Why consider AUSC?
The UK stock market has been out of favour with global investors, meaning that domestic company valuations, particularly those of smaller businesses, are looking very attractive in both absolute and relative terms. Small-cap stocks typically outperform their large-cap brethren over the long term but have lagged in the last couple of years during a period of heightened risk aversion, suggesting a potential good entry point to this asset class.
AUSC’s relative performance is improving; its NAV has outpaced its reference index over the last 12 months. The trust’s portfolio is actively managed, with Glennie and Yeaman’s use of the Matrix enabling them to be nimble in identifying potential new attractive investments and highlighting portfolio companies with deteriorating scores that require further investigation.
The managers say that there is a wealth of opportunities available in their investible universe, meaning there is healthy competition for capital within the portfolio. Many portfolio names have positive earnings estimates revisions, which suggests a robust operating environment; this is confirmed in meetings with companies.
While AUSC aims to generate capital growth there has been solid progression in its annual dividend, supported by a diverse income stream. Over the last five years, the trust’s annual distributions have compounded at 9.5% per year, despite lower income during COVID. This has been helped by some portfolio companies paying special as well as regular dividends.
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AUSC: A good time to consider the trust?
AUSC’s relative performance is improving, having experienced a very difficult period in 2022 when growth stocks derated in an environment of rising interest rates. UK equities are very attractively valued, and small-cap stocks in particular have been out of favour with investors.
Looking at the trust’s recently released H124 report, its NAV and share price total returns of +7.3% and +12.9%, respectively, were ahead of the reference index’s +5.5% total return. The revenue return per share of 6.0p was 12.8% higher year-on-year, while the interim dividend of 3.7p per share was 23.3% higher than 3.0p per share in H123. AUSC’s board has indicated that it intends to at least maintain the final dividend at 8.0p per share, which would equate to a 6.4% increase in the total FY24 distribution. Ongoing charges of 0.91% in H124, were 4bp lower than 0.95% in FY23, helped by a reduced fee structure (please see our October 2023 review for more details). In an environment of above-average discounts, the board repurchased shares on most trading days in H124; 7.1m shares (8.1% of the share base) were bought back at an average 13.2% discount, which enhanced NAV by 1.1%. AUSC’s discount narrowed during H124 but has since widened from 10.0% on 31 December 2023. Regular share repurchases have continued in H224.
The investment approach
Glennie and Yeaman are sticking to their long-term successful process, using the proprietary Matrix screening tool, which has been employed since 1997 and reflects quality-, growth- and momentum-based factor analysis. ‘Quality’ highlights companies that have pricing power, resilient and visible earnings streams and strong balance sheets, ‘growth’ identifies businesses that can grow over the long term through economic cycles, while ‘momentum’ signals those companies with an ability to meet or beat consensus expectations. Companies that meet the Matrix’s quality, growth and momentum criteria will change over the course of the business cycle. Quality companies have the potential to outperform in a variety of market conditions: strong, moderate and falling markets.
The managers follow seven principles for successful small-cap investing:
- Focus on quality to enhance return and reduce risk – factors include strong financials, the strength of a company’s relationship with its customers and an element of pricing power.
- Look for sustainable growth – companies that can deliver consistent year-on-year earnings growth.
- Momentum – run your winners and cut losers.
- Concentrate your efforts – use of the Matrix helps identify suitable portfolio companies and reduces the risk of spending on stocks that do not meet the required criteria.
- Invest for the long term – identify the great companies of tomorrow and hold them for the long term, which helps to maximise returns and reduce trading costs.
- Management quality – high ownership and involvement by founders and CEOs with long tenures are viewed positively.
- Valuation aware – company valuations are embedded within the Matrix and the decision-making process but are not a primary focus.
An update from Glennie and Yeaman
Glennie and Yeaman are encouraged by the trust’s much brighter results in H124, including robust income, which is supporting AUSC’s positive dividend record. The managers are now having to talk less about the macroeconomic environment and more about the trust’s process and holdings, which they consider is a positive development. Glennie and Yeaman are firm believers in the investment process and are grateful for the shareholders that have stuck by AUSC through a difficult period of performance.
