Henderson Smaller Companies maintains gearing

Stock selection helped performance, and in particular gearing (debt), which currently stands at 9 per cent. As the trust's manager, Neil Hermon, expects positive returns he will maintain some gearing over the trust's coming year.

Companies that contributed to the trust's performance included WS Atkins (ATK), Ashtead (AHT) and Kentz.

Kentz is an international engineering services company supplying the oil and gas, and mining industries. Earlier this year it received a bid from Canada's SNC-Lavalin at a significant premium to the prevailing share price, and has now been bought by that company.

Ashtead is a plant hire company and its US operations account for over 95 per cent of its profitability.

"Ashtead has been a real winner over the last four to five years," says Mr Hermon. "It has done very well due to a structural shift in the US market from construction companies renting their plant fleet rather than owning it."

Also see why the IC rates Ashtead a buy

"However, we have sold this due to the fact it has entered the FTSE 100: our investment rules require us to sell a company when it enters that index within six months," he adds.

Henderson Smaller Companies' performance has also been helped by smaller companies significantly outperforming larger ones over the year to 31 May, although in 2014 there has been a reversal of the trend. But Mr Hermon predicts: "Small caps will grow faster than large in the next two years. However, we do need to see small- and mid-cap companies growing their earnings for the market to progress, and I don't think the returns of the last five years are achievable."

Small caps account for about a fifth of the trust's portfolio with the vast majority - 72 per cent - in mid caps. "Our weighting to mids has been high for a number of years," says Mr Hermon. (Also see why he was invested in mid caps last year)

"Our benchmark includes mid caps while the size of the funds our team runs mean we can't go into companies that are too small because we couldn't put in meaningful amounts. That said, we are not driven by size, but rather by value opportunities, and because we run our winners lots of our mids were once small caps."

Mr Hermon tends to take a long-term view with companies held on average for five years, and portfolio turnover is typically 20 per cent a year.

Read more on the case for mid caps

Reasons for selling a share include if it has problems, or the fundamentals change - for example, changes in company strategy or management, deteriorating financials such as significant cash outflow, and negative earnings surprises or earnings downgrades. "We want a company that is growing but at a reasonable valuation, so if this is extreme we will sell," he adds.

Companies that did not do so well over the trust's last financial year include Oxford Instruments (OXIG). "This suffered from emerging markets weakness, especially in China, but we are sticking with it because its long-term prospects are good," says Mr Hermon.

Oxford Instruments produces equipment for industrial and scientific research markets and has high exposure to nanotechnology, an emerging area set to grow strongly in future years.

Another holding where he expects to see an improvement is Thomas Cook (TCG).

"This has had a difficult year due to overcapacity in package holidays, the world cup and good UK weather," says Mr Hermon. "But I expect it to bounce back from lows - it is on a very low valuation and I expect good growth over the next 12 months."

In the long run he expects Thomas Cook to benefit from capacity coming out of the market and rationalisation of the industry.

The trust's largest holdings are housebuilders Bellway (BWY) and Taylor Wimpey (TW.). "Although the housebuilders have had a more difficult time recently, as investors fret over potential interest rate rises, the sector remains well-placed given the structural undersupply of housing in the UK and the capital discipline Bellway and its peers are displaying," he says. "The major difference between the two companies' strategies is that while Bellway is looking to expand its volumes (albeit from a much lower base), Taylor Wimpey is aiming to return significant amounts of cash, through dividends, to shareholders."

During the trust's last financial year it invested in six initial public offerings (IPOs) including Koovs (KOOV), Patisserie (CAKE), Servelec (SERV) and Safestyle (SFE). "There has been a real return of IPOs, especially during 2014, and I also expect a vibrant IPO market over the third and fourth quarter of 2014," says Mr Hermon. "We are quite pragmatic and view each one on its own merits."

For example, he likes Koovs because while it only has a market capitalisation of £36m it sells into India. "It was set up by the founder of online retailer Asos (ASC) and doesn't have much competition: it sells western fashions to the Indian middle classes," says Mr Hermon. "It is loss making and will be for the next two to three years but could be an interesting long-term story. The company's managers have also put their own money in."

Over its last financial year Henderson Smaller Companies increased its dividend to 11p, up 69 per cent on its previous financial year. The rise is partly due to a change in accounting policy since 1 June 2013 to charge 70 per cent of management fees and finance costs to capital, as well as the growth in dividend payments of underlying holdings.

Before this Henderson Smaller Companies didn't charge any of its expenses to capital, which is unusual among smaller companies investment trusts. "This brings us in line with the sector and you should have your costs allied to long-term returns," says Mr Hermon. "While it will detract from capital growth by a small amount it will not be a material change. We invest in companies that can grow their capital long term: our compound return is 18 per cent a year since 2002 (when Mr Hermon was appointed manager) and the vast majority of that comes from capital."

Going forward the trust aims to grow its dividend sustainably.

Source: Morningstar & *Henderson

Source: Morningstar, as at 23 September 2014

Top 10 holdings, as at 31 August 2014

Sector breakdown