Jupiter US Smaller Companies — New initiatives from US small-cap value specialist

In its annual results to 30 June 2017, published in October, the board of JUS announced a number of new initiatives designed to enhance shareholder value. In addition, the manager has indicated some small changes to the investment process in order to improve long-term performance potential.

Jupiter US Smaller Companies (JUS) began life as the F&C US Smaller Companies investment trust in 1993, taking on its current identity in 2014 after its manager since launch, Robert Siddles, moved from F&C Investments to Jupiter Asset Management. The trust seeks to achieve long-term capital growth by investing in small and mid-cap US companies in the $100m to $5bn size bracket. The manager has a value-orientated approach, with a focus on capital preservation as well as growth. All holdings must pass a rigorous ‘good company test’ to be considered for inclusion in the portfolio of c 50-60 stocks. Siddles seeks to blend companies that can grow and compound returns over the long term, with recovery and turnaround situations, usually held for a shorter period of up to three years. Given that US small and mid-cap companies are not generally high yielding, JUS does not pay dividends. It has also historically not used gearing; however, it has recently put a borrowing facility (£20m, or c 12% of net assets) in place for the first time.

Siddles notes that JUS’s value style has been a relative headwind over most of the past decade, a period that has seen growth stocks – particularly those in high-tech areas – outperform. He points out that using the Fama-French high minus low model of measuring rolling 10-year value versus growth stock performance, since 2014 the cheapest US stocks have underperformed the most expensive to an extent seen only twice before in the past 80 years. This occurred during the Great Depression in the 1930s, and the tech bubble in the 1990s, and in both previous cases, value went on to outperform strongly. Studies suggest that over the very long term, stocks in the cheapest valuation quintiles have done significantly better than those that are more expensive.

The manager argues that with some of the big US tech stocks having struggled over the summer to achieve new highs, there may be cracks appearing in the growth stock bull market. Meanwhile, there are mixed signals on the US economy, with indicators such as purchasing managers’ indices (PMIs) still strongly in expansionary territory, while an uptick in consumer credit delinquencies, at a time when interest rates and inflation are rising, could point in the other direction. Should markets be spooked by rate rises, geopolitics or overstretched valuations, Siddles points out that his strategy (both JUS and the open-ended Jupiter US Small and Midcap Companies fund) has tended to protect capital better than peers in more challenging market conditions. Meanwhile, an increased focus on maximising gains from winning stocks, by avoiding early profit taking, could stand the trust in good stead if the market continues to test new highs.

Siddles aims to blend two broad types of stock in JUS’s value-orientated portfolio: ‘Buffett compounders’ and ‘Graham recovery’ stocks, named for two prominent US value investors, Warren Buffett and Benjamin Graham (see our initiation note for a full explanation). Compounders are core, long-term holdings with valuable assets or earnings, while recovery stocks (usually with a shorter holding period of up to three years) may be cyclically depressed, or corporate turnarounds recovering from structural challenges.

While the investment objective is to achieve capital growth, the manager also seeks to limit downside risk in the 50-60 stock portfolio, made up of stocks broadly in the $100m to $5bn size bracket (a universe of more than 2,000 companies). He does this by focusing on avoiding ‘value traps’ and concentrating on good-quality companies whose share prices are depressed. The first stage in the investment process is a quantitative screen to identify stocks that have experienced short- or long-term price weakness. These are then subjected to a risk assessment, focusing on industry, style, and company-specific factors.

Siddles analyses industry cycles and trends, past bubbles, global capital flows, commodity cycles and regional population trends to identify promising candidates for further research. He tends to avoid certain areas such as most technology stocks, biotechnology, fashion and restaurants, while favouring staple goods and services, transport and distribution, non-life insurers and custodians of capital. The manager travels frequently to the US to meet companies, which may have little or no analyst coverage, on their own ground.

The core of the investment process is a rigorous, five-step ‘good company test’. Stocks must pass all five stages of the test in order to be considered for inclusion in the portfolio:

The first four tests are aimed at ensuring there is low business risk, while the fifth is intended to limit share price risk. Together the tests should provide a ‘margin of safety’, limiting potential downside. Relatively few companies can tick all five boxes, which means Siddles builds full financial models (the final stage of the stock selection process) on only a small number of stocks each year.

A strong sell discipline is employed to protect gains and limit losses. Companies may be sold for fundamental reasons, such as a change in corporate strategy or industry cycle, a failure to deliver growth over two to three years, or the investment thesis no longer applying (for example in the case of a recovery stock that has recovered); or market reasons, such as a very sharp upward share price move in a short period, or the market cap of a company becoming too large for a small- and mid-cap strategy. Positions may be trimmed to keep within informal limits of 5% in a single stock and 15% in an industry group.