For most of 2023, the UK market was driven by top-down factors, but starting in Q423 there is now more of a focus on company fundamentals and valuations. Hence, the managers are feeling more optimistic about the trust’s prospects, highlighting that AUSC’s remaining £15m debt facility was recently drawn down, indicating their bullish outlook. They report that when meeting companies the message is that while the operating environment is not without its challenges, trading is generally robust, and management teams are optimistic about the future and willing to invest, including in bolt-on acquisitions. Glennie and Yeaman expect interest rates to come down, but it looks as though the timing has been pushed out. As the growth benefits of post-COVID recovery and inflation wane, the managers stress the importance of focusing on companies that can grow under their own steam, and exceed expectations, while avoiding those whose results are likely to disappoint, as their share prices can sell-off sharply.
Glennie and Yeaman highlight that the UK market looks very inexpensive, which they say in itself is not a reason to invest. However, small- and mid-cap UK company valuations versus those of UK large-cap businesses are at historical lows. The managers comment that UK stocks have rallied nicely off the late-October 2023 low point, but while recent data are more supportive of an economic recovery, there is still a lack of investor appetite for UK equities. They note that in the past, UK stocks have rallied following the first interest rate cut of an easing cycle, with smaller companies’ shares outperforming those of large-cap businesses over the subsequent six and 12 months. Glennie and Yeaman highlight that AUSC’s portfolio is valued at a four-point forward P/E multiple premium to the benchmark, which is at the low end of the historical range.
Current portfolio positioning
At the end of January 2024, AUSC’s portfolio held 51 stocks, which is towards the low end of the typical 50–60 range. The trust’s top 10 concentration increased modestly over the period from 33.6% to 35.5%; four positions were common to both periods. At the end of January 2024, the active share was 82.0%, which was lower than 84.9% 12 months earlier (active share measures how the fund differs from its reference index, with 0% being full index replication and 100% no commonality).
While stocks are selected on a bottom-up basis, it is interesting to note, as shown in Exhibit 2, over the 12 months to the end of January 2024 there were some notable changes in AUSC’s sector exposure. These include higher weightings to financials (+6.1pp), a sector with a wide range of businesses, industrials (+5.8pp) and energy (+5.2pp), and lower allocations to technology (-7.9pp), which has more than halved, and consumer discretionary (-6.8pp). The trust retains a zero weighting in utility stocks as these companies do not fulfil the managers’ quality, growth and momentum criteria.
Recent portfolio activity
In September 2023, the managers initiated a new position in specialist engineering manufacturer Hunting (LON:HTG). In recent years, its business has become less cyclical via active diversification by product, end market and geography. Hunting has leading market positions, a strong reputation, quality products and service, and intellectual property protection. The company has a robust balance sheet, providing flexibility to invest both internally and via acquisition, while the strength of its customer base has improved. Two other new names entered the portfolio last September. XPS Pensions Group is one of the largest pure-play consultancy and advisory businesses in the UK. Having grown organically in a lacklustre market, the company is now benefiting from higher client demand because of regulatory changes and pension market volatility. Volex is a well-established manufacturer of power equipment with a leading position in a highly fragmented market.
The holding in XP Power, a provider of power supply solutions, was sold in October 2023 following the company’s profit warning and dividend suspension. A high level of debt amid difficult trading conditions required a subsequent equity raise. XP Power recently issued another weak trading statement.
In November 2023, the managers initiated three new positions. Premier Foods (LON:PFD) has a portfolio of well-known brands including OXO, Sharwood’s, Homepride, Angel Delight and Mr Kipling. Over the last five years the company has reduced debt, resolved its pension issues and generated consistent growth from its brands. Premier Foods has a strong record of innovation and execution with growth opportunities both domestically and overseas. Chemring Group is a defence business with robust cash conversion and a high-quality order book due to strong long-term customer relationships. Workwear supplier Johnson Service Group has higher organic growth and margins than its peers and its competitive gap is widening due to the company’s successful investment strategy.
