Recent regulatory changes could play to the strengths of smaller company investment trusts managed in a private equity style, writes Jennifer Hill.
European Union regulations designed to protect investors and increase transparency could spell bumper bargains for investors in smaller company trusts, particularly those employing a hands-on approach.
MiFID II, which came into force in January, forces brokers to charge separately for their research. This represents an enormous opportunity for investment managers such as Christopher Mills, who runs North Atlantic Smaller Companies – one of the earliest proponents of investing in smaller companies with a private equity style.
‘Hopefully, MiFID II is going to be very beneficial for us,’ he says. ‘More and more large institutions simply won’t bother with the companies we invest in because they don’t have the resources or time. Big blocks of stock could be going cheaply as people get out of the space.’
The argument for Mills and a small band of managers like him is simple: an assessment of a company using the same methods as employed by private equity buyers has the potential to spot value the market has missed. It is an approach that has amassed him a huge personal fortune, with a 30 per cent stake in the £540 million trust.
Managers such as Mills get more closely involved with investee companies than is ordinarily the case, by undertaking substantially more due diligence prior to acquisition, having a seat on the board, and providing strategic direction and business connections. ‘Like private equity buyers, they may be prepared to back a management team while it makes hard decisions about restructuring,’ says James Carthew, research director at QuotedData, an investment trust research firm. ‘These types of situations often throw up opportunities, as managers may pick up companies working their way through problems.
‘Private equity investors tend to be supportive of good management, but they may intervene to replace management teams they are uncomfortable with. The same is true of funds with a private equity style, though some are more activist than others.’
Investing in this way takes time and effort, so managers tend to run concentrated portfolios. That, of course, brings added risk. Having significant positions in fewer companies and building close relationships with managements can make selling at the ‘right’ time more complicated.
‘Being less diverse than generalist small company funds essentially means small company trusts with a private equity style are likely to be more risky,’ says David Liddell, a director at IpsoFacto Investor, an online investment advisory service. ‘This may not be a bad thing, of course, as it should enhance returns over the long term. But it means investors should look under the bonnet with greater diligence to make sure there’s not too much overlap with other holdings in their portfolios.’
For investors with little private equity or smaller companies exposure, a reasonable holding should aid diversification and improve the risk/return profile. ‘For all risk profiles, provided the time horizon is long enough – at least 10 years – funds following private equity styles can be a real benefit to overall returns,’ says Andrew Chorley, managing director at Financial Planning Wales. ‘Holding a core of “boring” and consistent assets allows investors to add satellites such as these that offer the potential for big wins, without being exposed to great risk.’
A typical balanced client of his has 5 per cent in this area, while a more adventurous investor has 10 per cent. Whitechurch Securities’ Gavin Haynes recommends an allocation of up to 10 per cent, while Kohn Cougar’s Roddy Kohn advocates up to 15 per cent.
Mills ‘had no money to invest’ when he became manager of North Atlantic Smaller Companies (NAS) in 1982, aged 30. He started buying shares in the trust in 1984, when he became its chief executive, and today owns £162 million of it.
‘That’s my money, and I’m very careful with it,’ he says. ‘We don’t do jollies. We invest when we’re as sure as we can be that we’re not doing anything stupid.’
The trust typically has 40-50 investments, both quoted and unquoted. The latter account for a fifth of assets, while the top 10 holdings account for 58 per cent of the portfolio. Some 69 per cent is in UK companies, 11 per cent in US firms (down from almost 30 per cent five years ago) and 20 per cent in US Treasury bills.
‘No doubt the substantial liquidity holding has hampered relative investment performance, as equities have been so strong,’ says Liddell. The trust has underperformed a composite of JPMorgan US Smaller Companies (25 per cent) and the UK smaller companies investment trust sector (75 per cent) over one, three, five and 10 years, though not by much. In the 35 years that Mills has run the trust, its net asset value per share has risen from 33p to £37.50.
Mills likes turnaround tales and advocates ‘being friends’ with management. A recent ‘major victory’ is bowling site operator Ten Entertainment Group, which floated on the London Stock Exchange last spring and has turned a £9 million investment into £40 million. ‘We don’t always get it right, but when we do, we tend to get big victories,’ Mills says. His current ‘problem child’ is Goals Soccer Centres.
Mills typically invests in companies worth less than £250 million and takes significant stakes, often becoming the largest shareholder. He achieves greater diversification though a holding in Oryx International Growth, another trust he runs through his Harwood Capital Management company.
