abrdn UK Smaller Companies Growth Trust — Solid relative performance recovery continues

Having experienced a difficult 2022, as rising interest rates put pressure on the valuations of growth stocks, AUSC’s relative performance is solidly back on track. The trust’s investment process involves bottom-up stock picking focused on quality, growth and momentum factors, and has proved successful through five economic cycles. In broad terms, AUSC tends to perform better when company fundamentals are driving markets, when markets are challenged and in periods of low growth. The trust tends to do less well in top-down driven markets or when the value style of investing is in favour.

Glennie and Yeaman comment that the investment environment has been kinder, with eight months of lower market volatility, and the UK has performed relatively better due to its low valuation and positive GDP revisions. As UK inflation has moderated there has been increased discussion about lower interest rates.

The managers emphasise that AUSC’s outperformance in FY24 was primarily due to successful stock picking. They highlight the trust’s well-defined process but note that its quality growth style of investing had been out of favour. Sentiment towards UK equities in general looks to be improving after a period of apathy, including more interest in UK small-cap growth stocks. The UK is dealing with its inflation issue, is seen as politically stable and GDP growth has exceeded consensus expectations (albeit off a modest base). Shares in UK small companies have been hit hard, so Glennie and Yeaman think there is potential for a strong bounce back. They note that quality growth stocks are yet to shine but their investment style is no longer facing headwinds.

The managers say that the UK market remains attractively valued and note that the UK savings rate is above the historical average, so if it is unlocked, it should be positive for household consumption. They suggest that the outlook for UK consumers is better compared with history, and also better than the outlook for consumers in other regions. Glennie and Yeaman highlight that the UK market tends to perform well when interest rates come down, with small- and mid-cap stocks outperforming over the subsequent six and 12 months.

Lower interest rates tend to improve sentiment towards and the operational performance of small-cap companies. They encourage businesses to expand, and give consumers more spending power, which is important for smaller companies that are often more dependent on the domestic economy rather than international economies. The managers note that over the last two years, investee companies that have continued to operate well, growing earnings and paying dividends, have not been rewarded by the market, leading to very attractive valuations.

In the 12 months to the end of August 2024, the number of stocks in AUSC’s portfolio was reduced by seven to 49, which is just below the low end of the typical 50–60 range. The trust’s top 10 concentration over the period increased from 31.6% to 35.5%. At the end of August 2024, the fund’s active share was 81.2%, which was lower than 83.6% at the end of August 2023 (0% is full index replication and 100% is no commonality).

Exhibit 2 shows AUSC’s portfolio breakdown by sector. Trading activity and market moves have resulted in some notable changes in sector weightings over the 12 months to the end of August 2024. There was an 8.9pp reduction in exposure to the technology sector and an 8.2pp increase in the weighting to financial stocks. The trust retains a zero weighting in utility stocks as these companies do not have the required quality, growth and momentum attributes.

During FY24, there were 13 new additions to AUSC’s portfolio, including Raspberry Pi, which the trust acquired at its recent IPO and 18 complete disposals. Portfolio turnover of 28% was moderately higher versus a more normal 20% as the stage of the business cycle has brought opportunities and the portfolio has experienced increased bid activity; the managers have been investing in several new ideas that have been highlighted by the Matrix.

The new holdings, most of which we have covered in our previous research reports, were: Ashtead Technology (subsea equipment rental); Boku (mobile payment solutions); Cairn Homes (Irish housebuilder); Chemring (defence and cyber); Clarkson (shipbroking); Hunting (oil services); Jet2 (package holidays; the company has been in the portfolio before); Johnson Service (textile rental); Premier Foods (branded food products); Renew Holdings (engineering services); Volex (power products); and XPS Pensions (pensions advisory, administrative and actuarial business).

Raspberry Pi is the first UK IPO in a while and since listing, its shares have performed well. The company makes single-board computers and has sold 60m units in just over a decade. Raspberry Pi is a founder-run business with significant intellectual property, which helps create barriers to entry and generate attractive margins, while keeping prices low. AUSC’s managers believe that this is a unique listed UK asset.

Four of the disposals were as a result of corporate actions: Ergomed (clinical research); Mattioli Woods (financial services); Smart Metering Systems (metering services and grid battery storage); and Spirent (testing and network solutions). Most of the other sales, listed here, were in cyclical businesses, with limited visibility around a business recovery: FDM (specialist recruitment); Focusrite (hardware for content production); Future (specialist media platform); GB Group (identity verification and fraud detection); Henry Boot (land and property development); Impax (sustainable investment); Kainos (digitisation programmes); Marshalls (landscaping products); Motorpoint (second-hand car sales); Safestore (self-storage); Serica (oil and gas production); Team 17 (video games); XP Power (components for power products); and Watches of Switzerland (premium watches and jewellery).

There are 24 funds in the AIC UK Smaller Companies sector. In Exhibit 3 we show the 12 largest companies with market caps above £100m. Within this selected peer group, AUSC’s NAV total returns are above average over the last 12 months, while lagging over the other periods shown. It should be remembered that the peers have different investment approaches.

