Standard Life UK Smaller Cos focuses on quality

"We have a focus on quality, so there is a pattern to performance," says Harry Nimmo, manager of Standard Life UK Smaller Companies Trust. "We do less well in periods of very strong stock market growth - especially when smaller companies are racing away. We find it hard to keep up with their pace in recovery phases and rampant bull markets. In a recovery, 'risk on' comes into its own, which can lead to us underperforming, although we benefit from the smaller companies effect. We still make strong annualised returns, but tend to be behind our benchmark and competitors. However, our clients are forgiving when they see strong absolute returns.

"But in more difficult markets our process comes into its own. Over the past 17 years four crises have influenced markets (the Asian crisis, Gulf war II and Enron fraud, the banking and the euro crisis) and in these periods we have continued to outperform. In the middle and later stages of a recovery we also do well."

Part of the reason Mr Nimmo's UK smaller companies funds get left behind during recovery phases is because they tend not to invest in companies such as housebuilders, estate agents, recruitment consultants and plant hire companies. "These are companies without differentiation and they have low barriers to entry," says Mr Nimmo. "In strong periods of recovery they tend to do very well. But we do not try to second guess the economic cycle, rather we stick with our process throughout and accept underperformance in rampant bull markets. Our investment process is quite prescriptive, and as a result the trust performs predictably."

That said, some of Mr Nimmo's holdings are geared to the UK recovery. "The consumer sector especially is increasing in strength and doing a lot better than it used to," he says. "This is a strong feature in the trust (consumer goods accounted for more than 11 per cent of assets at the end of July) and we have recently added an auto dealer, Lookers (LOOK). This is conservatively run and has good demand for its products. And it owns around half of its real estate."

The emphasis is on stock selection rather than sector allocation and he focuses on three areas: growth, business/share price momentum, and quality. Mr Nimmo says the vast majority of portfolio holdings have net cash positions and can grow from internally generated cash flows in a predictable way. "Dividend growth is strong and special dividends are quite plentiful without compromising growth prospects," he says. "What we are really pleased with over the past five years is the rate of dividend growth, albeit from a very low base."

The trust's yield was also helped by special dividends during the last financial year (to 30 June 2013) from three top 10 holdings. These were Hargreaves Lansdown (HL.), PayPoint (PAY) and Aveva (AVV). The trust is proposing an increase in its dividend of 30.6 per cent.

Read more on Mr Nimmo's stock selection process

Another of the trust's investment themes is online businesses, with portfolio holdings including online retailer Ocado Group (OCDO). "This is the only pure online grocery retailer, and has recently entered into a joint venture with supermarket Morrison," he says. "Ocado should continue to do well. We initially bought it in 2011 and have doubled our holding in the past six months."

Under the joint venture, Ocado will provide Morrison (MRW) with operational and intellectual property services so it can launch its online business.

"The internet has been helpful in projecting Supergroup (SGP) and Ted Baker (TED) and they have broken through internationally," he continues. "Both generate between 25 and 30 per cent of their sales outside the UK, and around 8 to 10 per cent online.

"Supergroup has strengthened its management considerably and is making great efforts to broaden womenswear, which should deliver strong growth."

Ted Baker has succeeded in making the breakthroughs that have eluded it for many years outside the UK - and in particular in the US. A strong and controlled mass-affluent brand positioning and PR-led approach to expansion is starting to pay off in a major way. The shares rose by 89 per cent (over the trust's last financial year to 30 June).

"These are very strong businesses and, even if the UK consumer cycle goes against them, they have international revenues," he adds.

Another strong performer has been Asos (ASC), which rose 128 per cent over the year to 30 June. This is the world's leading online clothing retailer and it distributes in countries including China and Russia. It recently delivered a very strong trading statement (read more on this).

However, Mr Nimmo took some profits on this company during the trust's last financial year, when the trust had made 16.7 times its money. He is likely to trim this holding again because he prefers not to have more than around 5 per cent of assets in one holding. "It's not that I don't like Asos, it is a matter of risk control," he adds.

Changes

Over its last financial year, the trust significantly increased its exposure to real estate, financials, insurance and media for the first time since 2007. Although this was as a result of stock selection rather than taking a sector view, it reflects new-found stability and growth prospects in these sectors.

Portfolio holdings in real estate include Big Yellow (BYG), Quintain Estate & Development (QED), and Workspace (WKP), which reflect the trust's "London as a place to do business" investment theme.

A theme that is being cut back is development in China, and this has been reflected by a reduction in exposure to electrical, engineering, food & drink and mining. It has led to the sale of shares including Oxford Instruments (OXIG), Renishaw (RSW), Devro (DVO) and Genus (GNS).

Performance

Source: Morningstar as at 19 September 2013