Small company rebound can boost this out-of-favour UK trust

Investing in smaller UK companies offers the prospect of market-beating returns, as fund managers seek to find tomorrow's top stocks, but this approach often comes with volatility and periods of being out of favour. 

Super-60 rated Henderson Smaller Companies (LSE:HSL) is no exception. While the trust failed to beat its benchmark in the last financial year, it delivered a year of two halves for investors, with the first six months producing a loss relative to a flat benchmark, followed by a staggering 24% rebound as markets rotated into the oversold and devalued small-caps favoured by HSL.

We look into performance and assess its prospects. 

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The numbers in detail (for financial year to 31 May 2024)

Price Return: +17.3% 
Net Asset Value (NAV) Return: +14.5% 
Index Return: +18.2% 
Full-Year Dividend: 27p (vs 26p prior year) 
Premium/Discount: -11.5% (vs -13.2% prior year) 
Gearing: 11.5% (vs 12.6% prior year) 

Performance

The trust enjoyed positive absolute performance throughout the year, returning 14.5% for shareholders (and a 17.3% NAV return), yet fell short of its Numis Smaller Companies (ex Investment Companies) index, which returned 18.2%.

The relative underperformance was largely attributed to stock selection, including company-specific issues for some of the highest-conviction names in the portfolio. For example, the fourth-largest holding, Oxford Instruments (LSE:OXIG), a high-end instrumentation manufacturer, suffered in the short term on account of export controls to China and supply chain issues.

Outlook

Manager Neil Hermon highlights that while the transition towards monetary easing is positive, markets still face the challenges of the delayed transmission of higher rates that businesses have been subject to, along with the wider risks associated with geopolitical tensions.

The picture for the troubled UK market is mixed as valuations remain low, but there are initial signs of revival across IPO and M&A activity, and smaller companies especially are supported by prospects of easing cost pressures.

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Discount

A narrowing of the discount contributed to the return for shareholders throughout the year, with HSL beginning the period trading at a discount of 13.2% to NAV, and ending at 11.5%. Shares were bought back during the period.

Dividend

HSL’s proposed dividend for the year of 27p represents an increase from last year’s 26p distribution, and the trust’s 21st consecutive year of dividend growth. This results in a portfolio yield of 3% and, pleasingly, the payout is covered by earnings.

Portfolio

There was a reasonable amount of portfolio activity during the period, including a number of new holdings initiated across a range of sectors, including book publisher Bloomsbury Publishing (LSE:BMY), as well as names across industrials and financials where outlooks now appear favourable.

The year also saw the disposal of three companies where operational has disappointed and the disposal of Howden Joinery Group (LSE:HWDN) as it ascended to the FTSE 100.

Notably, there was a substantial amount of takeover activity in the portfolio, with seven bids received across portfolio companies, reflective of the huge amount of private equity and M&A interest in listed UK companies.

The trust retains its largest allocations to the Industrials (36%) and Consumer Discretionary (22%) sectors, while also holding a notable overweight to Technology (12%) at near twice that of its benchmark index.

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Gearing

Gearing, while marginally lower as a percentage of NAV, remained relatively elevated throughout the period, ending at 11.5%. Given the upwards trajectory of the market and the portfolio’s companies, the contribution from gearing was a positive performance contributor and more than sufficient to offset associated costs of borrowing.

ii View

The results highlight a mixed year for HSL, but marked a notable recovery for the trust after two disappointing prior periods as the tide began to turn in favour of downtrodden smaller companies throughout the second half of the year. The results showed a positive 14.5% NAV return, and a 17.3% price return for shareholders, albeit still trailing the benchmark’s 18.2% return.

The trust’s NAV underperformance versus its small-cap benchmark is largely chalked up to stock selection, and evidently this underperformance was front-loaded in the first half of the period.

On a NAV basis, HSL sunk near 8% in the first half, while its benchmark was near flat. However, in the later six months, HSL rebounded a staggering 24% (+5.5% more than the benchmark) and rebounded more acutely than the index and peers as the market rotation in favour of oversold and devalued small-caps favoured HSL’s portfolio companies.

While in the context of the torrid investment environment of the prior two reported periods gearing had been a detractor from returns, it is encouraging that in the last year the decision to maintain and increase this level of gearing to capitalise on low valuations in anticipation of recovery across the sector finally paid off, more than offsetting the cost of borrowing.

A narrowing of the discount was also supportive for shareholders as the 13.2% discount at the start of the period shrunk to 11.5%. Post-period end, the discount has further atrophied into single digits (8% at the end of July).

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The increased full-year dividend (subject to final dividend’s AGM approval) marks the trust’s 21st consecutive year of dividend growth. While not a principal focus of the trust, the portfolio yield of 3%, marginally lower than last year on account of the uplift in share price, is towards the upper end of its peers. The distribution is more than covered by the revenue return for the year, which encouragingly showed growth on the prior year as portfolio companies returned more cash to shareholders via dividend payouts.

While the trust’s performance still disappoints versus its benchmark over the past three years, having struggled throughout 2022, the long-term track record of HSL remains very much intact. Over the past decade, HSL returned an annualised 9.4% on a share price basis, 3% more than its benchmark. And since the start of Herman’s tenure in late 2002, HSL’s return of 14.4% per annum outpaces the benchmark by 3.6%.

While UK small-caps have certainly been overlooked in favour of large global businesses, HSL’s impressive long-term record under Hermon is a reminder of the rich returns that skilled active managers can derive from this less-researched area of the market.

Challenges are still ahead and valuations of UK SMID still remain at base levels versus longer-term averages, but the market seems to finally be becoming supportive of smaller businesses, encouraged by the UK’s quick disinflation, resounding Labour victory and evident peak of the Bank of England’s tightening cycle.