At 30 September 2017, JUS had 52 holdings, a reduction from 58 at the 30 June 2017 year-end. The top 10 stocks made up 25.4% of the total, up from 23.9% at 30 September 2016. At a sector level, the biggest change in the portfolio over FY17 was a doubling of the consumer discretionary weighting, from 11.0% to 22.2% (20.1% at 30 September 2017). One stock (Big 5 Sporting Goods) was sold and seven were added, including Lions Gate Entertainment, now a top 10 position. Lions Gate is a film and TV company, known for franchises such as the Hunger Games films and the TV series Mad Men. Siddles says the shares were depressed when he bought the company in Q416 because of a slow period for film production; however, its acquisition of cable TV company Starz has brought in a more regular revenue stream, as well as reducing leverage and increasing distribution capability. Siddles believes the enlarged company could be a compelling takeover target for a content-hungry major media or telecom firm.

Since the FY17 year-end Siddles has continued to add to financial services stocks, focusing on low-cost, well-run regional business lenders and entrepreneurial investment banks. Consumer staples exposure has fallen following the sale of United Natural Foods, an organic food distribution firm that was a major customer of Amazon acquiree Whole Foods Market. Siddles is focused on companies that are undervalued because of perceived threats from Amazon, which they are in fact well placed to combat, such as off-price retailer Ollie’s Bargain Outlets (the largest position in the portfolio; branded goods manufacturers are resistant to selling discounted ends-of-lines online, preferring a physical discount store), and recent purchase MSC Distribution, which makes specialist technical parts for the metalworking industry, and has a highly knowledgeable salesforce that will not be easily disintermediated by a self-service internet model.

While JUS has produced creditable share price and NAV total returns of c 6-14% a year over one, three, five and 10 years, it has underperformed its US small-cap equity benchmark (except over 10 years) as a result of a prolonged period in which the value investment style has been out of favour. Adjustments to the investment process are aimed at building on the benefits of positive stock selection by increasing conviction in winning stocks and being less eager to take profits, while cutting losing stocks more quickly. The top contributors to performance over 12 months to 31 August 2017 were largest holding Ollie’s Bargain Outlet (compounder), shipping operator Navigator Holding (recovery), senior health and fitness specialist Tivity Health (turnaround), food wholesaler/retailer Chef’s Warehouse (compounder) and Addus Homecare (turnaround), which provides home care services to low-income older Americans. Together these holdings added 5.6pp to returns. The biggest detractors were Amplify Snack Brands, technology stocks Synchronoss Technologies and The Rubicon Project, and healthcare names Mednax and Kindred Healthcare. Together these detracted 4.4pp from returns, and all bar Amplify Snack Brands have now been sold.

At 31 October 2017, JUS’s shares traded at an 8.7% discount to cum-income NAV. This compares with average discounts of 9.1%, 10.2%, 6.0% and 6.5%, respectively, over one, three, five and 10 years. The trust’s board uses share buybacks with the aim of ensuring the discount does not exceed 10% in normal market conditions (see below). The discount has not been above 10% since 26 June 2017, having exceeded 10% on 34.5% of trading days in the 12 months to 27 October 2017.

A conventional investment trust with one class of share, JUS had 17.9m ordinary shares in issue at 27 October 2017. This is a reduction of 14.5% over 12 months as a result of JUS’s active discount management programme (2.9m shares repurchased at a cost of £23.9m). The new borrowing facility announced in the FY17 results (up to £20m with Scotiabank) is equivalent to c 12% of net assets versus maximum permitted gearing of 20%; however, as at 30 September 2017, JUS was ungeared.

Under the amended fee arrangements also announced in the FY17 results, Jupiter Unit Trust Managers will receive a management fee of 0.75% of net assets up to £150m, reducing to 0.65% over £150m and up to £250m, and 0.55% above £250m. Previously a flat fee of 0.80% was paid. The performance fee structure has been removed, backdated to the beginning of FY18, although in practice a performance fee was last paid in respect of FY14.

Because of its focus on capital growth and the fact that small and mid-cap US equities are not generally high yielding, JUS has never paid a dividend. What revenue income it receives (£1.3m in FY17) is more than offset by running costs, which are mainly charged to the revenue account.

JUS is a member of the Association of Investment Companies’ North American Smaller Companies sector, a small peer group of three funds. JUS has a value focus while its closest peer, JPMorgan US Smaller Companies, has a growth bias. The third fund, North Atlantic Smaller Companies, invests on both sides of the Atlantic and holds a mixture of listed and private equity as well as fixed income investments. For a more representative peer group, in Exhibit 7 we also show a selection of peers for the open-ended Jupiter US Small and Midcap Companies fund.

JUS has outperformed the open-ended fund (launched in 2014) over one and three years. It ranks second for NAV total returns among the closed-ended peers over 10 years, and third over one, three and five years. However, returns over most periods – while respectable in absolute terms – are below the average for both the open- and closed-ended peer groups, reflecting a long period in which value investing has been out of favour. Charges are competitive (the lowest in the AIC sector) and will fall further under the new fee arrangements. JUS is currently ungeared and trades at a wider discount to NAV than its closest peer.

JUS has five independent, non-executive directors. The chairman (since 1998), Gordon Grender, has served on the board since launch in 1993. Peter Barton, chairman of the audit and management engagement committees, was appointed in 1998, while senior independent director Norman Bachop joined the board in 1999. Clive Parritt and Lisa Booth were appointed in 2007 and 2015, respectively. The directors have backgrounds in fund management, investment banking, accountancy and law.