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Research: Investment Companies
Henderson Smaller Companies Investment Trust (HSL) has been managed by Neil Hermon for the last 20 years. He explains that small-cap stock price weakness in 2022 was due to valuation compression and was not a reflection of lower earnings; in essence macroeconomic events outweighed business trends at the micro level. However, the manager believes the interest rate cycle is close to peaking given that inflation is rolling over and the UK economy is relatively weak. Hermon considers the valuations of small-cap UK growth stocks to be ‘very appealing’ and believes that there could be a significant pickup in merger and acquisition (M&A) activity in a more robust economic environment when credit is more freely available.
Henderson Smaller Companies Investment Trust |
Weak sentiment outweighing operational strength |
Investment trusts |
11 May 2023 |
Analyst
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Henderson Smaller Companies Investment Trust (HSL) has been managed by Neil Hermon for the last 20 years. He explains that small-cap stock price weakness in 2022 was due to valuation compression and was not a reflection of lower earnings; in essence macroeconomic events outweighed business trends at the micro level. However, the manager believes the interest rate cycle is close to peaking given that inflation is rolling over and the UK economy is relatively weak. Hermon considers the valuations of small-cap UK growth stocks to be ‘very appealing’ and believes that there could be a significant pickup in merger and acquisition (M&A) activity in a more robust economic environment when credit is more freely available.
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Long-term NAV outperformance versus the benchmark, but more difficult period since Q321 |
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Source: Refinitiv, Edison Investment Research |
The analyst’s view
Over the long term, UK small-cap stocks have performed considerable better than the broad UK market, reflecting higher growth prospects in smaller businesses. Data from Janus Henderson Investors show that over the last 65 years, small-cap stocks have outperformed large caps by an average 3.3pp per year. Although HSL’s recent performance has been disappointing, it should be remembered that there has been no change to the investment process, which has proved successful over the longer term; the trust has outperformed its benchmark in 16 out of the last 19 financial years. HSL has been caught in a perfect storm of investor risk aversion, which has meant a preference for larger-cap companies and growth stock multiple compression, regardless of businesses’ operational strength. Earnings estimates are coming down due to economic weakness, but given low company valuations, investors could look through these negative revisions and focus on what should be easier comparisons in 2024, in which case there is potential for equities to rerate.
Scope for a narrower discount
HSL’s 13.5% share price discount to cum-income NAV is wider than the 9.0% to 12.7% average range of discounts over the last one, three, five and 10 years. However, once the trust’s performance is back on track and investor risk aversion declines, there is scope for HSL to be afforded a higher valuation, more befitting of its strong long-term pedigree.
Henderson Smaller Companies Investment Trust is a research client of Edison Investment Research Limited
The manager’s view: Interest rate cycle close to peak
Manager Neil Hermon explains that the UK market experienced a reasonably buoyant start to the year; unsurprisingly, given the historical precedent, those stocks that underperformed in 2022 rallied in early 2023. The manager notes that while HSL struggled to keep up with its benchmark, it outperformed its peers. Things changed in March 2023 and the market gave back its gains because of fears about another banking crisis. This followed the failure of two US regional banks and the rapid acquisition of Credit Suisse by UBS. Hermon explains that these concerns raised questions about the impact on monetary policy and banks’ willingness to lend. However, while the US Federal Reserve, the European Central Bank and the Bank of England are all raising interest rates, the manager believes that we are near the peak in interest rates. He suggests that while some elements within the inflation data are sticky, such as labour and food costs, comparisons with high numbers a year ago mean the overall inflation rate will come down.
Hermon highlights that small-cap stocks have continued to struggle this year. However, he points to the very attractive valuations of UK companies, in both absolute and relative terms. HSL’s gearing is towards the high end of the 0–15% historical range, which demonstrates his bullish outlook for UK small-cap companies. The manager notes that in the current uncertain economic environment, more than 50% of the fund is made up of businesses with net cash on their balance sheets. He is encouraged by the level of share buybacks and directors purchasing shares, illustrating the perceived underlying value within the UK market.
