An update from the managers
In this podcast we are joined by Harry Nimmo and Abby Glennie, managers of abrdn UK Smaller Companies Growth Trust plc (named Standard Life UK Smaller Companies Trust at the time of recording). Here they discuss what they look for from a smaller company and the year ahead for the sector.
Recorded on 3 March 2021.
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Interviewer: Hello, and welcome to the latest in the Aberdeen Standard Investment Trust Podcast Series. Today we're talking to Harry Nimmo and Abby Glennie, managers on the Standard Life UK Smaller Companies Trust on what they're looking for from a smaller company and the year ahead for the sector. Abby, I wonder if we could start by setting out the parameters for the trust? How are you defining small cap? And what sort of companies does this lead you to in practice?
Abby: Thanks, Cherry. So when we're thinking about small cap and the investable universe, we think about the Numis plus AIM Ex-Investment Trusts industry, which is really the bottom 10% of the market. And at the moment, when that rebounced in January, that included companies below one and a half billion market cap. I think what's really important for us is that we include AIM in that universe. AIM has been an increasingly attractive universe for us to invest in. It's very diverse, it's got a good sector spread. And now it's full of profitable businesses who are paying dividends, and importantly, also have good corporate governance.
Interviewer: Cool. Thanks, Abby. And sticking with you, I wonder if you could just talk a little bit about what's important to you when you're analysing a smaller company. And actually, whether that changed at all over the course of 2020.
Abby: Of course. So the focus of our investment process is on quality, growth momentum. And importantly, that's been true for over 20 years now in the UK smaller companies space and the way we invest. So we definitely didn't change that in 2020, or because of Covid. We believe that actually investing in quality growth momentum is really how you drive outperformance in smaller companies. And importantly, we want to take a lower risk approach towards investing. And that really comes from that quality focus within our process. So we're looking for aspects like strong balance sheets, which mean that for instance, businesses are able to invest and to grow. Importantly as well, we think part of the key aspect that we do is meeting management teams - that engagement with companies is critical for our fundamental research. And actually we importantly like founder run businesses, as well, we see a lot of that in the UK space. We also - one thing with smaller companies is we like to ensure that these businesses continue to invest in the infrastructure and the systems that they need to grow. Because I think the lack of support for growth is often the downfall of many smaller companies. And the last thing we're really looking for is businesses where we think there's a potential for earnings upgrades relative to expectations.
Interviewer: Great okay, thanks Abby. Harry, turning to you. How did - I mean 2020 was obviously an extraordinary year. I wonder if you could talk a little bit about how it played out for the companies in your portfolio.
Harry: Okay. Yeah. Thank you that. Actually 2020 - it was a difficult year for us. In many ways. There were some dramatic changes in markets. First off, we did extremely well - our process focusing on quality growth momentum provides real resilience in difficult market conditions. And this is what we found in March. And indeed March was the - was the best year of relative performance I think we've ever had as our stocks, our stable, growth, quality stocks, held up better than the market. And indeed, in the Covid period, right up to the discovery of the vaccine on the ninth of November, or the announcement thereof, our funds did really well as smaller companies started to recover. But still it was those resilience, quality growth companies that led the way. Now the discovery of the vaccine changed all that. And what you've seen since then has been a reversion - a massive sector rotation to what I call cyclical stocks, that can benefit from things getting better. In many ways it's what we call - we've seen it before at this stage and in other recessions. It's very like, actually, the aftermath of the banking crisis in the middle of 2009. I call it and many other commentators call it a dash for trash. So those great companies that were hit hardest are the ones that recover are strongest in that early phase. So that has led to underperformance from the ninth of March and particularly in the week following the announcement of the vaccine and that has actually continued into 2021.
Interviewer: Did you make any sort of major changes to the portfolio during the year?
