Dunedin Smaller Companies Investment Trust has announced its annual results for the year ended 31 October 2016. During the period, the company provided an NAV total return of 7.0% and a share price total return of 4.1%. According to the company, this compares against a total return of 6.7% for its benchmark index, the FTSE SmallCap (ex Investment Companies) Index. The discount to NAV widened over the period from 15.0% to 17.8%.
In terms of performance attribution, the trust says that, the companies in its portfolio have wide and varied geographic exposures and consequently the impact of the EU referendum at the level of the individual holdings was limited. The positive performance for the year arose from a range of businesses with exposure to diverse end-markets. These included RPC Group, which the trust’s chairman, Norman Yarrow, says continued its successful consolidation of the European plastics packaging market. He also says that Dechra Pharmaceuticals witnessed very good growth in its US operations whilst also benefitting from efforts to broaden its operations to serve the food producing animal market. Two recent introductions to the portfolio; Smart Metering Systems and Burford Capital also delivered strong performance. Norman says that, in each case, a combination of the delivery of better than expected results has combined with an increasing appreciation of their business models by investors to deliver substantial share price gains. He also says that, James Fisher, the marine services company, more than offset weakness in its oil and gas exposed businesses with pleasing contract wins in its nuclear, offshore wind and submarine rescue operations. BBA Aviation and Abcam, a provider of high end research laboratory consumables, are two other businesses that delivered substantial gains during the year as, in the chairman’s view, they continued to successfully execute their strategies. He also says that BBA’s share price has been a beneficiary of the weakness of Sterling given the vast majority of its revenues are in US Dollars.
In terms of detractors, the chairman says that Mothercare has been unfortunate to experience a downturn in trading in its international division at a time when the already troubled UK business has shown signs of improvement. Interserve, the construction and facilities management company, has also struggled, with three loss making construction contracts in the UK. He says that, despite resilient trading throughout the rest of Interserve’s business, the uncertainties caused by these have weighed on the share price.
In terms of portfolio activity, the manager, Ed Beal, says that they introduced four new holdings during the year and, in his view, each company is a leader in its respective market and they believe that these bring beneficial diversification to the portfolio. Smart Metering Systems are a leading meter rental company serving the electricity and gas utilities. Ed says that they benefit from a highly visible recurring, long term revenue stream underpinned by the blue chip nature of their customer base and that the current and contracted business should provide attractive profits and cash flows. However, he also says that they have a very significant opportunity with the impending roll out of domestic smart meters and that the company has a strong position in the supply chain which gives confidence that they will be able to execute effectively on a programme that has the potential to be company changing. Cairn Homes is a Dublin-based house builder which listed on the London Stock Exchange in mid-2015. Ed says that it has he two founders bring a combination of Irish housebuilding experience and real estate investing. The Irish market is reportedly experiencing supply shortages of new homes, particularly in and around Dublin. However, Ed says that the ability to ameliorate this is restricted because 80% of the best quality development land is owned by the National Asset Management Agency, an organisation that is unable to develop it. Meanwhile many of the individuals with the required skills set are precluded from involvement in the market due to personal and bankruptcy proceedings. Ed says that the Cairn premise is relatively simple -take advantage of a lack of demand for good quality residential building land in order to rapidly acquire a with-planning consent 10,000 unit land bank and then to move to a build out phase running at 1,500 homes annually by 2018. He says that assets are being sourced from both NAMA and the banks and that planning is a minimal issue because assets are bought with consent. Burford Capital is a provider of litigation financing and Ed says that there are two key drivers for the take up of this form of financing. In his view, law firms welcome it because their partnership-based model prevents them accessing external capital to fund lengthy legal cases, and litigants are incentivised to use it because it allows them to avoid carrying litigation costs through their profit and loss statements. Ed says that the attractions of the investment are the lack of correlation between Burford’s returns and the economic cycle. In addition, he says that the business could be regarded as having characteristics similar to venture capital but with more certainty over the ability to secure an exit. Assura is a UK REIT investing in and developing primary care property. Ed says that there has been some yield compression but nothing like the levels seen elsewhere in the real estate sector, meaning that yields in excess of 5% are achievable. He says that there are almost 9,000 GP buildings so the pool of potential assets is sizeable and that the portfolio has grown very significantly over the last seven years. Currently 100% of debt is fixed but an increasing amount of floating rate debt will be utilised which will deliver a natural earnings benefit as a result of lower interest costs. Ed also says that rents are either inflation linked or subject to open market review which has historically produced increases ahead of inflation. Ed says that there is a growing pipeline of development opportunities following an NHS reorganisation that had caused a hiatus over the two prior year and that this is important because newly developed assets with higher rentals drive up market rents for other assets.
