Smithson Investment Trust: two favourite stocks

Simon Barnard, portfolio manager at Smithson Investment Trust (LSE:SSON), explains to interactive investor's Kyle Caldwell how he finds quality businesses to invest in, recent portfolio activity and shares he owns that will continue to benefit from changes brought about by the pandemic.

Kyle Caldwell, head of collectives at interactive investor: “I wanted to kick off with Smithson's (LSE:SSON) motto, which is “small and mid-cap investments that have superior operating numbers”. Could you run through how you find these quality businesses that in theory should stand the test of time?”

Simon Barnard, portfolio manager of the Smithson Investment Trust:“Yes, absolutely. I mean the whole concept is that we are very, very strict in our criteria of looking for these companies. So, the first thing we do is that we take our reference index of around 5,000 names and we screen those down using financial criteria. So, this includes metrics such as return on invested capital, profit margins and growth, and when we originally did this two years ago, after also excluding certain sectors that we just don't think generate value over time - so those include very cyclical sectors or those with a lot of debt, so things like airlines and autos, or the commodity industries - that all boiled down to around 150 companies.

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“And then we took those 150 companies and did very deep-dive research on each one. So that took nearly a year going through that process, and that eventually left us with about 80 companies. We threw out about 70 that still weren’t up to our standard. And this now is what we call our investable universe. So, these are the stocks that we really think are very high quality and the only ones that we'd consider investing in. And then what we do is ball that further down into the portfolio itself, which we aim to be between 25 and 40 companies, currently it's 31 companies, but we select all those from that longlist of around 80.

“So, you know, it is worth remembering that we're looking at smaller mid-caps, but our version. You know, we’re not looking at micro caps, what many people think of as small cap, actually, we’re looking at those companies between £500 million in market cap and £15 billion. And actually, the average company is above £8 billion, so, you know, this is a relatively larger company than people think in small cap.

“And the reason for that is that we are looking for those companies that have already won in their niche or marketplace. You know, we're not looking for these micro caps that are still pre-profit or, you know, trying to establish themselves in the marketplace. In fact, the median company in our portfolio has been around since 1973, so we've got a lot of historical information to analyse and [a] track record to look at.”

Kyle:“It sounds like you are able to find enough of these quality businesses in the sort of mid and smaller-cap segment of the market. In terms of portfolio turnover, obviously part of the Fundsmith mantra is to trade as infrequently as possible. But how does trading activity compare, say, to Fundsmith Equity, given that you invest in the mid and small cap?”

Simon:“Yeah, I mean our turnover is still very low. It’s hard to compare to Fundsmith Equity in direct statistics because, for example, our turnover was around 6% in 2019 and for Fundsmith Equity their number was minute 4%. So why is that negative? Well, actually, it's because their fund had more subscriptions than they did actual turnover, so subscriptions count as negative, so overall it was a negative number, which is almost impossible to draw any conclusion from.

“So, if we looked at it another way, perhaps, we could say that in Smithson we bought one company and sold one company last year, whereas Fundsmith Equity bought two companies and sold two companies. So, I would say, actually, they're very similar, but, importantly, both are very, very low relative to the broader asset management industry, which is far higher than that.

“Even still, you know, I would say for Smithson, buying one and selling one is actually very low even for us, so maybe over the longer term in the future that might increase slightly, but we’d still keep that very low because ultimately we are very long-term shareholders.”

Kyle:“In terms of that one purchase made, was it made during the first quarter of this year when markets  heavily sold off in response to the threat of Covid-19? I also wanted to ask, in terms of your existing holdings, did you use that period of share-price weakness as an opportunity to top up some positions that perhaps fell a bit more than you expected?”

Simon: “Yes, we did. We did both, actually. That buy one and sell one was actually for 2019. In 2020, so in the first half of this year, we actually bought two companies, and we also did top up some other positions. So, the companies we bought: one was Rational (XETRA:RAA), a German oven manufacturer. They actually target professional kitchens and their ovens are very highly automated. So, the technology involved is way ahead of [the] competition and the brand name Rational is very strong in the professional chef markets. In fact, there is a Rational oven in both the White House and Buckingham Palace. They're really considered [to be] the best you can get.

“And the other company [we bought] was Qualys (NASDAQ:QLYS). This is a security software company specifically targeting end-point assets connected to corporate networks, so laptops and phones connected to corporate networks. As you might imagine, the cybercrime and hacking is continuing to rise very strongly, and so the necessity [is] for such software to cover all of those end points, particularly to automate the patching and security required for each of those. What many people don't realise is that a lot of hacking is down to human error where vulnerabilities appear in networks because people haven't properly patched them. Well, what Qualys does is scans the entire network across all the assets and constantly patches those automatically, taking out the human error.

“In terms of your other question, which [was about] any other trading activity that we did, we actually also trimmed some companies. We had several healthcare companies that did incredibly well over the period because they saw a large demand increase from Covid, and some of their share prices actually rose over a 100%. So, we found ourselves in the position where, actually, we had some very large positions in healthcare companies in the portfolio, because the general portfolio had drifted down with the market, while those healthcare positions had doubled, and so at the same time the valuation is obviously less attractive than it was.

“So we decided to trim some of those positions down to more appropriate levels, and then reinvest that cash back into a few of our industrial companies, which had fallen because of the concerns around Covid and the lower economic activity, and obviously [this] helped us to buy those two new companies which I just mentioned.”

Kyle:“And just to add to that, there's been a lot of talk among investment commentators that coronavirus has accelerated certain pre-existing trends following the systemic changes that have seen millions of people work from home over the past couple of months. Are there examples of some of your winners of the pandemic in which these sort of pre-existing trends did strengthen?”

Simon: “Yeah, Qualys is one good example because obviously with the movement [to] working from home there are a lot more laptops and endpoint assets connected to corporate networks, so they certainly benefited. But I think another good example in our portfolio is a company called Ambu. This is a Danish healthcare device company, which makes disposable endoscopes. So, as you know, the endoscope is what doctors use to look inside patients. And, in Europe particularly, every Covid patient that comes into the hospital is looked at, with a doctor, using an endoscope in their lungs. What they discovered is that because most endoscopes are reusable, in fact, they are used hundreds of times on patients before being thrown away, subsequent patients were catching Covid from the prior patient [using] the endoscope.

“And further to that, the people cleaning the endoscopes in between procedures were also catching Covid, so that risk of infection was far higher in a Covid environment than they'd witnessed before. And so, you can imagine that Ambu, being by far the largest producer of disposable endoscopes where you just use it once and throw it away, saw a surge in demand given that risk of re-infection [is] obviously down to zero with a disposable endoscope. In fact, they saw their scopes up 71% in Q2, which was the main Covid period.

Kyle:“Simon, thank you very much for your time today. Lots of interesting points made. Thank you.”

Simon:“It's been a pleasure. Thanks very much.”

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