Video games company Team17 Group was sold last November following a profit warning, while December 2023 saw the sale of the position in technology consultant FDM Group (LON:FDM) following a disappointing meeting with the company’s management team, where it seemed unclear about the reasons for a difficult 2023 trading environment.
Performance: More friendly investment backdrop
AUSC is one of 24 funds in the AIC UK Smaller Companies sector. In Exhibit 3 we show the 13 largest companies with market caps above £100m. Compared with the selected peer group, the trust’s NAV total return is above average over the last 12 months and below the mean over the other periods shown. The funds shown below all follow different mandates; AUSC is unique with the managers using the proprietary Matrix to screen for companies that meet their quality, growth and momentum criteria.
An analysis using Morningstar data highlights that most of the selected peer group are classified as small-cap blended funds (a mix of growth and value attributes), whereas AUSC and Montanaro UK Smaller Companies Investment Trust (MTU) are classified as small-cap growth funds. Comparing the performance of these two funds, AUSC has a higher NAV total return over the last one, five and 10 years, with a significantly superior return over the last decade.
Further analysis by Morningstar shows that AUSC has a higher cyclical exposure (to sectors that are highly sensitive to the stage of a business cycle) than MTU (34% vs 26%), a lower sensitive exposure (to sectors with a moderate correlation to the business cycle, 55% vs 59%) and a lower defensive exposure (to anticyclical sectors, 11% vs 15%).
Returning to the selected peer group, AUSC’s discount is wider than average in a group where just one fund is trading at a premium. The trust has an average ongoing charge, its net gearing is below the mean and its dividend yield is above the selected peer group average despite the focus on long-term capital growth.
Glennie and Yeaman are encouraged by AUSC’s outperformance in H124, which was supported by resilient earnings, particularly for the portfolio’s bigger positions. The largest positive performance contributors were: Ergomed (+101bp), which received a private equity bid at a 28% premium to its pre-bid share price (the position was sold); Ashtead (LON:AHT) Technology Holdings (+89bp), which delivered a strong operating performance and announced the acquisition of ACE Winches, which together led to a 25% uplift in its FY24 earnings estimates; Hill & Smith (+54bp), which is experiencing strong momentum in its US business (73% of operating profit) along with resilient UK operations; Hilton Food Group (+54bp), which benefited from its defensive characteristics and secured new customers in Canada and Singapore; and Paragon Banking Group (+52bp), which reported results that met consensus expectations despite difficult macroeconomic conditions.
Conversely, the largest detractors to the trust’s performance were: Big Technologies (LON:BIGB) (-90bp), which experienced a pause in its growth rate and reduced earnings estimates due to contract timing unpredictability and a lack of major wins; XP Power (-74bp), which issued a meaningful profit warning and was sold ahead of an equity raise; Team17 Group (-67bp), which was also sold following a disappointing trading update; Auction Technology (LON:ATG) Group (-49bp), which delivered revenues below expectations and reduced organic growth guidance; and CVS (-44bp), which was subject to a Competitions & Markets Authority review.
As highlighted in Exhibit 6, AUSC gave back a significant amount of relative performance in 2022, a period of rising interest rates that led to a devaluation of growth stocks. The trust’s performance has improved in recent months as investors focus more on company fundamentals rather than the macroeconomic environment. AUSC’s NAV is ahead of its reference index over the last one and five years and remains considerably ahead over the last decade.
Upside/downside capture
AUSC’s upside/downside capture over the last decade is shown in Exhibit 8. Its upside capture rate of 117% suggests that the trust will outperform in months when UK small-cap shares are moving up. The 107% downside capture rate implies that AUSC will underperform, but to a lesser degree, during periods of UK small-cap share price weakness.
As the trust’s relative performance declined at the beginning of 2022, when investor focus shifted from growth to value stocks, AUSC’s downside capture rate increased from around 80% to above 100%, suggesting that for several years prior to early 2022 the trust was likely to outperform in both rising and falling markets.
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