Smithson underperforms for the first time, here’s why

The trust applies the investment philosophy of Terry Smith’s Fundsmith Equity fund to smaller companies. 

Smithson (LSE:SSON) investment trust underperformed its benchmark for the first time since launch in the first half of this year. 

The trust, managed by Simon Barnard, returned 4.1% in share price terms, while its net asset value (NAV) return stood at 5.9%. The MSCI World Small and Mid Cap Index, its benchmark, was up 12.4%.

The trust, which applies the investment philosophy of Terry Smith’s Fundsmith Equity fund, but instead focuses on global smaller companies deemed too small for the original Fundsmith, has notably outperformed since it launched in October 2018. Over this period, the share price total return is 78% and its underlying investments, the NAV, have risen by 74.7%. In contrast, the benchmark is up 41%.

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Barnard gave a couple of reasons why the companies Smithson owns did not keep pace with the benchmark.

First, he pointed out that expectations of higher inflation “reduces the value of higher rated growth companies, such as those owned in the portfolio, because the future earnings of these companies would have a lower perceived value today, once discounted back at the higher interest rates”.

He added: “More lowly rated companies, that don’t grow as fast, have less of their earnings in the future to discount, and so are less affected by this phenomenon.”

However, Barnard said that a period of higher inflation is not something he fears. “It is worth noting that inflation itself would likely not cause a significant problem for our companies. The companies we own tend to have low input costs, and subsequently high gross margins, as well as low capital requirements, allowing them to generate high returns on capital.”

The second issue, which Barnard said is somewhat linked, is that value shares enjoyed a resurgence in the first half of 2021. Smithson invests in ‘growth’ rather than ‘value’ shares.

“In a world with resurgent growth, investors are less willing to pay high valuations for companies that can grow consistently through good times and bad, such as those in our portfolio. Instead, they buy ‘cheap’ or ‘value’ companies, because they will also grow in this improving environment. As the saying goes, a rising tide lifts all boats. This meant that such ‘value’ companies did relatively better in the first half than the types of companies we own,” said Barnard.  

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The fund manager added that the performance of Smithson’s underlying investments in the first half of 2021 was “adequate compared to our own expectations, being an annualised gain of 12.3%”.

He also pointed out: “It is also the case that the underperformance was predominantly due to the macroeconomic factors discussed above and there were no serious underlying issues with any of the companies we own. In fact, we were very satisfied with the earnings reported by the vast majority of the portfolio companies during the period, given the obvious difficulties faced by many.”

In the six-month period, two new companies were added to the portfolio: Rollins (NYSE:ROL) and Wingstop (NASDAQ:WING). Rollins is a US-based pest control business and Wingstop is a franchised chicken wing restaurant and delivery business.

In the first half of 2021, the trust consistently traded at a premium to NAV. The average premium over the period was 2.3%.