An investment trust taking advantage of small-cap rebound

Throughout the year to end of June 2024, The European Smaller Companies Trust PLC (LSE:ESCT) outperformed its benchmark and peer group on both a net asset value (NAV) and share price basis. The investment trust is one of our Super 60 investment ideas.

The benchmark’s return (MSCI Europe ex UK Small Cap) of 10.1% was surpassed by the portfolio’s NAV return of 12%, and even more so by the share price return of just under 20%.

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While the strong price return was supported by a narrowing of the discount from -16.4% to -11.2%, throughout the 12-month period the portfolio outperformed largely on account of stock selection.

The investment trust has faced a backdrop of political uncertainty, with snap elections in France and the UK, and market volatility stemming from mixed economic data.

Nonetheless, the broadening out of market returns from the large companies at the top of global indices, such as Lvmh Moet Hennessy Louis Vuitton SE (EURONEXT:MC), Novo Nordisk AS ADR (NYSE:NVO) and ASML Holding NV (EURONEXT:ASML) in Europe, has been to the benefit of investors backing the smaller end of the spectrum.

The numbers in detail (for financial year to 30 June 2024)

Share Price Return: +19.5%
Net Asset Value (NAV) Return: +12%
Benchmark Return (MSCI Europe ex UK Small Cap): +10.1%
Premium/Discount: -11.2% (vs -16.4% in prior year)
Dividend: 4.8p (vs 4.7p in prior year)
Gearing: 10.7% (vs 13.1% in prior year)

Outlook

While conscious of the vulnerability of European small-caps should a recession befall the region, management view positively the easing of monetary policy in the second half of 2024 and think that a “soft landing” could be on the table.

Longstanding fund manager Ollie Beckett cites the rich and varied universe of smaller European businesses and thinks that, with valuations front of mind, the sector contains ample opportunity going forwards.

Portfolio

ESCT’s portfolio has a focus on valuations and growth potential, which has led management to favour or avoid certain sectors. It allocates most heavily to industrials at 36% of the portfolio (+10% overweight versus the benchmark) and 13% to technology (+4% overweight). It holds less than the benchmark in healthcare and real estate, while utilities are absent.

Geographically, Germany remains the largest country allocation at 20% of the portfolio (9% overweight). It is a country that management thinks has “incredible innovation and great businesses”, despite the apparent troubles of its reliance on Russian energy and Chinese demand.

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While the trust usually invests in Europe excluding the UK, the recent addition of London-listed IG Group Holdings (LSE:IGG), was a rare exception. Management deem the business to be cheap and possessive of great cash-generative capabilities.

Other new positions include recent IPOs with notable defence exposure: German gearbox producer Renk, and businesses involved in goggle manufacture, Theon International (EURONEXT:THEON) and Exosens SA (EURONEXT:EXENS), which are Dutch and French respectively.

Disposals were made where profits were taken from Italian-listed SAES Getters and Iveco Group NV Ordinary Shares (MTA:IVG). As a result, the Italy allocation has become underweight.

Discount

During its financial year the discount narrowed from -16.4% to -11.2% at the end. Shares were bought back during the period in a largely successful effort to contain the discount, which is in line with peer trusts (currently at -10.6%).

Gearing

The gearing level throughout the year was 10.7%, falling slightly from around 13% in the prior year. The trust remains the most leveraged of its peer group by a margin.

Dividend

The board has recommended a final dividend of 3.35p per share, which (assuming approval at the AGM) will make for a full-year dividend of 4.8p – reflective of a healthy revenue position and representing growth of 2% over last year.

While the priority for ESCT is capital growth and growing dividends isn’t a stated objective, it is nonetheless a historic trend for the trust.

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It has been noted that, as the management team perceive opportunities to capitalise on economic expansion in Europe, opportunities may be found outside certain yield-paying names. Therefore, investors ought not necessarily anticipate high rates of dividend growth in the longer term.

ii View:

Until the start of 2024, European market performance over the past few years has been defined by large-cap dominance over smaller businesses (as in many other regions).

However, although performance at the smaller end of the market has begun to pick up, we’re still yet to see a wholesale rerating of Europe’s listed small-cap businesses.

Accordingly, valuations still look quite meagre in comparison to larger counterparts – a factor that valuation-conscious investors such as Beckett and his team continue to take advantage of.

In the year to end of June 2024, ESCT succeeded in generating meaningful outperformance for investors, a reflection of stock selection, and the decision to take on a substantial amount of leverage – more than any immediate peer. This gearing was employed to capitalise on management’s view that valuations across European small-caps made for a compelling crop of investment opportunities, and this year the outlook was vindicated.

Meanwhile, the higher share price return of 19.5% is a product of the trust’s discount reverting to something like a more normal level, aided by the substantial buying back of shares and improved sentiment towards smaller companies.

The current discount of -10.6% is now slightly shallower than the three- and five-year averages for the trust.

The year reveals relatively minimal change from a sectoral positioning point of view within the portfolio, as management continue to find the most numerous opportunities in “growth”-orientated industrials and technology sectors, which together make up nearly half the portfolio.

Despite the sectoral bias, the differentiated circa 130-stock portfolio retains its stylistic neutrality, and diversifies itself across a small set of “early stage” names, a number of more established “quality growth” and “mature” businesses, and an allocation to “turnaround” names.

While the trust’s remit of investing across small-cap businesses, from quality-growth to neglected market segments and undervalued businesses, can make for high volatility for investors, the experienced team have proved themselves over both the short and long term.

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Since Beckett’s tenure as manager began in mid-2011, the trust has generated over 3% annualised outperformance versus its benchmark index.

On account of the trust’s substantial outperformance over three years, the investment manager once more earns a performance fee (albeit less than in the prior year), bringing the yearly ongoing charges figure (OCF) charge to 0.75%.

Even accounting for this performance fee, the overall charge remains competitive both in comparison to peer trusts and open-ended equivalents.

This is especially true in light of the impressive excess returns generated by the trust over the past five, 10 and 15 years.

The European Smaller Companies Trust earns its place in ii’s Super 60 list as a small-cap option for investors with a tolerance for volatility and a long-term investment horizon.