On a less bullish note, Hermon reports that fund flows are very challenging, with outflows across the whole UK market; he says that the lack of a marginal buyer is exacerbating valuation compression. The manager further explains that higher interest rates have caused private equity firms to step back so there has been a lack of M&A activity. He suggests that there is a lot of value in small- and mid-cap companies, so they should be being ‘snapped up by private equity firms’, but for this to occur, debt markets need to be open. Hermon says that the UK has been attractively valued since the June 2016 Brexit vote, and comments that since then ‘the UK has lurched from crisis to crisis leading to a significant derating’.
Recent portfolio activity
Looking at HSL’s recent portfolio activity, Hermon has been topping up some positions following share price weakness, such as Bridgepoint Group (a private equity and credit fund manager), Essentra (a diversified component manufacturer), JTC (provides fund services to institutional and private clients worldwide) and Workspace (an owner and manager of business space in London).
There are three new positions in the fund: GlobalData (provides proprietary data, analytics and insights), Spirent Communications (provides automated test and assurance solutions) and a third undisclosed name as HSL’s position is incomplete. Three holdings have been sold: EMIS Group (provides connected healthcare software and systems), The Gym Group (a chain of UK gym facilities) and Volex (a power products and cable assemblies manufacturer).
HSL’s portfolio turnover is running at 15% a year, which implies an average holding period of more than six-and-a-half years. Hermon emphasises that it is a high-conviction, low turnover fund.
Performance: Looking to a return to form
Exhibit 1: Five-year discrete performance data
12 months ending |
Total share price return (%) |
Total NAV |
Numis Smaller Cos ex-ICs (%) |
Numis Smaller Cos plus AIM ex-ICs (%) |
CBOE UK All Companies (%) |
30/04/19 |
1.8 |
0.1 |
(3.4) |
(5.0) |
2.5 |
30/04/20 |
(13.8) |
(14.3) |
(20.1) |
(16.5) |
(17.2) |
30/04/21 |
68.9 |
60.9 |
55.9 |
60.3 |
25.3 |
30/04/22 |
(22.4) |
(14.3) |
(7.4) |
(9.1) |
9.1 |
30/04/23 |
(10.0) |
(11.3) |
(3.0) |
(9.4) |
7.0 |
Source: Refinitiv. Note: All % on a total return basis in pounds sterling.
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Exhibit 2: Investment trust performance to 30 April 2023 |
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Price, NAV and benchmark total return performance, one-year rebased |
Price, NAV and benchmark total return performance (%) |
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Source: Refinitiv, Edison Investment Research. Morningstar. Note: Three-, five- and 10-year performance figures annualised. |
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HSL’s relative returns are shown in Exhibit 3. The last year saw a meaningful derating in UK small-cap growth stocks due to rising interest rates, which reduce the value of their long-term earnings streams. However, it should be noted that during this time, the earnings of the trust’s portfolio companies held up well. Unfortunately, HSL’s underperformance over the last 12 months has negatively affected its medium-term performance record, although the trust remains comfortably ahead of its benchmark over the last decade in both NAV and share price terms.
Exhibit 3: Share price and NAV total return performance, relative to indices (%)
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One month |
Three months |
Six months |
One year |
Three years |
Five years |
10 years |
Price relative to Numis Smaller Cos ex-ICs |
(2.1) |
(3.0) |
(1.1) |
(7.2) |
(15.8) |
(4.2) |
28.9 |
NAV relative to Numis Smaller Cos ex-ICs |
(0.5) |
(2.1) |
1.6 |
(8.5) |
(12.6) |
(2.7) |
20.7 |
Price relative to Numis Smaller Cos plus AIM ex-ICs |
(1.5) |
(1.5) |
3.1 |
(0.7) |
(10.7) |
(1.2) |
37.7 |
NAV relative to Numis Smaller Cos plus AIM ex-ICs |
0.1 |
(0.7) |
5.8 |
(2.1) |
(7.3) |
0.3 |
28.9 |
Price relative to CBOE UK All Companies |
(1.9) |
(6.1) |
(2.1) |
(15.9) |
(19.5) |
(16.7) |
32.8 |
NAV relative to CBOE UK All Companies |
(0.3) |
(5.3) |
0.5 |
(17.1) |
(16.4) |
(15.4) |
24.4 |
Source: Refinitiv, Edison Investment Research. Note: Data to end-April 2023. Geometric calculation.