Harry: We have just stuck religiously to our investment process of quality growth momentum, led by our Matrix system that helps us to find a shortlist of stocks. Obviously, there have been buys and sells throughout the period. But our processes aren’t changed, we don't try and turn the portfolio around in response to top down changes. We keep going with our process all the time, we accept that there are periods when we underperform, like after November 2020, like the middle of 2009. And actually, the middle of 2003 was a difficult period for us as we recovered from the.com bubble period. So there have not been major structural changes to the portfolio. Obviously, there have been stocks going in and out, there are many stocks that have done incredibly well during the period like JD Sports, and Dechra, Big Yellow and Aviva that we have sold, because they're actually no longer small caps any longer. Some of them are indeed in the FTSE 100. So we must be selling those and recycling money into the next things that are coming through.
Interviewer: But there's none where you've thought the environment that we're going to emerge into post Covid sort of fundamentally changes the investment thesis or anything like that?
Harry: Well, we just - we simply keep going with our process. I can tell you about some sectors that have actually - we've increased our exposure to because they exhibited higher Matrix scores, and I'm talking about financial services, leisure goods and media in particular. And those sectors, weightings have actually gone up significantly in the year in question.
Interviewer: Okay. Thanks, Harry. Abby, I wonder if we could turn to you just talk a little bit about the Investment Trust structure. I mean, it feels like theoretically, not having to manage inflows and outflows should be helpful in what was a very turbulent year. But was that the case are there other reasons why the Investment Trust structure helped you during 2020?
Abby: I think definitely one of the benefits of an investment trust structure is not having to worry about the outflows, you have less so the inability, I guess, to have natural inflows. And on the face of it, you'd think that that was helpful, you know, not having to worry about outflows in a turbulent year. But I would say actually, that, because of our strong performance, and I think our long term shareholder base, actually, that was not a problem that we saw in our open ended vehicles either. But one of the other benefits we have of the Investment Trust structure, and in particular, this Trust is also the discount protection mechanism that we have. You know, we do have the ability to buy back stock, and that is earnings enhancing to our existing shareholders. And we did do that in the middle of last year as well.
Interviewer: Great. Okay. Thank you. Harry, turning back to you - what are the main themes in the portfolio today and where are you finding opportunities at the moment?
Harry: Yes, I mentioned the sectors that we are heaviest in and this is a product of our bottom up stock selection. So it starts with software. We're always growth orientated and we have very large positions in some themes like digitalization and Kainos is the leading exponent of that. This is a company actually based in Belfast. They provide digitalization services mainly to governments, local governments and quangos and the like helping to take the paperwork out of interactions between governments and business, or between the government and the individual and they're most helpful when the government was setting up its furloughing programme for instance. And also they come into their own with all the new digital processes required with the UK leaving the European Union and all the different interactions between government and business that that will result in. So that's a big theme in the portfolio. And the next one I would say - financial services, long term savings and trading, managing portfolios online is a key theme and through stocks like AJ Bell, like Lion Trust and Impacts, Mattioli Woods and the like. And in particular Lion Trust and Impacts - specialists, among other things, specialist fund managers, amongst other things in ESG investing - that’s very much the mood of the moment, shall we say. And looks like it's really got legs. So that's a major new theme. So we're overweight in financial services. In that area as well fund administration is very important to us. It's very long term business, it's very sticky business. It’s long term contracts, five years or more, where there's loads of visibility of earnings and we like that a lot. Leisure goods - this is still a big theme, perhaps less so now. But that includes things like computer games, hobby games, Games Workshop, techno music through the likes of Focusrite, selling musical instruments online, gear for music and Team17, the other computer games stock. I suppose this theme was kick started by Covid. But it's not going to end with Covid. It's just accelerating what was happening already, media has also come into it. We see lots of new companies here. It's a better quality sector. It's a really a discovery of the paywall - the ability of these media companies to get the consumers to pay for media services like magazines, newspapers and the likes, through companies like Future. And through high quality market research. We're seeing that through companies like GlobalData. So these are some of the key themes that come through in the fund. We tend to downplay the more cyclical sectors - there's not much in terms of building materials or house building, or even retailers in the portfolio - at least the old style retailers have pretty much gone.
Interviewer: Great. And how do you how do valuations look today, I mean, both small cap relative to large cap, also relative to their history and possibly relative to their international peers as well?
