Scottish Oriental Smaller Companies 14 April 2021

Scottish Oriental Smaller Companies (SST) invests in market-leading businesses which have a market cap of below $5bn at the time of investment. These companies are chosen for their low levels of debt, strong management teams, and ability to compound earnings consistently over the long run.

SST performed very well after the 2008 financial crisis and the 2000 bursting of the tech bubble, as discussed in the performance section, which has contributed to it being one of the ten best-performing trusts in the AIC universe since 2000 on an NAV total return basis. Typically, high-quality companies can gain market share from weaker, more indebted competitors in times of crisis, and the managers report there have been signs of this happening in their portfolio during the course of the pandemic. However, the quality style and sensitivity to valuations as well as the country and small-cap biases have worked against SST, leading to disappointing performance over five years.

In response to this disappointing period, the board and manager have implemented a number of changes intended to help turn around performance. This includes Martin Lau being named as co-manager with Vinay Agarwal, lead manager since 2016, and the addition of the first structural gearing for many years. The market-capitalisation limit has also been increased from $3bn to $5bn, reflecting growth in markets, and the mandate has been broadened to include Australasia and Japan – bringing SST in line with the two Asia small-cap peers. There is no change to the quality, long-term investment approach being taken.

SST trades on a discount of 12.1% compared to a five-year average of 13.2% and the AIC Asia Pacific Smaller Companies sector average of 7.7%.

SST has had a disappointing few years in which it has faced multiple external headwinds. The quality-growth style has lost out to high growth and momentum, while the allocation to South Asia and low exposure to China have been unhelpful. Meanwhile large caps and technology have both been in favour. However, we think it is possible the pandemic will lead to a shift in style leadership. We note that after the past two global crises quality-growth outperformed, and SST did particularly well. With Asian economies having to deal with the aftermath of COVID-induced economic trauma, high-quality companies may find themselves in favour once again.

We think shareholders should be reassured by the board’s approach of evolution rather than revolution, ensuring the trust will stick to the strategy which has given it long-term success rather than chasing what has done well in the recent past. In our view the implementation of structural gearing adds to the attraction of the trust, as it is a way to potentially boost long-term returns which can’t be matched by open-ended funds. That said, it does add marginally to risks and/or volatility.

SST’s wide discount also looks interesting in our view. Many trusts have seen their discounts narrow in the reflationary trade since Q4 2020, but SST has lagged. There are risks in the near term as some of the countries it is heavily exposed to are still struggling to control the pandemic, but over the longer term there is catch-up potential.