Morningstar data show that within the selected peer group there are only three funds classified as small-cap growth funds: AUSC, Montanaro UK Smaller Companies Investment Trust (MTU) and Odyssean Investment Trust (ODI), which has a much more concentrated portfolio. Comparing their performance, AUSC has the highest NAV total returns of the three funds over the last year and of the two funds over the last decade. The three portfolios have a similar exposure to defensive sectors (anticyclical – 12–13%) but AUSC has the highest exposure to cyclical sectors (high sensitivity to the business cycle – 39% versus 31% and 24%) and the lowest exposure to sensitive sectors (moderate correlation to the business cycle – 49% versus 56% and 63%).

Within the selected peer group, AUSC’s discount is wider than average in a group where just one fund is trading at a premium. The trust has a below-average ongoing charge, an average level of gearing and a dividend yield that is 40bp above the mean.

In FY24 (ending 30 June) AUSC’s NAV and share price total returns of +18.1% and +21.0%, respectively, meaningfully outperformed the reference index’s +10.0% total return. Encouragingly, the trust outperformed in nine out of 12 months. Four acquisitions of portfolio companies (Ergomed, Mattioli Woods, Smart Metering Systems and Spirent) added around 2% to relative performance; the majority of AUSC’s outperformance was due to successful stock selection.

The three largest contributors to the trust’s relative performance in FY24 were: Ashtead (+153bp – a new position during the financial year, the company’s strong operational performance has led to a series of earnings upgrades); Ergomed (+102bp – received a takeover bid from European private equity firm Permira); and Diploma (+98bp – this company has continued to build on its successful long-term growth record). On the other side of the ledger, the three largest performance detractors in FY24 were: CVS Group (-130bp – the veterinary industry was subject to a review by the Competition Markets Authority focusing on price, consumer visibility and branding; the managers expect any outcome to be manageable); Big Technologies (-115bp – the company has suffered from a contract loss and a lack of large contract wins); and XP Power (-75bp – a series of disappointments and a lack of confidence in the management team meant this position was sold ahead of an equity raise).

This year has seen a solid improvement in AUSC’s relative performance. The trust is bouncing back from a period when rising interest rates negatively affected the valuation of growth stocks and investors focused on macroeconomic developments rather than on company fundamentals. AUSC is now ahead of the reference index over one year and its NAV is modestly behind over the last five years (Exhibit 5). The trust retains its commendable outperformance over the last decade.

AUSC’s upside/downside capture over the last decade is shown in Exhibit 8. Its upside capture rate of 120% suggests that the trust is likely to outperform by around 20% in months when UK small-cap shares are moving up. The 109% downside capture rate implies that AUSC is likely to underperform by around 9% during periods of UK small-cap share price weakness.

In FY24, the trust’s revenue earnings were 13.12p per share, which was a 5.5% increase versus 12.44p per share in FY23. This growth is back to a more sustainable level, following two years of elevated growth after the global COVID-19 pandemic. Only around 2.5% of FY24 revenue came from special dividends (Bytes Technology and Hollywood Bowl), which compares to around 20% of revenue 10 years ago.

AUSC pays semi-annual dividends in April and October. The board aims to pay out around a third of the total annual distribution as the interim dividend, with around two-thirds as the final dividend. The board is proposing an FY24 full-year dividend of 12.0p per share, which is 9.1% higher year-on-year and will allow 2.2p per share to be added to revenue reserves. There are four companies in the portfolio that the managers do not expect to pay a dividend soon, as they are reinvesting for future growth: Auction Technology Group, Big Technologies, Boku and Marlowe.

AUSC’s board is frustrated that the trust’s improved performance has not led to a higher valuation. Unfortunately, AUSC has not been immune to the trend of wider investment trust discounts during a period of elevated investor risk aversion, with small-cap shares particularly out of favour. However, the trust’s 11.5% discount is narrower than the 12.6% and 11.7% averages over the last one and three years, respectively. It is also towards the top end of the broad 10.0% to 15.0% range of discounts since the start of 2022 (Exhibit 10) and looks to be on an improving trend.

The board employs a discount control mechanism, targeting a maximum 8.0% share price discount to cum-income NAV in normal market conditions. Renewed annually, it has the authority to repurchase up to 14.99% of AUSC’s share capital. During FY24, c 14.1m shares (c 15.9% of the share base) were bought back at a cost of c £60.5m. The weighted average discount at which the shares were repurchased was 13.1% and the board calculates that this added 10.7p per share to the trust’s NAV.

AUSC’s board’s 14.99% share repurchase authority was granted at the November 2023 AGM. Given the pace of share buybacks in FY24, a further 14.99% share repurchase authority was granted at a general meeting on 3 June 2024, ahead of the next AGM, which is expected in November 2024.

The trust also has a discretionary tender mechanism in place, although no tenders have taken place since June 2015, as share buybacks are the primary method to manage AUSC’s discount.

Launched in August 1993, AUSC is quoted on the Main Market of the London Stock Exchange. Since 1 January 2023, the trust has been managed by Abby Glennie, who replaced long-standing lead manager Harry Nimmo; they had worked closely together since January 2016, and Glennie had been AUSC’s co-manager since 17 November 2020. Amanda Yeaman is the trust’s deputy manager; she joined abrdn in 2019. Glennie and Yeaman aim to generate long-term capital growth from a diversified portfolio of UK-quoted smaller companies.

