Liontrust explains how its top small-cap fund is thriving

AIM and small-cap shares have beaten large-caps over five years and in 2020. interactive investor’s Lee Wild caught up with Victoria Stevens at the Liontrust UK Smaller Companies fund to discover how portfolio managers are investing during the pandemic, the shares she’s been buying and the coronavirus testing stock she owns.

Filmed 28 May 2020

Lee Wild, head of equity strategy, interactive investor:  Small caps have outperformed large caps in 2020 so far. The AIM All-Share Index is down just 11% compared with the FTSE 100 about 20%. Could you explain why?  

Victoria Stevens, co-manager of the Liontrust UK Smaller Companies Fund:  Yes. So one of the primary reasons is that the UK main market has a higher exposure to both oil and gas and also financial stocks. The FTSE 100 has roughly twice the weight of the AIM Index in both of those two sectors, and those two sectors happen to have been the two worst performing sectors in the year to date. 

But I think it’s also worth remembering where we’ve come from. So large caps outperformed small caps over the past couple of years.  If we take 2018 and 2019 together, the return of the FTSE 100 had been almost plus 7%, whereas AIM was down 6% over the same two-year period. So I think there was also probably a bit of catching up to do as we came into 2020. 

What I would say though is that I would probably caution against drawing any strong conclusions from the performance of those two respective indices so far in the crisis. Because the coronavirus pandemic is hitting businesses of all sizes across all sorts of sectors of the economy. And, of course, while the government support packages might have staved off the brunt of the pain for some companies for the time being, the fallout for many of the others of them is really just beginning. 

And you know small-cap is often described as being a stock picker’s market, and I really think when we’ve got really unusual times such as these ones that we’re living in, it’s really more important than ever for investors to be very clear about the attributes that they’re looking for in businesses, and to be particularly disciplined in sticking to their own rules. 

Lee Wild:  And your portfolio will have come under a bit of pressure I imagine during the past few months. How has the portfolio performed during the pandemic? Have there been any specific drivers other than broader market moves? 

Victoria Stevens:  You’re right, and it is never nice to have to report on a down period of performance in absolute terms. But in relative terms, the Liontrust UK Smaller Companies Fund has performed well over the year to-date. So although the fund was down about 10.4% in the four months to the end of April, that was quite a way ahead of its benchmark index which is the FTSE Small Cap ex-Investment Trust, and also the average return of the peer group. So relatively speaking, a reasonably strong performance. 

And there are some reasons why the fund has performed strongly in relative terms, and it all really stems from my team’s bottom-up stock picking process. So to describe that process very quickly, it’s a process which has been applied to this particular fund for over 20 years now, and it is all centred around the search for so-called ‘intellectual capital’ or, in other words, intangible asset strengths. 

And for us there are three key intangible asset strengths that our companies must possess at least one of. And they are intellectual property, strength in distribution or high levels of contracted recurring income. And the reason why we like those are because we believe that these intangible strengths are very difficult for competitors to replicate. And that means, in turn, that they should give our companies the ability to maintain their pricing power and their competitive advantage over a very long period of time.

And then, as a second stage to that process, we then test whether or not the intellectual capital is working for our companies by looking at their return on invested capital. And we look for our companies to be able to consistently earn returns on capital which are comfortably in excess of the cost of capital.

I think it’s really important to add that we require all of our companies to be profitable before we buy them into the fund, and that is a bit of point of differentiation in the world of UK small-cap because there are many listed companies which are heavily loss-making.

And we also lastly focus heavily on the importance of management equity ownership because we require all of our small-cap companies to have at least 3% of their equity owned by their management teams, and the average in the fund is closer to 20%. So these owner managers have got lots of skin in the game alongside us as investors.

But back to your question in terms of the drivers of performance, well it’s the result of this investment process that leads us naturally to the overweight certain sectors and underweight others.

So where you will typically find our fund invested is in things like software companies, fee-based financial companies like the wealth management firms, industrial companies, media companies, profitable healthcare, all of these are areas that we find those key intangible strengths that we will look for. And it so happens that many of those are also areas that have proven to be relatively resilient during the current crisis.

And then, on the other hand, the investment process naturally steers us away from many of the sectors which have been hardest hit by the pandemic in the lockdown. So we’ve got very little exposure in the heavily people-to-people areas like retail and leisure and travel which we all know have borne the real brunt of the lockdown.

And neither do we own any companies in the areas of, for example, construction or natural resources or property. And it’s these attributes and these sector exposures, all of which tumble down from our investment process which have served the portfolio relatively well during this really difficult period.

Lee Wild:  Have you been taking advantage of lower share prices since the coronavirus outbreak? Any stocks that you’ve added to the portfolio? I see actually YouGov (LSE:YOU), that’s your largest holding currently, that was one of a number of portfolio stocks that roughly halved in value during the crash, admittedly along with much of the market. So, just anything that you’ve been taking advantage of?

Victoria Stevens:  We had many stocks, as did many others, that saw very dramatic share price declines at the start of the current crisis. But it’s also true to say that some have since staged really very strong recoveries as well. So YouGov is one of those, it’s recovered now to almost all-time highs again.

But during the sell-off we were doing some selective topping up of our existing holdings, particularly the ones of course where the share prices had been hit particularly hard and where we also had strong conviction in the company’s long term prospects.

And we supported a number of our companies which came to the market to raise capital. But I would say that we haven’t tried to be too clever in timing the market precisely with very large purchases or very large sales, because we recognise that that’s very difficult to do with consistency.

I clearly can’t talk about positions which we’re still building, but I will say that we took advantage of one capital raising in a non-holding to initiate a new starting position in that company. It was a company that we had been tracking for a long time and we already knew it quite well. So that was an opportunity that was thrown up by the market dislocation.

I’ll also mention simply because this timing was extraordinarily fortuitous with the benefit of hindsight, which is always lovely, and we of course can’t claim to have foreseen the extreme events that unfolded straight afterwards. But back in February we also participated in an IPO, the company was called FRP Advisory Group (LSE:FRP), and that was obviously just before the sell-off began.

And FRP happens to be a specialist restructuring and insolvency practitioner group, so it’s clearly having a good crisis, so that’s, with the benefit of hindsight, as I say, was quite good timing.

Lee Wild:  One of the big themes of the pandemic, in investment terms certainly, is the coronavirus testing stocks, a lot of them are very small cap, but in the right place at the right time and doing incredibly well. Is this an area that you’ve been tempted to buy into?

Victoria Stevens:  We do happen to hold one company which is held in the Liontrust UK Micro Cap Fund, which is called EKF Diagnostics (LSE:EKF). And EKF Diagnostics, among other things, is a manufacturer of a core reagent which is used in a device which collects blood samples, which is manufactured by one of the company’s American partners, Longhorn it’s called.

And this blood sample collection device deactivates the viruses and bacteria which are present in blood samples, which clearly reduces the risk from re-infection of others from transporting and processing those blood samples. And with many countries starting to really ramp up coronavirus testing in earnest, that company has been seeing many orders flow in for that core reagent.

But what I would say though is that that stock, as you rightly point out, is the exception rather than the rule for our funds. And the reason for that is because we focus on profitable small cap companies, as I’ve already said. Many of the listed companies that are involved in trying to develop tests or treatments for coronavirus are investing very heavily and as a result, many of them are heavily loss-making as well, which simply takes them out of our investment universe.

So many people can make great money from investing in such stocks but, for us, you know, we prefer to stick to our tried and tested investment process and the potential rewards of such stocks we think are outweighed by commensurately high risk.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.