Diane Weitz, a director at Ashlea Financial Planning, has used Oryx since 2016 to diversify portfolios worth more than £200,000.
Capital Gearing Trust (CGT), a Money Observer Rated Fund run by Peter Spiller to a wealth preservation mandate, invests in North Atlantic Smaller Companies, as does the Methodist Church. Meanwhile, a prominent multi-asset fund manager is looking to offload shares, as his funds have outgrown the trust, providing a possible entry point for other investors.
The shares are trading at a 24 per cent discount to NAV, which Winterflood analyst Kieran Drake says reflects its unquoted investments, concentrated shareholder base and low profile. The trust charged 1.7 per cent in the year to 31 January 2018, which included a performance fee of around 0.5 per cent.
Strategic Equity Capital (SEC) focuses on small companies with market capitalisations of less than £300 million at the time of investment. The £178 million trust is highly concentrated in 18 UK-listed holdings, with a top 10 that accounts for more than 70 per cent of its assets.
The trust has virtually no exposure to unquoted companies (one historic holding is worth 0.4 per cent of assets) but favours companies that are members of the FTSE Small Cap index or are listed on the Alternative Investment Market. It has 9 per cent in cash.
Its lead manager is a relative newcomer. Jeff Harris replaced renowned small-company manager Stuart Widdowson in early 2017, having been involved in fund management at GVQ Investment Management since 2014.
The investment philosophy remains unchanged, however. Harris looks for under-researched companies trading at discounts to intrinsic value, and constructively engages with their managements.
He favours niche market leaders with intellectual property and high barriers to market entry, while he avoids a ‘black list’ of companies with fundamental business risks such as heavy reliance on a single product or customer, weak cash flow or excessive borrowing. ‘This means that bank, estate agent, and oil and commodity stocks never appear in the portfolio,’ says Tony Yousefian, an investment trust research specialist at FundCalibre.
The trust’s largest sector weighting is in technology, specifically software and services. Holdings include Tribal Group, a student information systems provider, and Proactis, an e-procurement and spend-control software provider bought in November at what Harris considered an attractive valuation. Both stocks benefit from long-term structural growth drivers, large market shares and high degrees of recurring revenue.
The trust’s recent performance has been mixed. Its shares have underperformed the FTSE Small Cap index marginally over the past year and significantly (by almost 40 per cent) over three, although they have outperformed by a similar margin over five. ‘While exhaustive research helps mitigate individual stock risk, the portfolio's concentration means its ability to outperform tends to be lumpy and requires patience,’ says Yousefian.
In January the trust’s base annual management fee was cut to 0.75 per cent. Its total fee, including a performance fee, was 2.42 per cent as at 30 June 2018.
Charles Cade, head of investment companies research at Numis Securities, points to strong links within this small community of specialists: one backer of Widdowson’s new business is Mills, while Tony Dalwood and Graham Bird, co-managers of Gresham House Strategic trust (GHS), ran Strategic Equity Capital prior to Widdowson.
Pick of the bunch
For Monica Tepes, investment companies research director at finnCap, the pick of the bunch is the smallest of the three trusts we are looking at: the £35 million GHS, which backs intrinsically undervalued firms worth less than £250 million. Its shares are trading at a 30 per cent discount to NAV – the widest since the Gresham House team took over the mandate in August 2015. ‘At this point, I’d go for GHS,’ she says. ‘It’s rather unloved; this may prove a sweet spot.’
The portfolio is valued at a discount of almost 35 per cent to the FTSE Small Cap index, and it has a net cash position, in contrast to the net debt position for the index, effectively creating a double discount.
It is almost fully invested, with less than 7 per cent in cash. Investments are predominantly UK-listed, though 5 per cent is in unquoted companies.
It is incredibly concentrated, with just 15 investments. The top 10 holdings account for 85 per cent of assets and the largest holding, IMI Mobile, commands 45 per cent. IMI has returned 90 per cent since mid-2015.
IMI Mobile is at a pivotal point in its development.‘The managers believe it’s at a transformational stage, which will deliver further upside and potentially make it a good takeover target,’ says Tepes. ‘Once the holding is reduced or divested, the portfolio concentration argument for a wide discount will be removed.’
Tepes points to the ‘J' curve that private equity style investments tend to follow: dipping in value in the early years as changes are implemented and then rising sharply, as exemplified by SEC under Dalwood and Bird – its stellar performance from 2009 to 2014 was in large part due to investments they made between 2006 and 2009. The trust's small size means its charge is high at 3.35 per cent, including a performance fee.