AUSC’s portfolio is made up of 50–60 of the managers’ highest-conviction investment ideas. The trust’s performance is measured against the Deutsche Numis Smaller Companies plus AIM ex-Investment Companies Index (the Deutsche Numis Smaller Companies ex-Investment Companies Index before 1 January 2018). To mitigate risk, at the time of purchase, AUSC may hold no more than 5% of total assets in a single position, no more than 5% in companies with a market cap below £50m and the managers tend not to invest in ‘blue sky’ (not yet profitable) companies, although up to 5% is permitted. Up to 50% of the portfolio may be invested in companies that are constituents of the broad AIM index. The managers may vary the trust’s level of gearing between a net cash position of 5% and net gearing of 25% of NAV (at the time of drawdown). Over the last decade, the financial year-end position has ranged from 0.3% net cash to 5.8% net gearing.

AUSC started life as Edinburgh Smaller Companies in 1993, with Standard Life Investments (now abrdn) assuming management in 2003. The trust merged with Gartmore Smaller Companies Trust in 2009 and with Dunedin Smaller Companies Investment Trust in October 2018. With effect from 25 October 2021, the trust’s name was changed, following shareholder approval, from Standard Life UK Smaller Companies Trust (ticker: SLS) to abrdn UK Smaller Companies Growth Trust. The board deemed that the addition of ‘growth’ better reflects what the trust is seeking to achieve.

The managers follow seven principles for successful small-cap investing:

In their search for long-term capital growth, Glennie and Yeaman use the Matrix. This screening tool is based on a series of 12 quality, growth, momentum and valuation factors, including forecast earnings and dividend growth, earnings revisions, share price momentum, balance sheet strength and the level of directors’ dealing, to whittle down the investible universe of around 500 stocks to around 100 that are deemed worthy of further consideration. The most important factor, at c 40% of the Matrix weighting, is earnings revision momentum because back-testing shows this is the most predictive measure of future share price performance. Stocks are assigned a Matrix score between +40 and 40, with those between +10 and +40 deemed potential buy candidates and those between 10 and 40 potential sells. Companies considered for inclusion in AUSC’s portfolio are subject to further in-depth analysis and meeting company managements is an integral part of the research process. In keeping with other abrdn investment teams, the managers have a strong focus on a company’s ESG credentials.

Positions may be trimmed or sold if there is a deterioration in the Matrix score, the original investment thesis no longer holds true, they have grown to more than 5% of the portfolio or there is a higher-conviction name identified. The disciplined investment process has been employed since abrdn took over management of the fund in 2003 and has delivered creditable performance through economic and market cycles.

abrdn has more than 800 investment professionals, including c 50 ESG specialists around the world. It encourages companies in which it invests to adhere to best practice in the areas of ESG stewardship. abrdn believes this can be achieved by entering into a dialogue with company managements to encourage them, where necessary, to improve their corporate standards, transparency and accountability. By making ESG central to its investment capabilities, abrdn seeks to deliver robust outcomes as well as actively contributing to a fairer, more sustainable world. It considers ESG factors are financially material and affect corporate performance; companies that have higher standards tend to outperform those that do not.

The managers explain that for AUSC, ESG is really embedded at the core of the research process and is an important aspect of the focus on quality and the lower-risk approach. There is an ESG specialist on abrdn’s small-cap desk, and the managers also work closely with abrdn’s large and knowledgeable central ESG investment team. Glennie and Yeaman regularly engage with company management teams, including on ESG aspects. They say that it is important to highlight a couple of nuances for smaller companies. While external ESG data are used, it is not an ideal process because many of the companies are not covered at all, or are covered badly, providing a real opportunity for the managers to add value by conducting ESG fundamental research themselves. Also, smaller companies often have limited internal resources to focus on ESG, so many are keen to engage with the managers, who are able to help advise them and encourage them towards those ESG aspects required by shareholders.

AUSC has a £40m revolving credit facility (RCF) with Royal Bank of Scotland International, which expires on 1 November 2025 (and has a further £25m uncommitted accordion provision). At the beginning of FY24, £25m of the RCF was drawn down, with a further £15m utilised in March 2024, reflecting the managers’ increased confidence in the positive outlook for UK smaller companies.

With effect from 1 July 2023, the management fee is calculated quarterly in arrears at a rate of 0.75% per year on the first £175m of NAV, 0.65% per year on NAV between £175m and £550m, and 0.55% per year above £550m. From 1 January 2024, the manager no longer receives a secretarial and administration fee, which had been £75k plus VAT. However, it does receive a separate fee to provide AUSC with promotional activities; this was £207.5k plus VAT in FY24, which was considerably lower than £301.0k plus VAT in FY23. These changes contributed to a lower ongoing charges ratio of 0.92% in FY24 (FY23: 0.95%).

AUSC is a conventional investment trust with one class of share. There are c 73.2m ordinary shares in issue and c 31.0m held in treasury. Its average daily trading volume over the last 12 months is c 185k shares.