Acorn Income Fund — Finding opportunities in small-cap dividend payers

So far 2016 has proved a challenge for investors in both bonds and equities, with an ongoing tension between fears over the macroeconomic environment on one hand, and the need to eke out some kind of return in a continued climate of ultra-low interest rates on the other. This was exacerbated in June by the UK vote to leave the European Union, which led to an immediate sell-off in equity markets and a collapse in the value of sterling. While the first was reversed quickly (particularly for larger stocks with greater international exposure), the pound has only recently begun to recover a little. An interest rate cut by the Bank of England to a record low of 0.25%, accompanied by a new round of quantitative easing, has further delayed the anticipated normalisation of monetary conditions on this side of the Atlantic.

While share prices have risen, corporate earnings growth remains modest. This has led to falling levels of dividend cover, particularly for larger companies, leading to the possibility of dividend cuts. In light of this, a focus on well-financed, dividend-paying smaller companies with sustainable earnings could lead to a more stable and growing income stream, although with such a large, diverse and comparatively under-researched universe of UK companies (2,000+ compared with 100 in the large-cap index), investors may prefer to leave stock selection to experts in the sector.

Acorn Income Fund (AIF) was launched in 1999 to achieve a high income and the potential for capital growth from a portfolio that blends small- and mid-cap UK equities with high-yielding securities. It is incorporated in Guernsey and listed on the London Stock Exchange. An issue of zero dividend preference shares (ZDPs) in 2011 provided structural gearing and allowed for the repayment of debt, reducing interest costs and facilitating a material increase in the dividend, which is paid quarterly. The ZDPs are due for repayment in January 2017.

The fund has two distinct portfolios, with the smaller companies portfolio advised by Simon Moon and Fraser Mackersie at Unicorn Asset Management and the income portfolio advised by Paul Smith at Premier Fund Managers, which also acts as the overall investment manager. Benchmarked against the Numis Smaller Companies (excluding investment companies) index (NSCI), AIF has a very strong longer-term performance record; 10-year NAV total return of 211.5% is almost 100 percentage points ahead of its nearest rival in the AIC UK Equity & Bond Income sector.

AIF has a five-yearly discontinuation vote, with the next vote due at the AGM on 26 September 2016. AIF’s board wishes to remind investors that in order to vote for the continuation of the fund, they must vote against the special resolution.

AIF’s three investment advisers are keen to stress that it remains ‘business as usual’ in the aftermath of the Brexit vote, with clarity yet to emerge on how or when the process will be implemented and what its impacts will be. Smaller companies were initially hit harder than larger companies and took longer to recover, but Simon Moon and Fraser Mackersie see better earnings growth from small- and mid-caps both this year and next compared with FTSE 100 companies; combined with more favourable valuations, this should translate into superior returns and more sustainable dividends.

Where valuations have begun to look stretched, putting downward pressure on dividend yields, the managers have taken profits and reinvested into cheaper stocks with higher (average 5%+) yields. This has led to the fund being able to increase its dividend materially (+14% from the first to the second interim). Special dividends have also boosted portfolio income, but the managers stress that these are in many cases semi-regular rather than one-off specials, and come from well-financed companies with strong balance sheets and confidence in the future.

The post-referendum correction brought some stocks on to the managers’ radar that they would previously have deemed too expensive, including pub company Greene King. The firm made a significant acquisition in 2015 that is beginning to reap rewards, but was heavily sold off in the Brexit fallout amid recession fears because of its UK consumer focus. Moon and Mackersie note that in volatile environments, companies may be marked down severely for no apparent reason, adding that this is often a source of opportunity for them given their knowledge of the small-cap market.

Smith has run the income portfolio with short duration in recent years, commenting that this gives him greater liquidity and a more absolute return profile that is not reliant on central bank actions. He has added some index-linked exposure as he believes the market is underplaying inflation fears. As well as increasing holdings in closed-end funds, Smith has also added two structured notes in recent months. A J.P. Morgan-structured instrument is based on the performance of four large UK REITs versus the EPRA real estate index, and has produced good returns in the post-Brexit period as large-cap REITs outperformed the index; while a Natixis-structured investment is linked to the Euro Stoxx 50 and 10-year US swap rates. This has an 8.5% yield and 35% downside protection, meaning that it will not fall in value unless one of the comparators declines by 35% or more.

