Henderson Smaller Companies Investment Trust — Weak sentiment outweighing operational strength

Henderson Smaller Companies Investment Trust (LSE: HSL)

Last close As at 01/03/2024

678.00

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Market capitalisation

GBP506m

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Research: Investment Companies

Henderson Smaller Companies Investment Trust — Weak sentiment outweighing operational strength

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.

Melanie Jenner

Written by

Mel Jenner

Director, Investment Trusts

Investment Companies

Henderson Smaller Companies Investment Trust

Weak sentiment outweighing operational strength

Investment trusts
UK smaller companies

11 May 2023

Price

810.0p

Market cap

£605m

Total assets

£804m

NAV*

936.4p

Discount to NAV

13.5%

*Including income. At 9 May 2023.

Dividend yield

3.0%

Shares in issue

74.7m

Code

HSL

Primary exchange

LSE

AIC sector

UK Smaller Companies

Financial year end

31 May

52-week high/low

930.0p

680.0p

1,081.4p

781.3p

*Including income.

Gearing

Net gearing*

14%

*At 31 March 2023.

Fund objective

Henderson Smaller Companies Investment Trust (HSL) aims to maximise shareholders’ total returns (capital and income) by investing in smaller companies that are quoted in the United Kingdom. The fund’s benchmark is the Numis Smaller Companies (ex-investment companies) Index, which is the bottom 10% of the UK stock market by market cap (up to c £1.5bn market cap). In addition, the fund invests in the Alternative Investment Market (AIM).

Bull points

Interest rates could be close to peaking and M&A activity is picking up.

Operational strength of portfolio companies supports rising dividend.

Experienced team with long-term disciplined process and philosophy.

Bear points

Smaller companies can be more volatile, less liquid and more cyclical than larger businesses.

Small-cap stocks are currently out of favour with investors and UK fund flows remain challenging.

Gearing can amplify losses in a falling market.

Analyst

Mel Jenner

+44 (0)20 3077 5700

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.

Long-term NAV outperformance versus the benchmark, but more difficult period since Q321

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
return (%)

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.

Exhibit 2: Investment trust performance to 30 April 2023

Price, NAV and benchmark total return performance, one-year rebased

Price, NAV and benchmark total return performance (%)

Source: Refinitiv, Edison Investment Research. Morningstar. Note: Three-, five- and 10-year performance figures annualised.

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 (%)

 

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
cap £m

NAV TR
1 year

NAV TR
3 year

NAV TR
5 year

NAV TR
10 year

Discount
(cum-fair)

Ongoing charge

Perf.
fee

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

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.

General disclaimer and copyright

This report has been commissioned by Henderson Smaller Companies Investment Trust and prepared and issued by Edison, in consideration of a fee payable by Henderson Smaller Companies Investment Trust. Edison Investment Research standard fees are £60,000 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2023 Edison Investment Research Limited (Edison).

Australia

Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

General disclaimer and copyright

This report has been commissioned by Henderson Smaller Companies Investment Trust and prepared and issued by Edison, in consideration of a fee payable by Henderson Smaller Companies Investment Trust. Edison Investment Research standard fees are £60,000 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2023 Edison Investment Research Limited (Edison).

Australia

Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

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