JPMorgan Smaller Companies

One of the strongest performing trusts in 2019, we look at JMI and the portfolios continued outperformance of the benchmark and peers…

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Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by JPMorgan 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.

JPMorgan Smaller Companies

Summary

JPMorgan Smaller Companies Trust (JMI) offers investors access to some of the fastest growing and innovative companies in the UK. JMI’s managers believe these companies should be able to grow regardless of the state of the general economy, particularly relevant to the UK’s current situation.

The trust is managed by Georgina Brittain and Katen Patel, who employ a bottom-up stock picking approach, aiming to take advantage of valuation inconsistencies within the smaller companies sector. Quality, value and momentum are the characteristics that drive stock selection, contributing to a diverse portfolio of around 90 stocks.

Both short term and long term performance has been excellent, with the trust outperforming the benchmark over one, three and five years. The last year has been particularly eventful, with the first six months showing both strong absolute and relative performance, buoyed by the removal of political uncertainty and the belief that the Conservative government would boost the economy. This was then stopped in its tracks by the outbreak of the coronavirus and its impact on the economy. The smaller companies sector was badly hit, particularly in terms of widening discounts and portfolio performance. Despite this, as we discuss in the Performance section, JMI achieved a creditable outcome and managed to outperform the benchmark and peers.

The trust, despite its continuing outperformance of benchmark and peer group, trades on a discount of 4.3%.

Kepler View

JMI has been one of the most consistent performers in the smaller companies sector, delivering first quartile performance over one, three and five years. In fact, in 2019 the trust was one of the strongest performers in the entire investment trust universe.

Due to the ability of smaller companies to grow regardless of the wider economy, there is a strong case that the trust can continue to perform strongly regardless of the impact of the pandemic. This is also supported by the managers’ focus on finding high quality companies which should be more resilient to tough economic times.

Furthermore, the managers’ vast resources give them an advantage in understanding companies in detail over smaller asset managers. We believe this has been demonstrated in 2020 with the trust holding up better than peers and the benchmark due to their capacity to understand the impact of COVID-19 on cash flows and balance sheets.

Although having narrowed considerably recently, we still believe the current discount of 4.3% presents an attractive opportunity to enter the trust. Given the consistent performance and tilt towards quality, we see it possible that the discount continues to narrow and possibly moves to a premium as the trust continues to deliver attractive returns.

BULL BEAR
Excellent long and short term performance
Gearing can increase the volatility of the trust
The vast resources of JPMorgan give the managers an advantage in understanding companies
After the sizeable correction, it might take time for investors to recover their appetite for small caps
Trading at a discount to NAV despite exceptional performance
Uncertainty surrounding Brexit remains

Portfolio

JMI is managed by Georgina Brittain and Katen Patel, who utilise a bottom-up stock-picking approach to identify smaller UK companies.

Together they look for fast-growing, innovative smaller companies, which will often have their own structural growth drivers, making them less reliant on the overall UK economy and meaning they should be able to grow regardless of the market cycle.

The key thesis for the trust is that the UK smaller companies market continues to be a good hunting ground for active managers. The managers believe that they should be able to generate high levels of alpha for investors, principally due to the inefficiencies within the smaller end of the stock market and the diverse range of opportunities. In our view, the long term performance of the trust shows their process can take advantage of these inefficiencies, as the trust has outperformed the market significantly (see Performance section).

The managers look to identify stock opportunities in companies which display varying degrees of three different characteristics: quality, value and momentum. To understand the quality of the business, Georgina and Katen look at the profitability, the sustainability of earnings and the management’s track record of capital allocation.

In comparison, when looking at the valuation aspect of a company, the team look at the humble P/E and the free cash flow. However, there are clear challenges to this at this time, with the Covid-19 pandemic and associated economic shutdown sharply impacting both near-term expectations and historic numbers. Georgina and Katen re-evaluated all holdings, placing a significant emphasis on understanding the operational fundamentals for their holdings, seeking to understand which companies stand to win in a more normalised environment. Valuation assessments are not attempting to pick the ‘cheapest’ stocks, but to identify stocks where the relative and absolute valuation does not reflect the fundamental growth in the business. Given the short-term challenges, Georgina and Katen have been looking to understand what a more normalised operating environment would look like. This has typically included assumptions that 2020 and H1 2021 are essentially write-offs, before a greater normalisation of conditions later in 2021 and into 2022. Some of their holdings stand, in their view, to be structural winners from the change in economic environment and secular trends towards greater remote working, amongst others. Others, such as in the housebuilding sector, have different structural drivers of top-line growth but may be expected to have a greater lag to realising growth due to the nature of the businesses. However, in the context of the housebuilding sector, the managers note that there are already signs of activity picking up.