The smaller companies portfolio of AIF normally makes up 70-80% of total assets, with the income portfolio at 20-30%; a 75/25 split is viewed as a neutral allocation. In the small-cap portfolio managers Simon Moon and Fraser Mackersie seek profitable companies with competitive advantages in growing markets. Stocks must be on a clear path to paying dividends if they do not do so already, as the managers believe the highest-quality companies should be able both to fund growth and reward investors with an income stream. The use of quantitative (profitability, income [yield and dividend cover], growth) and qualitative (analysis of end-markets and competitive advantage) screens narrows down a universe of more than 2,000 UK-listed companies to c 150-200 potential investments. The managers undertake c 500 company meetings annually so they can build a detailed understanding of existing and potential holdings. This gives them an advantage in assessing companies that may lack sell-side analyst coverage.

The managers limit themselves to a maximum of 50 holdings (currently 46 compared with a typical number nearer 40), which should be well financed, with high operating margins. Holdings come from across the small- and mid-cap bracket, with c 54% currently in companies with a market capitalisation below £250m. Some 38% of holdings are listed on AIM. Stocks in this area may be less liquid, and the managers hope to minimise any problems arising from this by doing their own dealing, which allows them to make best use of their networks and to be patient in building or selling down stakes. The most common reason for exiting a position is where strong capital performance has led to stretched valuations and caused a stock’s dividend yield to fall; in these situations the managers will rotate into more attractively valued, higher-yielding stocks.

The income portfolio has a threefold aim of increasing the overall yield and providing a hedge to the extra capital volatility that may come from being structurally geared and from focusing on small-cap equities. Manager Paul Smith runs a longer stock list than in the equity portfolio (69 holdings at 31 August) in spite of having a smaller portion of the overall assets; this allows him to overcome issues with bond market liquidity and take positions in smaller bond issues (such as retail bonds) that would be impracticable for managers of larger mandates. Holdings are chosen on a bottom-up basis, though Smith takes account of the macro environment and the outlook for interest rates. The portfolio is currently a mix of fixed income securities, structured investments and closed-end funds.

Following a shift in the allocation between the portfolios, AIF’s smaller companies portfolio currently accounts for the maximum permitted 80% of assets, with the income portfolio at 20%. This reflects both a degree of confidence in the equity outlook and an appreciation of the difficulty of finding attractive investments for the fixed-income portfolio in the current climate. The smaller companies portfolio (Exhibit 3) has exposure to a broad range of sectors, although the managers avoid the resources and pharmaceutical sectors as a matter of policy, on the basis that they do not have the specialist technical knowledge necessary to gain an edge over other investors in these areas. There is a tilt towards industrial companies, including a c 11% weighting in industrial transportation.

While Moon and Mackersie take a longer-term approach to investing, their focus on valuation and dividend growth potential has led to several portfolio changes so far in 2016. Longstanding industrial holdings VP (plant hire and equipment) and Diploma (specialist technical products and services) were sold after strong capital performance led to yield compression, although the managers say they would happily repurchase the stocks at a lower price. The managers used the proceeds to invest in higher-yielding stocks on more favourable valuations, specifically greetings card retailer Card Factory, logistics firm Wincanton, pub company Greene King, audiovisual equipment distributor Midwich, private airport operator BBA Aviation and in-home lender Morses Club. Midwich and Morses Club were bought at IPO, while Wincanton, Greene King and BBA Aviation were already held in the managers’ open-ended portfolios.

Former top 10 holding British Polythene Industries has exited the portfolio after being acquired by RPC Group, and mail operator DX Group was sold following disappointing performance.

While some stocks in the small-cap portfolio were negatively affected by the Brexit vote, such as top 10 holding Secure Trust Bank, the managers point to the broad diversification of the portfolio, with two-thirds of revenues coming from the UK and one-third from abroad.

In the income portfolio (Exhibit 2), exposure to banks (18.1% at the time of our last note) has fallen after some issuers used the first opportunity to ‘call’ their contingent convertibles (CoCos). Closed-end fund exposure has risen, with manager Paul Smith actively trading JPMorgan Global Convertibles Income to take advantage of falling bond yields, and buying credit hedge fund DW Catalyst and alternative finance fund Hadrian’s Wall. With value in conventional bonds hard to find, Smith has also been structuring investments with issuers such as J.P. Morgan and Natixis (see The managers’ view), and buying inflation-linked retail bonds issued by Tesco.

