Scottish Oriental Smaller Companies 04 November 2020
Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by Scottish Oriental 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.
Scottish Oriental Smaller Companies Trust (SST) aims to buy market-leading Asian businesses with a market cap below $3bn and hold them for the long term as they grow. Manager Vinay Agarwal aims to find companies which can generate high and sustainable earnings, typically from dominating a niche and having advantages which can’t be easily replicated. He aims to buy these companies on reasonable valuations and invest on a three- to five-year time horizon.
A key element of the investment process is investigating the downside performance of companies in tough economic periods in the past. Vinay looks for companies with operational resilience, low levels of debt and management teams with a track record of making prudent capital-allocation decisions. As we discuss in the Performance section, this focus on quality and resilience helped SST to outperform hugely in the aftermath of the 2007/8 global financial crisis.
After the outbreak of the pandemic Vinay took advantage of the market-wide falls to improve the quality of the portfolio, picking up some new holdings which were previously too large or too expensive, and adding to his preferred companies as they fell in price. The aim is to own businesses which should have the strength to survive the rough period and dominate the competition in the recovery.
Vinay does not make calls on individual countries, but his process has led him to have a large overweight to India and underweight to China, which has contributed to SST underperforming in recent years (including 2020). This underperformance is likely why the discount has widened out to 15.1%, over one standard deviation wider than its five-year history.
SST is out of favour, with its shares trading on a wide discount compared to its history. While performance has been challenging in recent years, there could be better things ahead for the trust, with the pandemic potentially leading to more defensive, quality growth companies coming back into favour. In the meantime, there is an active buyback programme which could provide some downside support.
In our view, SST’s portfolio of high-quality companies with low levels of debt should do well in any rough economic period following the emergence of the pandemic, and thereby be in a good position to steal market share from competitors as the latter go out of business and struggle under debt burdens or under the pressure of reduced demand. This is what happened following the last global crisis of 2008, as we discuss in the Performance section.
Nonetheless history may not repeat itself, and crucial factors in the medium term will be the highly active country positioning (into India and out of China) and sector positioning (towards defensive consumer staples and away from high-growth companies and technology). However, after a period in which both biases have been deleterious to performance, we think the chances of mean reversion for the fortunes of the portfolio are good, with the economic fallout from the pandemic a potential catalyst.
|A track record of outperforming in a post-crisis recovery
|Highly active sector and country positions can lead to underperformance over periods
|Wide discount relative to history, providing a good entry point
|Asian small caps could remain out of favour with international investors
|A focus on absolute returns and downside protection which should help in rough markets
|SST has a performance fee which some investors do not like