Acorn Income Fund Limited — Income and growth with UK small-cap bias

Equity markets began 2018 in a continuation of the buoyant mood of 2017, before a spike in volatility saw a relatively sharp sell-off in February and March. Earnings growth was historically high in 2017, supporting higher share prices, but a number of geopolitical and macro factors have weighed on markets so far this year, including inflation, central bank policy, the UK’s protracted negotiations to leave the EU, and the potential for a global trade war sparked by US protectionism. While markets have largely recovered from the dip in the first quarter of 2018, there is still potential for further upsets, with the higher level of volatility so far this year suggesting that fear may be overcoming greed in the minds of investors. The large-cap UK FTSE 100 index has recently reached a new all-time high, although Exhibit 2 shows that over time, smaller companies have outperformed the UK market as a whole. Dividends remain an important part of total returns, and are perhaps surprisingly higher among smaller companies than among mid-caps, with the FTSE Small Cap index yielding 3.1%, compared with 2.7% for the mid-cap FTSE 250.

AIF was launched in 1999 as a Guernsey-domiciled closed-end fund and its two share classes (ordinary shares and zero-dividend preference shares, or ZDPs) are listed on the London Stock Exchange. It aims to achieve a high income and the potential for capital growth through a dual-portfolio structure split between UK smaller companies (c 70-80% of assets) and an absolute return-focused income portfolio offering a higher yield than conventional bonds (c 20-30%). The fund is managed by Premier Asset Management (Guernsey), which delegates portfolio management to two investment advisers: Unicorn Asset Management (Simon Moon and Fraser Mackersie) runs the smaller companies portfolio, while the income portfolio is managed by Premier Fund Managers (Paul Smith and team). In line with the primary focus on UK smaller companies, AIF uses the Numis Smaller Companies (excluding investment companies) index (NSCI ex-ICs) as a benchmark. It also measures returns with reference to the FTSE All-Share, FTSE Small Cap and BofA Merrill Lynch Sterling non-Gilts indices. The fund is a member of the AIC’s UK Equity & Bond Income sector. The portfolio is constructed without reference to any of these benchmarks, and the smaller companies portfolio is biased to the smaller end of the smaller companies universe (at 31 December 2017, two-thirds of the portfolio was invested in companies with a market capitalisation below £500m).

AIF is structurally geared through its ZDPs, which were issued as a rollover from the 2011 issue in January 2017, with a fixed life until February 2022 and a gross redemption yield of 3.85%. This structure gives AIF the benefit of gearing without the burden of interest costs, facilitating the payment of a higher dividend since the ZDPs were first introduced in 2011.

Moon and Mackersie retain a bias to UK companies with domestic earnings (c two-thirds domestic versus one-third overseas), insulating the smaller companies portfolio from threats of a global trade war, while still diversifying some of the risk that may arise from Brexit negotiations. The managers say their portfolio companies are generally optimistic on the outlook for the negotiations and are taking a pragmatic and sensible view of any changes that may be necessary as a result of the UK’s exit from the EU. Moon and Mackersie have added to consumer stocks that suffered in the market volatility earlier this year, increasing their position in Card Factory on share price weakness. The company subsequently reported strong like-for-like sales growth and announced a special dividend.

The managers expect dividend growth in line with earnings growth forecasts of c 10% for 2018 and report that they have seen many companies increase their payout ratios, including FDM and Hill & Smith. Dividend cover on the underlying portfolio is also strong, at 2x historic dividends, supporting further dividend increases within the portfolio and also underpinning AIF’s own record of dividend growth. While the failure of Conviviality in March has had an impact on revenue income, this has been offset in absolute terms by strong growth and special dividends elsewhere in the portfolio.

In the income portfolio, the managers still see inflation and interest rate rises as the primary risks. Bond spreads (the difference between coupons on riskier corporate debt and safer government bonds) are still very tight, meaning any increase in central bank rates could make the risk/reward balance of some corporate debt look unattractive. As a result, Smith and the team are retaining their absolute return focus, holding a blend of short-dated bonds, high-yield issues and less mainstream assets, such as investment company BioPharma Credit, where the 7% yield is underwritten by royalty payments on drug sales. The managers continue to see the outlook for fixed income as challenging and as such the income portfolio remains below 20% of AIF’s total assets.