The first half of 2016 was a challenging period for AIF, with sentiment towards smaller companies hit by rising risk aversion at the start of the year, followed by a sharp fall in values in the immediate aftermath of the UK’s EU referendum. While the large-cap UK index bounced back quickly, smaller companies took longer to recover and AIF’s portfolio was punished more severely than the benchmark NSCI. AIF’s NAV and share price performance beat the NSCI in August, but underperformance in the first half of 2016 has dented the fund’s medium-term track record versus both the index and the wider UK stock market (Exhibits 4 and 5). However, longer-term performance remains very strong, with annualised share price and NAV returns approaching 20% over five years, and the recent uptick may point to a re-establishment of AIF’s positive long-term record (Exhibit 6).

Strong performers in the small-cap portfolio recently include concrete screeding equipment maker Somero Enterprises (which derives most of its revenues from the US and is thus a beneficiary of sterling weakness), international IT recruitment specialist FDM and transport infrastructure play Hill & Smith. The income portfolio has benefited from holdings in bonds issued by BT and ITV.

At 16 September, AIF’s shares traded at an 11.4% discount to cum-income NAV. While this is within the longer-term range, it is wider than the average over one, three and five years. A tension between the attraction of a high dividend yield (4%+) and the swings in sentiment towards smaller companies, which are seen as more risky than large-caps, has seen the fund move between a premium and a discount over recent years. Unusually, the shares spiked to a three-year high premium of 5.9% in the immediate aftermath of the EU referendum – a period in which most investment trust discounts widened – because the prices of the underlying small-cap stocks declined more quickly than the price of AIF’s own shares, leading to a steep (if swiftly reversed) fall in the NAV.

AIF currently has two classes of share, with 15.9m ordinary shares and 21.4m ZDPs in issue. The ZDPs mature in January 2017 and the board and management of AIF are considering options for replacing them, possibly with a rollover issue of ZDPs or with another form of leverage. The ZDPs have a final capital entitlement of 138p and at 9 September traded at a price of 136p with a NAV of 134.5p. Gross gearing via the ZDPs was 47.2% at 1 September.

An annual management fee of 0.7% of AIF’s total assets is payable to Premier Asset Management (Guernsey), from which fees to the investment advisers are paid. A performance fee of 15% of excess returns may be payable if the NAV per share plus dividends has grown by more than 10% per annum compound since the last year-end in which a performance fee was paid. No performance fee has been paid since FY13. We calculate ongoing charges at H116 (30 June 2016) as 1.6%.

AIF pays dividends quarterly, in March, June, September and December. In the last three financial years, the first interim dividend has been set at the same level as the fourth interim of the previous year, with a higher second interim setting the bar for the rest of the year. On this basis, with one dividend of 3.5p and two of 4.0p declared so far for FY16, it would be reasonable to assume a total for the year of at least 15.5p, a prospective yield of 4.5% based on the 16 September share price.

Dividends have been fully covered by income in each of the last five financial years and have grown at a compound annual rate of 14.5%. Based on guidance for the FY16 dividend, the payout will have more than doubled since 2011, when the introduction of the ZDPs allowed the repayment of bank borrowing, reducing interest costs and allowing a materially higher dividend to be paid.

AIF is a member of the AIC UK Equity & Bond Income peer group. The sector contains funds that hold a mix of equity and bond investments, although the split between asset classes varies and most of the peers have a larger-cap equity focus. Strong longer-term performance means AIF is comfortably top of the group for NAV total returns over five years, while the more challenging recent conditions have seen it slip to last place over 12 months and mid-table (although still above average) over three years. Ongoing charges are in line with those of its closest peer (run by Aberdeen), and AIF is one of three funds with a performance fee structure in place. The ZDPs give AIF the highest level of gearing in the sector, while the yield and the discount are both broadly in line with the unweighted average. Risk-adjusted performance as measured by the Sharpe ratio is below average over one year, but in line over three years.

There are three non-executive directors on the board of AIF. Helen Green became a director in 2007 and has served as chairman since 2012. Nigel Ward was appointed in 2011 and David Warr joined the board in 2012. The directors have professional backgrounds in accountancy and investment management and all are resident in Guernsey, where AIF is incorporated.