In terms of disposals, four holdings were sold in their entirety. Ed says that Bellway had been a very successful investment for the company but, as the UK housing market has recovered strongly post the recession so companies like this have done very well. He says that they believed that the valuation was pricing in a permanently favourable outlook and that they considered that this was unduly optimistic. The Restaurant Group has seen a significant, indeed arguably structural, change to its market. Specifically, Ed says that, as e-commerce takes a greater share of the retail pie, those assets located on sites where shopping is the key driver of footfall are finding it difficult to sustain, let alone grow, sales. In Ed’s view, the company remains a fine operator but he says that they believe the task of repositioning the business will be complex and lengthy and they decided to exit the holding. Ed says that Bloomsbury Publishing has a long term strategy to seek to adjust to their increasingly digitised markets and they believe that the company faces a prolonged period of low earnings growth with no guarantee that they will be successful in making the necessary transition. Numis had been held in the portfolio for over a decade. However, ed says that they believed that although this was a deeply cyclical business they had an opportunity to build a franchise that was able to deliver through cycle growth and that they had a balance sheet that gave them the flexibility to capitalise on this opportunity. However, falling commission rates for stock brokers have been evident for several years and Ed says that the situation now looks set to deteriorate further with regulatory interventions reducing the opportunities for the company to make money from institutional broking. With pressures rising on fund managers’ margins there will be reduced levels of fees available for research provided by the sell side. Ed says that they concluded that the long term prospects for the company were insufficiently attractive for it to warrant a position in the portfolio.
In terms of Outlook, Ed says that global growth looks set to improve next year aided by an on-going recovery in the US, Russia and Brazil exiting recession and a Chinese economy that increasingly looks to have stabilised, albeit at levels of expansion below those enjoyed previously. However, the risks posed by Brexit, the fragility of the European banking system alongside various regional elections and the impending change of Administration in the US all mean that there are significant uncertainties facing investors, companies and consumers. The US economy is still making progress as evidenced by solid employment data and indications that interest rates are likely to be raised again later this year. Brexit, in Ed’s view, has so far been more of a political shock than an economic one in the Eurozone and the region remains on course to grow by around 1.6% this year. He says that Chinese growth is holding steady but factors such as weak corporate investment and loss of momentum in real estate suggest a need for further stimulus if the current level of expansion is to be maintained. Looking forward, he says that it is not only investors that do not know what the post Brexit landscape will look like, company management teams and consumers are equally unsure. A period of slower activity is therefore to be expected and some of the economic and confidence surveys that have been released since the vote support this. As a result of this uncertainty, companies that have actually traded quite well during 2016 find themselves having to inject caution into their outlook statements. However, in Ed’s view, this does not mean that the long term prospects for the economy have been irretrievably damaged. Whilst earnings expectations have declined slightly compared to forecasts pre the vote, they have not declined by anything like as much as the more negative commentary for the outlook for the economy as a whole would suggest. Indeed, Ed says that it is notable that as more data has become available some of the most downbeat commentators have been forced to shift to a less extreme position. In the meantime Sterling weakness is being regarded as a positive for the profitability of many UK companies and hence equity markets. Ed says that this holds true to a point but devaluing the currency is not a panacea and brings with it the risk of future inflation with some economists now forecasting that it will reach 3% by the middle of 2017. He says that this could be problematic given the difficulty of using conventional policy to address the issue. Looking at the company’s holdings, Ed says that, although trading is generally fine they too are suffering from the uncertainty that surrounds the shape of the Uk’s future relationship with Europe. Ed says that a temporary hiatus is manageable but a prolonged period of constrained investment will impact the medium term prospects.
Dunedin Smaller Companies benefits from holding a range of businesses with exposure to diverse end-markets : DNDL