Exploit this short-term opportunity in a small-cap trust

ASIT seeks companies capable of generating high levels of income, but which are priced below fair value. The kicker, to potential investors, is that the trust is due to wind up on 1 July 2024, when investors should get their investment back at a price close to the trust’s net asset value (NAV). As of 22 September, the trust’s ordinary shares were trading at a discount to NAV of 8.9 per cent, which should narrow as the wind-up date approaches. This could boost returns for investors if the portfolio performs well over the next nine months, or cushion the losses if it does not.

Even in the current interest rates environment, ASIT’s 7.25 per cent yield is nothing to sneeze at. The trust normally pays an interim dividend in February and a final dividend in August, so those buying shares between now and January should be entitled to the full dividend for the financial year to June 2024. The trust increased its revenue reserves last year to help protect this year’s dividends, since an economic downturn and the wind-up process could dent the levels of income coming from the portfolio.

Small caps are usually a long-term investment, and investing in a fixed-life vehicle with such a short time horizon is not without its risks. A downturn near the wind-up date could reduce NAV, for example. And although it is unlikely that UK small caps will permanently stay this cheap, it is hard to predict when investor sentiment could turn – or whether ASIT’s holdings might mirror any boost to small-cap sentiment.

In the trust’s latest annual report, the board recognised that “the spectre of recession and the general apathy towards UK assets mean that the upside in [the portfolio] is unlikely to be fully realised by 1 July 2024”. It added that it is exploring options to allow shareholders to continue to invest “in some form”, as well as redeem their cash – an option that could be attractive to investors who bought the shares at a discount.

The trust trades via both ordinary and zero dividend preference (ZDP) shares. The ZDP shares will be worth 127.25p each when the trust is wound up, which represents a 6.5 per cent return on the current price of 119.5p per share. Though a less risky option, this leaves no space for higher returns if the portfolio does well. The capital raised from the ZDP shares is used to gear the portfolio, currently by about 38 per cent, which could make losses worse in a market downturn.

Cheaper than ever

Aberforth’s value strategy uses the ratio of enterprise value to earnings before interest, tax and amortisation (EV/Ebita) to establish a company’s target price. The manager then invests following a “value roll” that seeks to move capital from companies whose share prices are close to their targets into those at a wide discount. Aberforth also focuses on engaging with its investee companies.

The resulting portfolio is cheaper than the trust’s investment universe. As of June 2023, the portfolio’s average historical price/earnings (PE) ratio was 8, against the 10.8 of the Numis Smaller Companies index. The manager recently noted that the trust’s corner of the market is undervalued in multiple ways: the UK looks historically cheap compared with the rest of the world, small caps are historically cheap compared with large caps, and the trust’s portfolio is historically cheap compared with the rest of the small-cap universe. This was calculated comparing the relevant PE ratios as of 30 April 2023 with their 32-year averages.

ASIT’s strategy has done well in the past three years, since the post-Covid-19 recovery started, but the track record since the trust’s inception in July 2017 is choppier. Overall, the manager’s value style has been a tailwind in the past year, although the artificial intelligence rally earlier in 2023 brought growth stocks back into the spotlight.

As to the holdings, they look reasonably well-placed to hold value between now and July. We ran ASIT’s portfolio through our version of finance professor Joseph Piotroski’s F-Score screen (see table), which measures stocks against nine tests of corporate resilience, including whether net income is increasing and whether net debt is falling, among others. As the table shows, the portfolio scored in line with the total market average of 5.6. In short, there is little reason to believe the portfolio should do worse than the broader market.

Among the top 10 companies in the portfolio, Bloomsbury Publishing (BMY) got full marks, passing all nine tests, while bus and rail operator Firstgroup (FGP), engineering company Vesuvius (VSVS) and van rental company Redde Northgate (REDD) passed eight. Of the 62 companies in the portfolio, 26 saw their profits after tax increase year on year, a test that feels especially relevant because it can be a signal that a company may be in recovery mode and in the process of rerating.

An average portfolio company yield of 5 per cent also augurs well for investment income. Even if capital values flatline, dividend income alone should be enough to boost the portfolio’s NAV, pushing the potential total return between now and the wind-up date above 12 per cent. While small caps always carry risks, the possible rewards in ASIT look positively skewed.