For momentum the managers look at price movements, including whether they reflect recent earnings statements and the outlook for the company, but in particular they look at earnings momentum. Given the extraordinary economic conditions of 2020, there have been significant divergences in operational momentum amongst the constituent companies of their investable universe. In this context, Katen notes that they are on the whole seeing improvements in reported numbers during revisions from the companies they have retained. This has been tangible in Future, a publishing company. Most of Future’s publications have significant online footprints, and include areas such as technology reviews which have seen a rise in readership demand. With a strong organic presence in search engine results, Future has been able to support its earnings growth through rising advertising sales, and earnings have been towards the top-end of consensus expectations. Although there has been a prominent short-selling campaign against Future, focussing in large part over their previous acquisition strategy, Katen highlights that the company has been able to rapidly integrate these acquisitions onto their platform and rapidly deleverage from improved free cash flow generation.

Typically the managers will ‘dip their toe in’ before making a full investment, but positions are sized based on stock-specific conviction. With this said, the team are mindful of the wider environment in which companies sit, and stock analysis reflects their awareness of broader market and economic conditions.

The research process involves both qualitative and quantitative sources and, as one might expect from a team at JPMorgan, the depth of analysis available to the team is wide-ranging. This has been beneficial in the uncertainty of 2020, with the team conducting extensive research into the ongoing operational challenges (and opportunities) that companies are facing.

Alongside the resources available to JPMorgan, the team at JMI have benefited from the existing relationships the team have with company management teams. They have been able to utilise their connections to help understand the relative competitive positions of many companies, as well as the fragility (or otherwise) of supply chains and the resilience of order books against ordinary market conditions. With the team having experience of similar, drastic market drawdowns as those seen earlier in Q1 2020, they have leant on this and sought to ensure they are incorporating and weighting towards the stock ideas where they see the greatest potential upside at this time.

Currently the portfolio is made up of 93 holdings and this is above the typical range of between 60 – 90 holdings. The top ten holdings make up c. 35% of the total NAV.

Top Ten holdings

HOLDING % OF NAV
Future 5.4
Games Workshop 4.3
Pets at Home 4.1
Dunelm Group 3.8
Team17 3.7
Computacenter 3.4
Ergomed 2.7
SSpirent 2.5
Codemasters 2.5
CMC 2.4

Source: Morningstar

The largest sector overweights currently come from the consumer goods (+10.4%), consumer services (+4.9%) and technology (+3.7%) sectors. At the other end of the spectrum, the trust has its underweights in basic materials (-7.5%), oil and gas (-4.4%) and health care (-3.2%). The sector positioning has seen some changes over the past year, as the managers have generally shifted towards the companies which will best withstand, or even benefit from, the uncertain environment (as discussed above). Namely, we have seen sector allocation increases towards health care and consumer goods. However, we have seen large decreases towards industrials and consumer discretionary.

SECTOR POSITIONING

Source: Morningstar

Gearing

The company’s gearing policy is to operate within a range of 10% cash and 10% geared. The trust has a flexible loan facility and gearing levels are decided by the managers within this range.

Gearing has proven a headwind thus far in 2020, with the trust close to the top-end of their gearing policy range at the start of 2020. This reflected the convictions of the managers that a reduction in political uncertainties, following the 2019 UK General Election, would cause global investors to rectify the substantial underweights they held to UK equities relative to historical allocations (as evidenced by surveys such as the BoAML Fund Manager Survey). At the half year (31/01/2020), the trust’s gearing was 9.8%, but by the end of March (when we saw the bottom of the market) it had been reduced to 4.1%. In part this reduction was a reflection of the challenges of declining NAV levels, which mechanically increased the gearing ratio. In order, amidst substantial market volatility, to ensure they remained within their policy limits, the managers were aggressive in reducing gearing. It has subsequently increased to 10.5% (31/10/2020). The managers note that, even without gearing, they believe there is very substantial upside potential in the companies they currently hold. The trust tends to employ above average levels of gearing relative to peers, with only one trust in the sector employing greater levels of leverage. This obviously exacerbates NAV value fluctuations in both rising and falling markets, as we discuss in the Performance section.

Returns

JMI is one of the standout trusts in the UK Smaller Companies universe, over both the long and short term. Over the past ten years, to 15 November 2020, the trust has NAV total returns of 239.4%, considerably outperforming the peer group (168.1%) and the benchmark Numis Small Cap Index plus AIM ex IT (105.2%). The trust’s benchmark was changed in 2018, from the FTSE Small Cap Index to Numis Small Cap Index plus AIM ex IT which better reflects the managers’ investing universe which also includes AIM companies (the Numis index has also outperformed over the longer term). As such, on a calendar year basis, the past ten years have seen the trust outperform its respective benchmark in seven of the past ten. The trust has typically performed strongest during rising markets, and conversely has underperformed during falling markets. A contributing factor to this could be the gearing, which (as we discuss in the Gearing section) has remained relatively high over time, and it could also be the momentum factor which is sought after in the investment process.

