Value Investment trusts – A 'look under the bonnet'

Tuesday, 11th April 2023 17:15 - by David Harbage

Following on from the previous blogs which reviewed two of Janus Henderson’s UK equity multi-cap investing trusts Henderson Opportunities (HOT) and Lowland (LWI), this article seeks to highlight two more trusts which invest in UK listed company shares and have a clear focus on Value: Aberforth Smaller Companies (ASL) and Artemis Alpha (ATS). The DIY investor can search online and discover more – via the companies’ own websites, regulatory news service (RNS), video interviews and independent articles – about the fund managers’ strategy, perspective on the economy or market, advice of prime selections and recent transactional activity. For what it is worth, and without recommendation, here are the factors that prompt support for (and in some cases, ownership of) these actively managed investment vehicles:

The Edinburgh-based, Aberforth Smaller Companies trust seeks to outperform the Numis Smaller Companies (excluding investment trusts) index - which typically represents businesses worth up to approximately £1.6bn. One of the largest investors in UK smaller companies, the trust’s market capitalisation is currently just over £1bn and, rather unusually within the fund management industry, has been managed by its experienced owner partners over its 33 year history. Aberforth has a clear focus on ‘bottom-up’ (individual company, as opposed to ‘top-down’ macro-economic driven) selection and, in particular on valuation metrics. The latter is evidenced by the portfolio’s low price to earnings rating (enterprise value compared to cash generation), relatively low debt (measured by financial gearing) and attractive price to book (or tangible assets).

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As a consequence of owning seemingly undervalued businesses, ASL’s constituents have been a beneficiary of take-over activity by overseas buyers and from domestic competitors over the past few years. The fund managers believe that sterling priced assets are particularly cheap taking a global perspective and that, within its universe of prospective investee companies, smaller fully listed (as opposed to AIM listed) companies offer best value. With 50% of the portfolio’s revenue being generated in the UK, the prospects for ASL is clearly closely linked to the domestic economy. In the managers’ opinion, the media’s portrayal of the British economy overplays the gloom and ignores the corporate sector’s resilience – in particular, its nimble management’s ability to take positive action in an economic downturn. Taking those factors into account and believing the inherent cyclicality within the portfolio represents an opportunity as recovery appears in 2024, ASL’s research team consider the fair value of its portfolio to be circa 100% higher than that currently ascribed by the market.

A 60 year analysis of how stock market quoted smaller UK businesses perceived as Value have performed compared to those smaller companies considered Growth suggests outperformance from the former over 80% of the 1960-2022 time period. Barring the odd exceptional year, Growth has only outperformed Value when low interest rates prevailed, notably since the global banking crisis (GBC) of 2008. A return to more normal monetary conditions, which began a year ago, could be the catalyst for a revival in investor interest in UK smaller companies. This could also extend to predatory corporate interest from both the listed and private sectors as improving visibility in the global macro economy, an easing in interest rates and uncertainty in the debt markets emerges prompting further Merger & Acquisition activity and resulting in an upward re-rating.

ASL has benefitted from owning such apparently undervalued businesses – in the past year seeing takeovers for constituents Brewin Dolphin, Go-Ahead, McKay, MicroFocus, RPS and Stagecoach – with more than twenty deals being executed at an average price of 14 times earnings versus ASL’s 7x valuation. Company management also recognise that their listed businesses are mispriced - evidenced by the current 3.4% income yield offered by ASL’s portfolio and the dividend being covered 3.6 times by profits - and therefore vulnerable to a trade buyer or other predatory action. In response, management have been paying special dividends and initiating share buybacks. ASL has an impressive record in growing its dividend: by 7% per annum from 1990 to 2021, and the trust hold revenue reserves (equivalent to 1.7 years pay-out, should profitability come under pressure or government directive a la Covid inhibit dividend distribution).

Another investment trust which focuses on Value, albeit by investing across all sizes of UK listed company shares, as it seeks to outperform the FTSE All-Share index, is Artemis Alpha trust. This £100m market capitalised portfolio, managed by Kartik Kumar and John Dodd on a high conviction, focus on individual company stock selection. This concentration is evident from the fact that the largest ten holdings account for 65% of the trust’s worth. The managers emphasise that they are not constrained by their benchmark, but rather will seek to invest in companies with attractive valuations, robust business models, with favourable long term industry fundamentals and high quality management teams. It should be noted that the trust’s directives progress diversification by restricting the amount that can be invested in any one exposure (as at the time of purchase) or to unquoted companies (in total) to 10%.

The managers take an opportunistic approach and, driven by the search for wherever valuation is most appealing, will often alight upon businesses which may appear to have dull or cyclical prospects. Their strategy and the portfolio’s Value credentials can best be seen by reference to some of ATS’ largest investments:

Frasers Group (FRAS) currently has grown to represent 12% of ATS’ worth, and the managers commend the retailer for its capital allocation and the way that the business has re-engineered its balance sheet to the benefit of equity shareholders. Since 2015, 40% of free cash-flow has been directed to repurchasing its equity (at circa 400p), enhancing earnings per share and reducing the share count by 20%. ATS say 40% of the trust’s constituents are buying back their own shares – including financial derivative platform Plus500 (PLUS) and European technology conglomerate Prosus (whose primary asset is a stake in Chinese internet firm Tencent).

Another strategy is to favour unloved cyclical businesses in areas of essential service or product like the travel firms easyJet (EZJ) and Ryanair where industry consolidation is occurring or the market underappreciates the merit of changing demographics (budget airlines continue to take market share from the national carriers) or balance sheet strength. Within the latter, house builders Berkeley Group (BKG) and Redrow (RDW) feature as medium term needs to meet an acute undersupply of shelter (relative to a growing UK population) are obvious, as is also the absence of debt – by contrast with previous cycles - amongst the industry’s leading players.

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The prospect of higher interest rates provides an opportunity for well-managed banks to increase their profitability via an expanding interest margin and for pension fund deficits to shrink as a higher discount rate is applied. The electrical-technology retailer Currys (CURY) is a portfolio constituent that could see a diminishing cost of servicing its pension, funeral director Dignity’s (DTY) liability in terms of its pre-paid scheme should ease, while ATS’ ownership of Lloyds (LLOY) and NatWest (NWG) could produce incremental top-line income from the prospect of higher rates.

As examples of thematic situations, ATS’ fund managers are keen on out-of-favour digital technology, via the intellectual property of Nintendo and the recent website-driven distribution channel for hobbyist Hornby (HRN). Industry diversification is aided via the ownership of personal care product business Haleon (HLN) (demerged from GlaxoSmithKline (GSK)) and French industrial conglomerate (and significant owner of infrastructure projects) Vinci Group. Allied to those, investment in special situations or recovery prospects - notably loss-making food delivery firms Just Eat Takeaway (JET) and Delivery Hero – also feature in the portfolio.

Finally, both Aberforth Smaller Companies and Artemis Alpha investment trusts pay half yearly dividends (although ASL are paying a special dividend in 2023), charge annual management fees of 0.75% and their shares appear attractively priced at a 14% discount to the underlying worth of assets. While ATS has not used debt to inflate the worth of its assets, a positive view on its portfolio’s immediate prospects has prompted ASL to effect 6% financial gearing to potentially enhance returns. Commentary on other trusts, across other areas of investment – by asset class and strategy – will follow in future blogs.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.