Harry: I should point out that valuations do not lead our investment process. Quality growth and momentum does led by our Matrix. We've never found that buying a portfolio of so called cheap stocks is a good idea in smaller companies. Actually what you're buying is you're buying trouble. You’re buying profit warnings, you're buying dividend costs, you're potentially buying bankruptcy. So we tend to avoid the really cheap stocks and our back testing shows that portfolios of cheap stocks actually do underperform quite sharply in the long term. So just bear that in mind. Now, what we've seen since November the ninth with the vaccine discovery is our high quality stocks trade off quite significantly. And indeed comparing the valuations – and I think this is the right way to look at it – of our portfolios with where they were a year ago, or five years ago, they're actually looking remarkably cheap compared with past history. Now, our portfolios, reflecting their quality and their growth and their momentum, are never going to look cheap, but they certainly look a lot cheaper compared with the recent and indeed long term history of the portfolio. So actually, we think it's a pretty good buying opportunity for our investment trust.
Interviewer: Abby, ESG has become big news over the past year and is obviously a key part of the investment process at ASI. So can you talk a little bit more about how this happens in small cap space?
Abby: Of course. So ESG is really embedded at the core of our research process. And importantly for us, it's a really key aspect of that focus on quality and that lower risk approach that we take. Actually on the desk as well, we've invested in terms of our resource for ESG. And last year, we hired Juliana Lavente, who's our on desk ESG expert. So while ESG is the responsibility of all the analysts in the desk, you know, Juliana has really helped us in terms of that depth and breadth of ESG expertise that we have. We also do work closely with the very large and very knowledgeable central ESG investment team we have. You know, for us on smaller companies, we very much look at both the risks and the opportunities that ESG aspects present. You know, and importantly, we have that engagement with management teams on a regular basis. And in all of those meetings, we will be also focusing on ESG aspects, a couple of nuances for smaller companies I would highlight would be, you know firstly, we do like to utilise ESG data. But unfortunately, in smaller companies that's not an ideal process, because many of the companies are not covered, or many of them are actually covered badly. So what we find is, it's a real opportunity for us to add value by doing that fundamental research ourselves. Similarly, we engage with management teams and actually, a lot of these smaller companies have limited resource internally to focus on ESG. So actually, many of them are quite keen to engage with us. And for us to be able to help advise them and encourage them towards what ESG aspects they should be showing shareholders. Also things like, as I said, we really like to invest in founder owned businesses, whilst some investors see that as a negative. And I think that's a key in smaller companies. And another reason that, you know, screening in ESG, or passive investing in ESG, I think does not work very well. I think it needs to be about those nuances and that real engagement. Particularly where I would say you can't trust all of the data that's out there.
Interviewer: And can we just finish off Harry by talking a little bit about the future? I mean, how optimistic are you feeling about economic recovery, and the outlook for small caps?
Harry: I am looking optimistic. I've been optimistic since March the 19th. Because that was the start of the new cycle. And I suppose for the five years previous to March 19th, I was pessimistic because I've been predicting a downturn for years and years and years. It was never happening - this upturn was going on for so long. So in some ways, this Covid emergency kind of clears the air. And we now know that we're through the worst. And we're into the recovery phase. And in the recovery phase, in the earlier part of the economic cycle, smaller companies do better. This is what the history teaches us. And we are in that cycle. And that's good for us. Now in the early stages, we will underperform while all the cyclical dash for trash stuff goes up. But we will underperform a rising smaller companies market and we find that investors are less concerned when we're showing good absolute returns lower than our small cap benchmarks but still showing good returns. And then after this dash for trash phase is over which should be in the next few months, our investment process really comes into its own again. So the medium and long term outlook for our investment process is strong. And remember, we've been following this process since January 1997, unchanged in 24 years. It's backed, back-tested by our Matrix and we feel that our performance demonstrates that it works in that medium to long term.
Interviewer: Great. Okay, thank you, Harry and Abby for your time today and those insights and thank you to our listeners for tuning in. You can find out more about the trust at www.standardlifeuksmallercompaniestrust.co.uk and please do tune in to future podcasts.
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