Market volatility providing more opportunities

Over the last five years, in sterling terms, the US market (both large and small caps) has meaningfully outperformed the domestic FTSE All-Share index (Exhibit 2, LHS). This is partially due to the UK’s currency weakness but also reflects a highly entrepreneurial culture in the US, along with a reduction in corporate tax, which, in aggregate, have enabled American companies to deliver superior earnings growth.

In terms of valuation, US companies (measured by the Datastream US index) are trading on a forward P/E multiple of 17.3x, which is a 17.2% premium to the world market, somewhat higher than the 15.9% and 13.3% average premiums over the last five and 10 years respectively.

Along with the risk inherent in above-average valuations, there is potential for further reductions in earnings estimates as the escalating trade dispute between the US and its trading partners begins to have a more visible effect on corporate profitability. With this uncertain backdrop, investors may be rewarded by being more selective; a fund investing in niche businesses aiming to generate capital growth in rising markets while preserving it in more volatile times could hold some appeal.

JUS was launched in March 1993 as the F&C US Smaller Companies Trust. In 2014, manager Robert Siddles moved from F&C Asset Management to Jupiter Asset Management, taking the trust with him. He aims to generate long-term capital growth from a diversified portfolio of quoted US mid- and small-cap companies. The manager employs a risk-averse approach, aiming to preserve capital in periods of stock market weakness by investing in high-quality companies whose share prices reflect limited downside risk.

The trust’s portfolio typically has c 40–50 holdings (primarily in the $100m to $10bn market cap range), which can broadly be considered as one of two types of value stock: firms that can grow and compound over the long term, and recovery and turnaround situations, which are held with a shorter-term, two- to three-year view. JUS does not pay dividends. Since end-September 2017, it has had the ability to employ gearing up to a maximum of 20% of total assets (net gearing of 4.8% at end-May 2019). Data from Jupiter show the potential relative benefits of considering investing in US small-cap companies. Between 1970 and 2016, the asset class generated total sterling returns of 13.3% pa, which is meaningfully higher than 11.7% pa from UK stocks and 10.9% pa from US large-cap stocks.

Siddles says the US economy remains reasonably strong; while the key ISM Purchasing Managers Index has fallen from its cyclical high point, it is still indicating good growth. The manager explains that at the end of 2018 there were concerns about slowing economic activity, principally outside the US, although domestically there were signs of a slowdown in the volatile auto, housing and energy sectors. Global stock market weakness in Q418 was exacerbated by an escalation in the trade dispute between the US and China; however, the US, along with other markets, rallied strongly in Q119 as investors gained confidence in a resolution to the trade issue and the US Federal Reserve adopted a more dovish approach to monetary policy, suggesting no interest rate hikes in 2019. The manager says the catalysts for a market rally in Q119 were in place at the end of 2018: more confidence in earnings growth, a favourable monetary environment and weak investor sentiment. Siddles has taken advantage of stock market volatility in recent months to both initiate and sell out of a selection of JUS’s holdings (highlighted in the Current positioning section); he says all of the trades were undertaken on a stock-specific basis, rather than as a result of focusing on certain themes within the portfolio.

The manager highlights a potential changing feature of the US stock market that could provide a tailwind to JUS’s performance – relative weakness in technology shares. He notes this segment of the market has been particularly strong for the last decade and sector leadership typically runs in 10-year cycles; at the end of this period, there are no more bears left to convert to bulls, sceptical investors either capitulate or lose their jobs. Siddles suggests there are now greater question marks over the technology industry’s fundamentals, such as mobile phone growth having peaked, and a slowdown in the US auto industry, which is a large user of semiconductors.

There are myriad smaller-cap US companies available to invest in, many of which are relatively immature, either financially or operationally, or in terms of management experience or market position. To mitigate these risks, the manager focuses on companies with a strong franchise that generate significant amounts of free cash flow, have high insider ownership and are trading on reasonable valuations. He notes that many smaller US companies are under-researched, offering the potential for undiscovered value.

Siddles employs a rigorous three-stage, bottom-up stock selection process, aiming to generate long-term capital growth while limiting downside risk. Stage one is a quantitative screen of the investible universe of c 3,000 stocks with market caps between $100m and $10bn, seeking companies that have suffered share price weakness (either short or long term). Stage two is a qualitative risk assessment, aiming to identify and avoid value traps, which are shares that look attractively priced but are unlikely to appreciate in value. There are certain sectors that the manager favours, such as those providing essential goods and services, and areas he largely avoids, including technology and restaurants. He also considers industry cycles, including past bubbles, global capital flows and sector-specific problems. Siddles employs a ‘good company test’; a potential investee company must pass all five elements of this to be considered for inclusion in the fund. They are: a strong franchise; robust levels of free cash flow; a high level of insider ownership; potential pricing flexibility; and a cheap valuation (at least 50% upside potential). Very few companies make it to stage three of the investment process, which is in-depth fundamental analysis, including a detailed financial model.

Portfolio holdings broadly fit into two main categories: compounders (companies that can grow consistently and be held for many years); and recovery stocks, where the manager has a shorter-term time horizon.

There are three disciplines for selling a stock: for fundamental reasons, such as a deterioration in growth prospects; a market sale if a company has grown too large or lacks the potential for further upside; or for portfolio considerations – if a holding exceeds 10% of the fund, an industry exposure rises above 15%, or if there is a more attractive opportunity available.

