Henderson Opportunities Trust — Taking AIM at the opportunity

HOT is focused on providing long-term growth, in excess of the broad UK market, with a secondary objective to grow dividends over time. The trust’s all-cap focus gives it the flexibility to seek growth opportunities from across the market, including companies listed on AIM, underpinned by a value-driven style that invests in out-of-favour or under-researched companies. At its core, the HOT 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 lifecycle, from promising early-stage businesses to established businesses reinventing themselves.

HOT’s truly all-of-market investment approach is complementary to a wider range of more mainstream offerings, seeking to provide long-term growth, mainly from smaller and mid-sized (SME) companies, while balancing the risks, through a high level of stock diversification (c 90 holdings) and the ‘ballast’ of 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.

The trust has been managed consistently for many years by two experienced investment managers, James Henderson (since 2007) and Laura Foll (since 2018) of Janus Henderson Investors (JHI). In turn, they are supported by the broader resources of the JHI equity team.

The investment managers believe the recent relative outperformance of SME companies does not reflect their potential, following a period of sustained underperformance. In particular they highlight:

We reported on HOT’s outperformance of its benchmark in the six months to 30 April (H124) in our last note, and this has continued since. HOT’s H124 NAV total return was 18.6% compared with 14.2% for the benchmark, while the share price total return was 25.5%. For the 10 months to end-August 2024, HOT’s NAV total return is 28.0% compared with the benchmark 19.7%, and its share price total return is 33.0%. Stock selection has had a positive impact on performance in the current financial year (FY24), including strong performances from larger companies (the banks, Rolls- Royce, Marks & Spencer). Some of the key detractors of performance have been the North Sea oil and gas exploration companies, Serica Energy and Jersey Oil & Gas. On top of an extension of the ‘windfall’ tax, the feared removal of capital allowances in the October budget would be a significant headwind to their operations.

Portfolio positioning by market cap segment has been mixed, with mid-cap stocks and selected smaller companies outperforming but the AIM index lagging.

The impact of the relative weakness of SME companies, particularly those listed on AIM, still weighs heavily on HOT’s otherwise strong performance record. Although not apparent in standard performance data shown in Exhibit 5, as we showed in our May 2024 review, looking closely at the 10-year period to April 2024 (H124), performance for the first seven years was very strong, compared with an even more significant period of underperformance over the more recent years. During the first seven-year period, HOT’s NAV total return of 97% was more than twice that of the 42% delivered by its benchmark. Smaller companies were outperforming during the period, but HOT’s performance was still well ahead of the Numis Smaller Companies Index including AIM but excluding investment trusts (NSCIAEX)2 return of 76%. Throughout the 10-year period there was no material change in HOT’s strategy and aims, or in the consistent approach applied by the managers, which includes running a diversified portfolio to manage risk. The overriding factor in the underperformance of recent years has been weakness of SME stocks and AIM-listed stocks in particular. Stock selection had a modest positive impact in the period.

In our May review, we discussed the relative weakness of the AIM market in recent years but that the market continues to be home for many success stories. Over the past five years, the top performers within the portfolio were all AIM-listed stocks (Ceres Power, IQGeo, Learning Technologies and Vertu Motors).

The inheritance tax break on qualifying AIM shares means that these can be passed on, tax free, if held for at least two years before an individual dies. There is no doubt that it has attracted funds into the AIM market and that its removal would likely create near-term weakness in certain shares or, at the very least, market volatility. A number of investment funds exist specifically to benefit from the inheritance tax breaks on AIM, alongside direct equity investments from founders, families and individual investors. Ironically, if IHT relief were abolished and significant divestments were made, potential share price declines would substantially limit the amount of tax revenue that may otherwise have been expected. More fundamentally, the removal of IHT relief risks reduces access to growth capital for smaller, entrepreneurial companies and undermines the government’s aim to reinvigorate the economy.

Investors have been alert to the potential tax change since the UK general election in July and while the outcome remains uncertain, the AIM market’s performance in recent weeks suggests that some investors have decided to realise profits ahead of the budget whereas others have pulled back from investment. Henderson and Foll note that they are invested in stocks where either the company’s future success or HOT’s long-term performance is not dependent on IHT exemption. They argue that these are good businesses in their own right and that medium-term valuations will be determined by achieving sustainable and growing profits. Where access to capital is an issue, they mostly have strong governance and reporting standards in place that would allow a transition to the main market.

The market cap weightings shown in Exhibit 1 are the output of the investment process rather than a target in themselves. The portfolio managers are focused on long-term returns, with investment decisions driven by a selective, bottom-up approach. They are looking for the best capital growth opportunities, with no specific sector or size remits, and these are most often identified by the managers among smaller companies, particularly those at an early stage.

In monitoring the positioning of the trust, the managers look deeper than the basic distinctions of small, mid and large cap, instead grouping their holdings under one of six classifications or ‘buckets’. The stocks within each of these, with the exception of resources, are expected to generate above-average earnings and capital growth over time. To clarify the process even further, the buckets are grouped under the two broad headings of ‘tomorrow’s leaders’ and ‘stabilisers’. As the name suggests, it is among ‘tomorrow’s leaders’ that the managers expect to see the strongest growth over time. Balancing the expected returns with the risks involved, the managers select a diversified list of companies across all stages of the growth cycle. 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. We provide details of each bucket in our May review.

‘Tomorrow’s leaders’ accounted for 60% of the portfolio at the end of April (H124) when the last full breakdown was published, and the managers have indicated that this has since increased. This is the area in which they see the best opportunities, and where sentiment has been weakest and valuations are more attractive.

At the end of August (the last published factsheet), four of the top 10 holdings were AIM stocks, with three banks (Barclays, Standard Chartered and HSBC), Marks & Spencer (in the ‘recovery’ bucket), supermarkets group, Tesco, and miner Rio Tinto accounting for the balance. In aggregate, these 10 holdings accounted for c 26% of the total portfolio, down from c 30% at the end of April (H124). The reduction in the top 10 weighting includes profit taking in strong outperformers such as Barclays and Rolls-Royce, funding the further portfolio migration towards smaller companies including, within the top 10. Rolls Royce was the second largest portfolio holding in April with a weighting of 3.4% but by August this had been reduced to less than 1%. an increased holding in Marshalls. As a measure of the diversification of smaller company holdings, the other 80 holdings were on average 0.9% of the portfolio each.

The AIM stocks within the top 10 holdings may be less well known and are a diverse group, by activity and size (market caps shown are as at the date of publication):

Recent portfolio investments include:

The portfolio positioning by sector is also a by-product of stock selection rather than a target. The significant overweighting to industrials reflects the investment managers’ assessment of the upside potential of more domestically focused, cyclical businesses where the valuations fail to capture the longer-term potential from operational gearing and re-rating. The recent reduction in the industrials weighting primarily reflects the profit-taking in Rolls Royce while the increase in the consumer discretionary weighting includes the investment in Entain as well strong performances from existing holdings such as Flutter and Gym Group.

HOT is a member of the AIC’s UK All Companies sector, comprising seven member trusts of which HOT is the smallest. Despite HOT’s modest size, its ongoing charges are in line with the group average, and despite its focus on capital growth, dividend growth has been strong and HOT provides the second highest yield in the sector.

Among the sector constituents, there is undoubtedly overlap between investment strategies, although HOT is the only trust that is truly UK and truly all-cap.3

For the reasons discussed above, HOT’s exposure to smaller companies, and AIM-listed stocks in particular, has significantly affected its short-term performance versus this diverse peer group and this has fed through to the long-term performance data. The trust’s discount to NAV is nonetheless broadly in line with the simple average of the peer group.