Invesco Perpetual UK Smaller Companies 21 March 2019

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.