Aberforth Split Level Income 09 June 2023

Aberforth Split Level Income Trust (LON:ASIT) has just over one year remaining until its planned wind-up date. By our estimates, the current share price is implying a total return of c. 17.4% for shareholders over that period, assuming there is no change in the portfolio value (see Performance and Dividend for the reasoning). This is thanks to the high income generated for ordinary shareholders, through the use of zero dividend preference shares (ZDPs), which don’t receive dividends but have a fixed capital entitlement on wind-up.

As well as boosting the income to ordinary shareholders, the ZDPs mean the portfolio is highly geared, so changes in portfolio value are magnified. Gearing allows the managers, a team of six at Aberforth Partners, to invest more than the ordinary share capital into what they view as undervalued UK small caps. This strategy has worked well since the reflationary rally in late 2020, the portfolio outperforming the Numis Smaller Companies ex IT Index benchmark since then.

Nevertheless, the portfolio is still cheap by historical standards, while UK small caps are cheap versus UK large caps, and UK large caps are cheap versus their international peers. It all creates an intriguing set-up, with a recent uptick in M&A activity, led by private equity, possibly indicating that sentiment towards the UK is shifting. Recent upgrades to GDP forecasts by the IMF and the Bank of England bring optimism that the earnings of UK companies may hold up better than previously feared, and perhaps better than that implied in current share prices.

The managers will continue to explore options with shareholders and the board for wind-up on 1 July 2024, whereby shareholders will have the option to either realise or continue their investments.

The high income which looks deliverable from the current portfolio has effectively created a cushion for an investment in ASIT during its last planned 13 months before wind-up. We think the potential returns look attractive over such a short period of time, although the gearing does mean that in the event of a sell-off over the next year, investors could receive a low or even negative return. Nonetheless, we think the current pricing is attractive for those who want to be invested in the current market.

While risks abound, there are two factors which make us positive on ASIT over the next year. The first is the value in the portfolio. ASIT is cheap versus the small-cap market, even compared to history. Meanwhile, UK small caps are cheap compared to UK large caps, and UK large caps are cheap compared to international peers. As such, there is a lot of value in the portfolio, in our view, even after a strong two years of relative performance. The second factor is the economic environment. It is looking increasingly likely that the UK will escape recession and may see reasonable economic growth this year. This would create favourable conditions for earnings growth and, if the cheap valuations referred to above reflect fears of a recession, then there is clearly scope for a rerating. Meanwhile, the more stable political environment we seem to be enjoying – with the decline of nationalists and there being two relatively centrist main party leaders in the UK parliament – may encourage investment in the UK stock market from overseas.