While the split between AIF’s smaller companies and income portfolios is broadly in the range of 70-80% small-cap and 20-30% income, the opportunities available in each segment will determine the exact split, which is agreed between the board, the manager (Premier Asset Management) and the investment advisers at Unicorn and Premier. The smaller companies portfolio is expected to provide the majority of both capital growth and income, while the income portfolio aims to provide diversification of capital and income returns, potentially limiting the impact of equity market volatility, and to manage the level of structural gearing that exists through the ZDPs.

Moon and Mackersie begin the process of stock selection for the smaller companies portfolio using quantitative screens to filter their large investment universe (there are more than 800 companies in the small and mid-cap Numis Smaller Companies index, which covers the smallest 10% of UK-quoted stocks by market capitalisation). The screens allow the managers to assess factors such as profitability, growth potential, valuation, and income factors including yield, dividend cover and dividend growth. The managers also make a qualitative assessment of competitive factors and the attractiveness of companies’ end markets. Company meetings are an essential part of the process, with Moon and Mackersie undertaking c 400 meetings and site visits each year with both current and potential holdings. Ideas often arise through the managers’ own knowledge and networks; an example is the recent purchase of paving company Marshalls, a long-standing holding in the Unicorn UK Income fund, where a drop in the share price combined with continued progress in the dividend meant that it fell within AIF’s remit for the first time.

The managers have a strict 50-stock limit, which keeps them focused on the companies with the best combination of yield and growth potential. All holdings must be profitable and well-financed, with high operating margins and strong positions in growing end markets. There is a strong preference for stocks offering a good yield, although companies that do not currently pay a dividend may be included as long as there is a clear path to their doing so. The most common reason for exiting a holding is where the share price has risen to the extent that the yield no longer looks compelling; in such cases the managers will rotate into better-value, higher-yielding alternatives.

The income portfolio managers seek assets with attractive yields relative to bond market averages in a variety of areas, including government and corporate bonds, investment companies and structured notes. The relatively small size and diversified nature of the portfolio (which has a longer stock list than the small-cap allocation) means the managers are able to access small issues such as retail bonds, which often offer higher yields than those aimed at institutional investors.

Hedges may be used in order to limit downside risk in the equity portfolio or duration (interest rate sensitivity) in the income portfolio. There is currently a short position in long-dated gilts to limit interest rate risk in the income portfolio, but the smaller companies portfolio is unhedged.

At the 31 December 2017 year-end there were 49 stocks in AIF’s smaller companies portfolio and 72 holdings in its income portfolio. The top 10 holdings at 30 April 2018 were all from the smaller companies portfolio, and made up 23.9% of the total portfolio compared with 24.5% a year earlier. The largest sector weightings in both portfolios (Exhibits 3 and 4) at 30 April were to financial services. This represented a small increase (+1.5pp) over 12 months for the smaller companies portfolio and a larger increase (+5.8pp) for the income portfolio. Support services, previously the largest sector in the small-cap portfolio, fell by 4.1pp over the year, while the income portfolio saw a reduction in its closed-end fund exposure, although this remains an interesting area of opportunity for the managers.

New holdings in the small-cap portfolio in recent months include two companies bought at IPO: adviser-focused investment platform Transact’s parent company IntegraFin (up c 40% since coming to the market in February 2018) and specialist motor insurance firm Sabre Insurance, which focuses on offering cover to drivers deemed too risky by mainstream insurers. The managers have also purchased tenpin bowling operator Hollywood Bowl, paving company Marshalls and specialist steel fabricator Severfield. These have all paid, or are likely to pay, special dividends and were purchased on 12-month forward yields of 3.6%, 3.3% and 3.5% respectively. Moon and Mackersie exited positions in UPVC window firm Safestyle (held since IPO in 2013, it was sold at c 230p a share and the share price has since fallen to c 60p); publishing company Quarto, where operational issues meant the managers were less confident in the dividend; car dealer Pendragon and carpet company Headlam, which were both sold in response to more difficult end-market conditions as consumers scale back on big-ticket purchases.

In the income portfolio, the managers have bought into small retail corporate bond issues from companies such as Helical and Workspace (both property-focused), which were offering yields of 2.5-3.0% for a two- or three-year maturity, compared with 1.4% for a 10-year gilt. While the overall investment company weighting has fallen, the team has taken part in several new issues, such as a ZDP issue from RM Direct Lending, and C shares from BioPharma Credit and SQN Asset Finance, as well as initiating positions in the ordinary shares of Tetragon Financial Group and UK Mortgages. Taking the view that inflation risk is under-appreciated, they also bought some long-dated US index-linked bonds (treasury inflation-protected securities, or TIPS). Sales have generally been from long-dated assets (such as 30-year EDF bonds), in line with the managers’ desire to limit duration risk.

