Scottish Oriental Smaller Companies 02 October 2019

Scottish Oriental Smaller Companies Trust (SST) aims to generate capital growth from a portfolio of Asian ex Japan smaller companies which are selected for their long-term growth potential. Manager Vinay Agarwal looks for high quality companies trading on attractive valuations, and aims to hold them for three years at a minimum, but ideally for much longer. The strategy centres on finding companies with strong positions in growing markets and industries, and with management teams who work in the interests of all stakeholders, giving the approach a strong ESG tilt.

Vinay took over in 2016 and has revived the portfolio, accelerating a process of portfolio concentration initiated by the previous manager, Wee-Li Hee, and increasing focus on a new generation of businesses with strong competitive positions in growing markets. He has also benefited from the decision at the last AGM to expand the investment universe, which allows SST to invest up to 20% in companies of up to $3bn in market cap at the time of investment which are now larger; that threshold was previously $1.5bn. This change has allowed the trust to keep pace with growth in the size of local markets, the manager explains, and has brought a number of companies into its remit which he believes can grow to many times their current size.

Downside risks are a key consideration, and Vinay aims to limit the loss potential even in down markets, which is aided by his concern for valuation. The defensive characteristics of the trust are clearly shown in the historic performance numbers. SST is currently running a cash weighting of 9.9% as high valuations lead to sales executing more rapidly than purchases; and Vinay maintains some dry powder to take advantage of market setbacks.

SST has managed to outperform the MSCI AC Asia (ex Japan) Small Cap Index handsomely over the past five years. In particular, the trust managed to outperform in the falling markets of 2018, thanks to the defensive characteristics of a value- and quality-centred approach. As a highly active strategy, at times the trust can underperform thanks to market movements it has no intention of chasing – so for example in 2017 it was held back by a low weighting to China which stemmed from a mixture of quality and corporate governance concerns and the restrictions of its previous market cap limits.

The objective of the trust is to grow capital, so dividends are not explicitly targeted. That said, we understand the board is keen to at least maintain the dividend, which has thus been held at 11.5p for the past six financial years, making use of revenue reserves where needed. The yield is currently 1.2%.

SST’s discount has been stubbornly wide in recent years, over a period in which – unusually – small caps have underperformed large caps in the region. This discount may also be the result of lingering uncertainty over the management of the trust from 2013 to 2015 (when there were two changes of manager after a long-standing leader retired) as well as the 2017 underperformance. The trust is now trading on a 12.4% discount compared to its five year average of 11.8% and the all-cap AIC Asia Pacific sector average of 8.8%.

In our view, SST’s portfolio looks more exciting than it has for years, with a ‘leaner and meaner’ line-up of high conviction holdings – now shorn of the lower conviction tail. This puts the trust in a stronger position to generate alpha in the future, we think. The expansion of the mandate to allow the manager to invest in larger companies is a potential game-changer, opening up a wider universe of quality companies which are still small relative to their fast-expanding stock markets.

The focus on stock-picking fundamentals is a highly attractive way to invest over the longer-term, in our view; and is especially appealing at the moment given that Asian markets have become dominated by central bank and political factors which are hard, if not impossible, to predict. By looking through the noise to long-term secular trends, we believe the manager has a good chance of outperforming (judging by the team’s track record and approach), while the discount does not reflect the changes made to the portfolio and improving performance in recent years.