Peer group comparison
HSL is the third largest of the 24 funds in the AIC UK Smaller Companies sector; in Exhibit 4, we show the 13 companies with market caps greater than £100m. HSL’s NAV total returns are below the averages of the selected peer group, ranking eighth over the last 12 months, ninth over the last three years, eleventh over the last five years and eighth out of 11 funds over the last decade. The trust’s discount is wider than average, in a group where just one fund is trading at a premium. HSL has a very competitive ongoing charge, the lowest in the group and 50bp below the mean. The trust is one of four funds that is eligible for a performance fee. HSL has the third highest level of gearing and an above-average dividend yield that is 80bp above the mean.
Exhibit 4: Selected peer group at 10 May 2023*
% unless stated |
Market |
NAV TR |
NAV TR |
NAV TR |
NAV TR |
Discount |
Ongoing charge |
Perf. |
Net gearing |
Dividend yield |
Henderson Smaller Companies |
605.1 |
(4.3) |
22.5 |
1.0 |
114.9 |
(13.9) |
0.4 |
Yes |
113 |
3.0 |
Aberforth Smaller Companies |
1,085.8 |
3.7 |
65.3 |
6.1 |
100.6 |
(13.4) |
0.8 |
No |
106 |
3.7 |
Aberforth Split Level Income |
134.3 |
7.3 |
77.0 |
(4.3) |
|
(11.0) |
1.2 |
No |
137 |
6.1 |
abrdn UK Smaller Cos Growth |
385.4 |
(10.6) |
5.8 |
1.7 |
110.7 |
(14.5) |
0.8 |
No |
102 |
1.9 |
BlackRock Smaller Companies |
645.5 |
(8.8) |
20.7 |
2.2 |
136.2 |
(13.6) |
0.7 |
No |
110 |
3.0 |
BlackRock Throgmorton Trust |
593.6 |
1.0 |
27.4 |
15.7 |
161.3 |
(6.5) |
0.5 |
Yes |
114 |
1.9 |
Invesco Perpetual UK Smaller |
144.9 |
(10.1) |
22.3 |
5.9 |
122.2 |
(13.3) |
1.0 |
No |
100 |
0.0 |
JPMorgan UK Smaller Companies |
214.6 |
(3.0) |
40.0 |
23.8 |
135.3 |
(13.1) |
1.0 |
No |
110 |
2.5 |
Montanaro UK Smaller Companies |
178.7 |
(3.1) |
7.3 |
(1.4) |
49.1 |
(7.6) |
0.8 |
No |
106 |
4.2 |
Odyssean Investment Trust |
189.2 |
4.8 |
72.7 |
66.0 |
|
2.2 |
1.5 |
Yes |
100 |
0.0 |
Oryx International Growth |
165.6 |
(5.4) |
39.0 |
61.6 |
295.7 |
(21.0) |
1.5 |
No |
100 |
0.0 |
Rights & Issues Investment Trust |
117.0 |
(7.4) |
40.9 |
9.6 |
190.4 |
(16.9) |
0.5 |
No |
100 |
2.0 |
Strategic Equity Capital |
154.9 |
5.1 |
52.2 |
34.3 |
189.2 |
(10.3) |
1.1 |
Yes |
100 |
0.6 |
Simple average (13 funds) |
355.0 |
(2.4) |
37.9 |
17.1 |
146.0 |
(11.8) |
0.9 |
108 |
2.2 |
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HSL rank |
3 |
8 |
9 |
11 |
8 |
10 |
1 |
3 |
5 |
Source: Morningstar, Edison Investment Research. Note: *Performance to 9 May 2023. Based on ex-par NAV. TR, total return. Net gearing is total assets less cash and equivalents as a percentage of net assets.
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