AIF’s share price and NAV bounced back strongly in April following widespread market declines in February and March. Total returns over all periods shown in Exhibit 5 are positive, and while the NAV total return lags the benchmark NSCI ex-ICs over three, six and 12 months, reflecting the impact of the collapse of former largest holding Conviviality in March, AIF has outperformed both its benchmark and the wider FTSE All-Share index over three, five and 10 years in share price and NAV total return terms (Exhibit 6). Over 12 months to early May, Conviviality was the only detractor of more than 100bp, costing 2.4pp of performance, although over the life of the holding total returns were positive and the managers of the smaller companies portfolio took profits in late 2017. The top five positive contributors together added 687bp to AIF’s NAV, led by Midwich (share price up 120% over 12 months to 11 May, adding 185bp to AIF’s performance), discoverIE (+68% and 150bp), Macfarlane Group (+43% and 130bp), Numis Corporation (+55% and 120bp) and Somero Enterprises (+20% and 102bp). The Midwich position has been trimmed into strength, while the others now make up four of the top five holdings. The managers of the income portfolio remain focused on absolute return opportunities and bonds offering positive real yields against a backdrop of rising inflation expectations.

At 4 June 2018, AIF’s ordinary shares traded at a 1.7% discount to cum-income NAV. While this was wider than the 12-month low of 0.1% reached in mid-March, it is narrower than the averages over one, three, five and 10 years (4.2%, 5.4%, 5.0% and 9.8% respectively). In the past the fund has frequently traded at a premium and has the potential to do so again if the recent positive performance is sustained. No shares have been issued or repurchased since January 2017.

AIF is a closed-end investment company incorporated in Guernsey and listed in London. It has two classes of share, with 15.9m ordinary shares and 21.4m ZDPs currently in issue. The ZDPs, which provide the fund with structural gearing (41.4% gross at 30 April 2018), mature in 2022 and have a gross redemption yield of 3.85%. Shares may be issued or repurchased in order to manage a premium or a discount; where this occurs, ZDPs will also be allotted or bought back in order to maintain the gearing ratio. No buybacks or allotments have occurred since January 2017.

Annual management fees of 0.7% of total assets are paid to Premier Asset Management, which in turn pays fees to the smaller companies and income portfolio investment advisers at Unicorn and Premier. A performance fee (15% of returns above the hurdle) may be paid if AIF’s NAV per share plus dividends has increased at a compound annual rate of more than 10% since the last year-end at which a performance fee was paid. A performance fee of £559,967 was accrued in respect of FY17, the first time such a fee has been paid since FY13. Ongoing charges (excluding performance fees) were 1.53% at end-FY17.

AIF aims to provide its investors with a high level of income as well as potential capital growth and pays dividends on its ordinary shares quarterly, in March, June, September and December. Having historically increased the quarterly dividend at the second interim stage, FY18 has been the second consecutive year that the increase has been brought forward to the first interim payment. Four dividends of 4.5p (total 18.0p) were paid in respect of FY17, with the first interim dividend for FY18 having been set at 4.95p. If last year’s pattern is maintained, this suggests total dividends for the year of c 19.8p, which would be a 10% y-o-y increase (FY17: 18.0p, FY16: 15.5p). Revenue returns per share in FY17 were 20.36p (FY16: 27.19p) and the company again added to its revenue reserve, which stood at c 1.0x the annual dividend at the year-end. Based on the 4 June 2018 share price and the last 12 months’ dividends, AIF’s ordinary shares currently yield 4.0%.

AIF is a member of the AIC UK Equity & Bond Income sector, a small peer group made up of funds with an income focus that may invest in both equities and bonds. There are five funds in the sector, a reduction from seven since our last note, following the reclassification of one fund (F&C UK High Income) into an equity sector and the rollover of another (Jupiter Dividend & Growth into Jupiter UK Growth). Of the remaining peers (which may hold up to 100% in either equities or bonds, but must be at least 80% invested in the UK), the most comparable with AIF is Aberdeen Smaller Companies Income. Within the peer group, AIF’s NAV total return performance ranks it fourth out of five over one year, first over three years, second over five years and first (by a margin of almost 150pp) over 10 years. Ongoing charges are above average and AIF is one of two funds to charge a performance fee. In a sector where two of the peers currently trade at a premium, AIF has the smallest discount to NAV. Gearing is the highest in the group because of AIF’s structure (with structural gearing via its ZDPs). The dividend yield is below average for the sector but above that of the closest peer.

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