Henderson Smaller Companies continues strong run

UK smaller companies had an unexpectedly strong 2017, which was driven by faster earnings growth, according to Neil Hermon, manager of Henderson Smaller Companies Investment Trust. And while he cannot promise that performance will be as strong this year, he is reasonably confident on the outlook for smaller companies – especially as the UK economy seems to have weathered the vote for Brexit better than initially expected.

"If you look at the global positioning of international investors, the UK is the most hated market in the world, with most investment strategies very underweight the UK," he says. "You can somewhat understand why: we've got Brexit [coming up], political instability, a minority government and slower gross domestic product (GDP) growth. But when you strip that back the UK corporate sector is generally in good fettle and that presents an opportunity, because if we were to see sentiment shift back to the UK, the upside from the money that would flow back from international investors would be quite significant."

But even though Mr Hermon is aware of the macroeconomic picture, he focuses more on company specifics and credits good stockpicking for the trust's performance. Over the six months to 30 November 2017, for example, the trust benefited from strong share price returns from holdings such as Renishaw (RSW), a high-technology precision measuring manufacturing group, and NMC Health (NMC), a healthcare provider operating mainly in the middle east. These increased by 44.8 per cent and 25.1 per cent, respectively. Henderson Smaller Companies also benefited from not holding Carillion (CLLN), which is now in liquidation.

Mr Hermon and his team aim to invest in quality growth companies at the right valuation, with a market cap of at least £100m. They decide whether to invest in a stock via a four-stage process they call the 'four Ms': model, management, money and momentum.

They examine a company's business model, preferring ones with an enduring franchise or competitive advantage. Then they scrutinise the company's management, looking at the team, strategy, motivation, business vision and corporate governance.

Regarding finances, they will only invest in profitable, cash-generative companies and have a preference for those that pay dividends. Mr Hermon and two of his colleagues have a background in accountancy, so are experienced in analysing company balance sheets and accounts.

Finally, they assess earnings momentum – the potential for a company's earnings to do better than current market expectation.  And they meet with more than 400 companies a year.

The UK market is polarised between cheaper domestic-facing stocks and more expensive internationally-exposed stocks. Although Mr Hermon is not avoiding any one area of the market, he is more underweight domestically focused companies such as general retailers, food producers and banks, which he thinks could be more vulnerable to a UK financial downturn.

Mr Hermon has recently added a number of new companies, including Alpha Financial Markets (AFM), a consultant to the asset management industry; Arrow Global (ARW), a debt management and purchase company; Footasylum (FOOT), a sportswear retailer; IQE (IQE), a compound semiconductor company; Just Group (JUST), an enhanced annuity company; TI Fluid Systems (TIFS), an automotive supplier; and Ultra Electronics (ULE), a defence company.

And he sold stocks he thought were set for poor price performance or where the valuation had become too high. These included Abcam (ABC), Dunelm (DNLM), Interserve (IRV), RPC (RPC), Spire Healthcare (SPI) and Vectura (VEC).

Several of the trust's holdings were subject to successful takeover bids during 2017, including Aldermore (ALD), Atkins, Exova, Imagination Tech, Paysafe, Quantum Pharma, Servelec and SQS (SQS). These were generally bought at decent premiums and Mr Hermon thinks merger and acquisition (M&A) activity could again give the trust's holdings an uplift.

"Overseas corporates are seeing the value of UK equity markets, cash levels globally are very high, internationally debt is cheap and confidence is improving," he explains. "Average [company] leverage is much lower than it was in 2008, which means we'll see more M&A as those balance sheets can be utilised for acquisitions. And dividends will continue to rise."

The trust's board is increasing its interim dividend by 20 per cent to 6p per share, and also expects to increase the final dividend, although it has a total return mandate. For the year ended 31 May 2017 its total dividend was 13p and the trust has a yield of about 2 per cent.

Henderson Smaller Companies is trading at a discount to NAV of around 10 per cent, one of the tightest levels in two years.

The trust's chairman, Jamie Cayzer-Colvin, has recently urged investors not to rely on the Key Information Document investment trusts are now required to produce. This document indicates that Henderson Smaller Companies could lose nearly 20 per cent a year in bad stock market conditions but make returns of 28.5 per cent in favourable conditions.

Mr Cayzer-Colvin says: "[The performance calculation] is prescribed by the regulation and is derived from the recent past performance of the trust. However, we do not believe that this is an appropriate or helpful way to estimate future returns, and for this reason the results shown in the new documents should not be used for this purpose."

Henderson Smaller Companies Investment Trust (HSL)

Performance

Source: Winterflood Securities as at 25/01/18

Top 10 holdings as at 31/12/17 (%)

Source: Janus Henderson

Sector breakdown as at 31/12/17(%)

Source: Janus Henderson