continue to own companies even after they have become constituents of the FTSE 100; although the team 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 their own performance. So, with no house view, stock selection is the sole responsibility of the two managers. Macro views gleaned 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, 2020 has seen IPU experience a marked de-rating – both in absolute terms but also relative to peers. As we mention in the Dividend section, the catalyst for its previous move to a premium rating 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. For a number of years thereafter it traded at a narrower discount than peers and, at the end of 2019 and the start of 2020, on a premium to NAV. Indeed, the board was able to issue shares to satisfy demand. At the time, we saw this development as a testament to the strong investment package that IPU offers investors: a combination of consistent management, sector-leading returns with below-average volatility, and a yield premium relative to the investment trust peer group.
Whilst none of these factors have changed, market sentiment seems to have swung the other way, and IPU now trades on a significant discount to NAV. The current discount of 16% seems unwarranted relative to the peer group average of 9%. The managers themselves appear to see value, and we understand have both been adding to their personal shareholdings. As regards buybacks, we understand that the board continues to monitor the discount level at which the shares trade but has not yet made any. The board have stated that they will look to limit discount volatility through the prudent use of both share issuance and share buybacks, as circumstances require. The long-term discount control is a periodic continuation vote – the last one in 2019 having been passed by a significant majority. In the same way, the directors intend to put “further options” regarding continuation to shareholders at the AGM in 2024 or sooner, but only if they believe this to be in the interests of shareholders. We understand that the precise nature of these options will depend upon the circumstances prevailing at the time.
IPU pays a base management fee of 0.75% of net assets and no performance fee. IPU’s OCF of 0.97% is marginally ahead of the weighted average OCF for the peer group, which is 0.77% (source: JPM Cazenove). This OCF is not out of line with what we might expect, however, given that IPU has net assets of £163m; this is somewhat below the average of the peer group, which has a simple average of £293m. We also note that several peers with lower headline OCFs still charge a performance fee, meaning that in strong years of performance their ‘fully loaded’ OCFs will be higher.
Invesco as a house is committed to being a responsible investor by applying ESG approaches in the investment processes of its teams, and by being an active owner. The Henley office has a dedicated team of three ESG specialists, who help each team to navigate ESG issues and engage with companies. Additionally, the Henley office regularly discuss ESG issues with companies and make use of the information gained from these meetings when voting in the AGMs of their investee companies.
Jonathan and Robin clearly fit within the broader ESG process by virtue of being part of the Henley team. It is fair to say, however, that ESG is not an overriding input into their investment process. Nonetheless, the managers’ report that they are always keenly aware of governance in the businesses, they invest in, and that they aim to avoid ethically dubious businesses which tend to attract regulatory pressure.