Henderson Opportunities Trust — Patience is bitter but the fruit is sweet

This note provides an update on our detailed review published on 19 July. In brief, the trust seeks growth opportunities from across the market, including those listed on AIM, underpinned by a value-driven style that invests in out-of-favour or under-researched companies. At its core, HOT’s portfolio is a blend of what could be tomorrow’s leading British companies, across a wide range of activities and market caps, at different stages of their life cycle, from promising early-stage businesses to established businesses reinventing themselves. ‘Tomorrow’s leaders’ are complemented in the portfolio by investment in ‘stabilisers’. These are often larger, mature but still growing businesses, with more predictable cash flows, as well as natural resources companies that provide a hedge against unexpected developments in commodity markets.

The data in Exhibits 1 and 2 are taken from the interim results, but we do not believe there has been any material change since. Current exposure to AIM-listed companies is c 45%.

Smaller companies recovered strongly from the pandemic sell-off and, although the managers identified pockets of small company exuberance as prices rose through 2021, selectively reducing exposures accordingly, the ensuing correction has been much deeper and more enduring than they expected and is yet to show any signs of unwinding.

Given HOT’s significantly greater focus on smaller companies compared with its all-market benchmark, marked divergence in net asset value (NAV) total return performance over shorter time periods is inevitable. Over the past two years, the negative impact of small-cap weakness on HOT’s NAV total return performance relative to the benchmark now obscures the positive performance of earlier years.

During the past two years, HOT’s Achilles heel has been its exposure to AIM. While the market covers a wide range of market caps (several companies have market caps of more than £1bn and up to c £2bn), it is here where most of the smaller and early-stage companies, with the strong, secular growth potential, targeted by the investment managers, can be found. Not all of these companies succeed, and the outcomes are often binary, but over the longer term HOT’s investments in AIM stocks have created significant value, driven by a combination of stock selection and risk mitigation. Stocks such as Serica Energy, Blue Prism and Keywords Studios have provided exceptional returns on a 10-year view and, in aggregate, the top 10 AIM performers have contributed more than 50% to performance.1

The greater volatility of smaller company performance can better be seen in HOT’s returns on a discrete calendar year basis. HOT has tended to outperform the index when the market is rising, and this was clearly the case in 2020 as the market recovered strongly from the pandemic low point.

The investment managers firmly believe there is a strong opportunity to benefit from a recovery in smaller stocks. This is based on several observations and expectations, including:

On a blended basis, including its larger company exposure, as well as early stage companies where currently sales may be of little significance, HOT calculates its end-FY23 P/sales ratio at c 0.6x, a five-year low, and well below the long-term average of little under 1x.

At c 16%, HOT’s discount to NAV is not materially different to its five- and 10-year averages of c 15% and c 14% respectively, although it has traded within a broad range. Early in the period, it reached a premium of c 5% before moving to discount range of 15–20%. In 2021 it again re-rated, to close to par, as small- and mid-cap shares recovered strongly from the pandemic. Similar peaks and troughs can be seen in a comparison of HOT’s P/NAV with that of its Association of Investment Companies (AIC) peer group. As the performance data above indicate, when share prices rise strongly, HOT’s performance in absolute and relative terms tends to follow, to a degree that more than reflects gearing, and also, perhaps unsurprisingly, its absolute and relative P/NAV follows. HOT’s discount compares with an average of a little more than 10% within its AIC UK All Companies sector, which we estimate is similar to the 10-year average. AIC data show a c 12% average discount for the UK smaller companies sector and a c 13% for all funds.

HOT has consistently provided an investment strategy that is complementary to a wider range of more mainstream offerings, seeking to provide long-term growth, mainly from smaller companies, while balancing the risks, through a high level of stock diversification (c 100 holdings) and meaningful exposure to larger, more established businesses. For many investors, this would be difficult to replicate, and HOT’s permanent capital base is ideally suited to the long-term, patient approach required. While the past two years have been painful, past recoveries have shown how this can quickly change.

HOT shares are widely held by retail investors, with holdings via the platforms Hargreaves Lansdown, Interactive Investor and Halifax Share Dealing accounting for more than 40% of shares outstanding. Outside of this, its largest shareholders are Saba Capital Management (7.1%2), Cazenove (5.8%) and Janus Henderson (5.1%, held through other funds that it manages). Saba Capital Management, a New York-based investment adviser, founded in 2009, has been an investor in HOT for some time and first disclosed an interest of 5.05% in May 2022. Among a range of investment strategies, within investment trusts it focuses on securities that are trading at significant discounts to NAV, and selectively pursues an activist approach where it believes this may be an effective way to unlock shareholder value.

Saba has reported stakes in a number of other UK investment trusts, and recent press reports3 have said that has ambitions to expand its investments in the sector, through a new fund that will specifically focus on activist positions4. There has been widespread press coverage of Saba’s activist stance with European Opportunities Trust (EOT), including pressing for an increase in the scale of company’s plans for capital return, and urging a vote against continuation at the AGM that was held on 15 November. In the event, all resolutions put to shareholders, including for a continuation of the company, were passed by a comfortable margin.

We have no particular insight into Saba’s investment rationale other than to reasonably assume that it believes that HOT’s share price undervalues the company This should send a positive signal to other investors. With a discount to NAV towards the low end of its historical range, share repurchases would certainly be accretive, but much the same could be said of the UK investment trust sector. As a relatively small trust, HOT is able to operate nimbly in the smaller company space, and despite its size, costs are broadly in line with its peer group average.5 The management fee is charged at 0.55% of net assets per annum, on a quarterly basis, and performance fee arrangements were recently removed,6 allowing shareholders to benefit fully from a performance recovery. We would also add that the strong conviction of the investment managers suggests this would be an inopportune time to be shrinking the trust’s asset base and we would see any reduction in share trading liquidity as unwelcome.7

HOT has not repurchased shares in the past three years and it is the board’s position that if these were to be considered, it would be with the aim of enhancing the NAV for existing shareholders rather than seeking to maintain the discount at any specific level. A continuation vote is held every three years, most recently at the March 2023 AGM. A clear majority of votes cast (c 76%) were in favour of continuation, although this was lower than in 2020 (99%).