Calendar year graph

Source: Morningstar

The past five years have seen impressive NAV total returns of 80.2%, almost double that of the new benchmark (42.7%) and considerably greater than the AIC (41.6%) and IA (58.4%) peer groups. Over this period the managers have generated alpha of 4.9%, although the beta of 1.15 is one of the highest in the sector; as the greater beta increases the assumed market return used in calculating the alpha, this emphasises to us the contribution from the investment process. The five-year standard deviation sits at 22.1%, around the middle of the sector but higher than the benchmark (17.7%).

Five year returns

Source: Morningstar

Over the five year period the majority of the outperformance came in 2019. More specifically the trust rebounded after the general election and, over the full year, five of the top ten holdings delivered returns of more than 100%. The excellent relative performance has continued into 2020. Year to date, ending 15 December, the trust has NAV total returns of 5.3%, compared to -1.0% and -2.4% from the benchmark and AIC peer group. The strongest performances have come from the likes of Team17, Avon Rubber and Games Workshop, each of which has doubled in 2020.

one year returns

Source: Morningstar

Dividend

The key aim for JMI is to give investors access to the fast-growing, innovative smaller companies that help drive the UK domestic economy. As such, dividends are not a principal focus for the managers, although the trust does have a yield of 2.2%. This is marginally lower than the sector weighted average yield of 2.6%.

Dividends are paid annually and the trust delivered a dividend of 5.5p per share for the 2019 financial year, up from 5.4p in 2018. However, there is no specific progressive dividend policy in place.

Annual dividends

Source: Morningstar

It is worth noting that the dividend figures are comparative figures, following a five for one share split in 2018.

Management

At the helm of the trust are Georgina Brittain and Katen Patel. Georgina has been working in the industry, and JPMorgan, for close to 26 years and has run JMI since 1998. She currently holds the title of managing director and is the fund manager of multiple UK small- and mid-cap funds alongside JMI, including the open-ended JPMorgan UK Smaller Companies Fund and the JPMorgan Mid Cap Investment Trust. She is also a co-manager for a range of European small-cap funds.

Katen has been working in the industry for 15 years, seven of those at JPMorgan. He was named co-manager in 2014. He is also Georgina’s co-manager on the JPMorgan UK Smaller Companies Fund and the JPMorgan Mid Cap Investment Trust. Previously he worked at HSBC in a European equity sales role.

Discount

As the chart below shows, the trust has tended to trade at a relatively wide discount, although there have been periods when the discount has significantly narrowed. The most recent prolonged period when the discount narrowed was following the Conservative election victory, in the last quarter of 2019, and investor optimism about U.K. economic growth prospects. However, the discount also narrowed considerably, but briefly, in April of 2020.

Coronavirus and Brexit uncertainties and their impact on the UK economy helped the trust once more move out to a double digit discount, however this has more than halved in recent months to the current level of 4.3%. The board has not conducted any share buybacks this year.

Discount / premium

Source: Morningstar

Charges

The trust has an ongoing charges figure (OCF) of 1.11%. This compares to a sector-wide weighted average of 0.78%. Of this, the trust charges 0.75% of gross assets up to £200m and 0.65% on gross assets over £200m for the management fee. With the current total assets of £283m, the effective management fee is 0.72%. The trust has no performance fee.

The KID RIY for the trust is 1.53%, in comparison to the AIC UK Smaller Companies sector weighted average of 1.39% (JPMorgan Cazenove). It is worth noting, however, that calculation methodologies can vary among companies.

ESG

JMI is managed by JPMorgan Asset Management (JPMAM). JPMAM is a signatory to the United Nations’ Principles for Responsible Investment and therefore is committed to their six principles, which aim to incorporate ESG criteria into investment processes and to promote ESG disclosure.

ESG issues are now incorporated at every stage along the decision-making process, including quantitative and fundamental analysis. This is primarily achieved through a number of third-party sources, eventually giving each prospective company an absolute score for ESG.

The team are able to draw on ESG specialists within the wider JPMAM team who are tasked with ongoing assessments on how companies deal with ESG risks and issues. This utilises a ‘red flags’ model where each company’s corporate governance, forensic accounting and financial distress are assessed. In the future, the managers envisage all the research coming from in-house; however, this is still being developed.

Further supporting the ESG aspects of the process, Katen was in 2019 named manager of a pan-European ESG fund. Some of the output from this is expected to filter down to the JMI portfolio as Katen gains greater insights into the area.

Fund History

Disclaimer

This report has been issued by Kepler Partners LLP.  The analyst who has prepared this report is aware that Kepler Partners LLP has a relationship with the company covered in this report and/or a conflict of interest which may impair the objectivity of the research.

Past performance is not a reliable indicator of future results. The value of investments can fall as well as rise and you may get back less than you invested when you decide to sell your investments. It is strongly recommended that if you are a private investor independent financial advice should be taken before making any investment or financial decision.

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