In October 2017, the manager announced enhancements to JUS’s investment process, including holding a more concentrated portfolio, running winning positions for longer and being more willing to sell underperforming stocks. This strategy has proved very successful, as highlighted in the Performance section on pages 6 and 7.

In keeping with other Jupiter fund managers, Siddles has a keen focus on corporate governance. There are three pillars to the analysis:

Siddles has continued to concentrate JUS’s portfolio; at end-May 2019, the top 10 positions made up 41.1% of the fund, 4.5pp higher than 36.6% a year earlier. The trust’s sector exposures are shown in Exhibit 3, with the most notable changes over the past year being higher weightings in healthcare (+4.7pp) and consumer staples (+3.9pp).

Higher stock market volatility has led to an increase in portfolio turnover as Siddles seeks to capitalise on a wide range of investment opportunities; over the last six months, it is running at an annualised rate of c 40%, which is broadly double the typical level. The manager highlights the main portfolio changes that have been undertaken since our last report was published in November 2018, starting with the new positions:

Positions that have been sold in recent months include: CatchMark Timber Trust (timber price weakness due to higher harvests and slow recovery in the housing sector); Civitas Solutions (bid for by a private equity firm); Gray Television and LiveRamp (both on valuation grounds); Michaels Companies (craft retailing is a very competitive market); Netgear (competitive threat from Amazon); RPC (oversupply in the pressure pumping market); and Wabtec (a major acquisition clouds the investment case).

Over the last 12 months to the end of May, JUS has solidly outperformed its benchmark, with NAV and share price total returns of +1.9% and +2.1% respectively versus a -5.3% index total return. Strong contributors to performance in recent months include holdings in America’s Car Mart (auto retailing), DMC Global (metalworking) and Ensign Group (healthcare facilities), while positions such as Bottomline Technologies (electronic payments) and Brookdale Senior Living (assisted living facilities) have detracted from returns. The trust has generated solid absolute performance over the long term (Exhibit 5, RHS). Over three, five and 10 years, NAV and share price total returns are between 9.6% and 16.9% a year.

JUS’s relative returns are shown in Exhibit 6. It has outperformed its benchmark in both NAV and share price terms over one and three years, while lagging over five. Over 10 years, its NAV is broadly in line, while its share price has outperformed. The trust has generated markedly superior returns versus the FTSE All-Share index over one, three, five and 10 years. Looking at the three-year NAV relative performance in Exhibit 7, the benefits of tightening up the investment process, including a more concentrated portfolio and running winning positions for longer, are clear to see. Since October 2017, JUS has outperformed its benchmark by c 15pp.

JUS’s shares are currently trading at a 9.1% discount to NAV. This compares with a range of discounts between 1.2% and 11.4% over the last 12 months, and average discounts of 7.8%, 9.0%, 9.1% and 6.2% over the last one, three, five and 10 years respectively.

The board actively repurchases the trust’s shares, aiming to keep the discount at or below 8% in normal market conditions. During H119, the board bought back a modest 0.2m shares at an average discount of 8.5%. There is scope for JUS’s discount to narrow, given the manager’s improved performance since the investment process was enhanced in October 2017.

JUS is a conventional investment trust with one class of share; there are 14.0m ordinary shares in issue. It historically did not employ gearing, but since 29 September 2017 has had a flexible loan facility with Scotiabank (Ireland). JUS is permitted to gear up to a maximum 20% of total assets; $15m is currently drawn (increased from $10m in March 2019 to fund new purchases), and net gearing was 4.8% at end-May 2019.

Jupiter Unit Trust Managers receives a management fee of 0.75% of net assets up to £150m, 0.65% between £150m and £250m, and 0.55% above £250m. (Before 1 October 2017, there was a flat management fee of 0.80% of NAV and there is no longer a performance fee.) In H119, JUS’s ongoing charge was 0.97%, which was 5bp lower than 1.02% in FY18.

US smaller companies are not a high-yielding asset class and JUS focuses on long-term capital growth rather than income; therefore, it does not pay a dividend. In FY18, JUS’s £1.4m revenue income was more than offset by management fees and other expenses.

JUS is one of just two trusts in the AIC North American Smaller Companies sector; they are not directly comparable as JUS has a value bias, while JPMorgan US Smaller Companies has a growth bias. JUS has a higher NAV total return over the last 12 months, but its performance has lagged over the other periods shown, which have been characterised by the outperformance of growth rather than value stocks. The trust has a lower ongoing charge, a higher level of gearing, but unlike its peer, JUS does not pay a dividend.

To enable a broader comparison, in Exhibit 9 we also show the sterling share classes of open-ended US smaller companies funds. JUS has outperformed the average of the open-ended funds over one year, while lagging over three, five and 10 years.

There are five directors on JUS’s board, all of whom are non-executive. The chairman is Gordon Grender, who joined the board at the trust’s inception in 1993 and assumed his current role in October 1998. Norman Bachop joined the board in February 1999 and has been the senior independent director since June 2007. The other three directors and their dates of appointment are Peter Barton (February 1998), Clive Parritt (January 2007) and Lisa Booth (September 2015). Changes in corporate governance rules mean directors that have served more than nine years are no longer considered to be independent. The directors have experience in financial services, including investment management, private equity, corporate finance, investment banking, law and accountancy.