Schroder UK Mid Cap Fund has announced its annual results for the year ended 30 September 2016. During the period, the Company’s net asset value produced a total return of 6.5%, which it says compared to a total return of 8.6% for its benchmark, the FTSE 250 (ex-Investment Companies) Index. The trust’s chairman (Eric Sanderson) says that this relative underperformance was largely attributable to our holdings of domestically-focused stocks which performed less well than those with a more export led turnover. The trust’s share price produced a negative total return for the year of 4.0%, reflecting a significant widening of the Company’s share price discount over the period from 9.3% to 18.3%. The chairman says that this widening is representative of a trend across UK-centric investment trusts in the sector, in part triggered by the results of the EU referendum. The average share price discount for the year was 13.6% and it ranged between 5.8% and 21.7%.
Eric says that performance during the first half of the year was affected by uncertain markets leading up to the UK’s referendum on its membership of the EU and that, immediately after the vote, mid cap share prices became exceptionally weak on concern about the implications for domestic growth. He says that, subsequently, these fears have generally dissipated and mid cap share prices have recovered. In advance of the referendum, the company held net cash on its balance sheet and took advantage of lower stock prices by utilising limited gearing to add to the portfolio at that time.
While performance lagged the benchmark, the company reports a significant increase in income generated by the portfolio during the year under review: the revenue return per share increased by 25.5%, from 9.82 pence per share to 12.33 pence per share. Reflecting this, the Directors recommend the payment of a final dividend of 8.50 pence per share for the year, which, together with the interim dividend of 2.75 pence per share, brings total dividends for the year to 11.25 pence per share, an increase of 22.3% over dividends declared in respect of the previous financial year.
Looking at individual holdings, the manager says that the underperformance relative to the benchmark was largely attributable to domestically-focused holdings, which included automotive retailer Lookers, gaming group Rank and housebuilder Redrow. The manager says that, for the most part, these companies have reported solid or strong trading updates, but the shares have nonetheless suffered in the months leading up to and immediately after the EU referendum amid fears about the UK’s economic outlook. Meanwhile, Lookers, Rank and Redrow raised their dividends by 20%, 18% and 67% respectively, in contrast to much of the wider market, underpinned by rising streams of profits in all cases. The manager says that, more generally, the company delivered earnings growth, driven primarily by dividends from the underlying holdings, of 26% relative to the benchmark’s c.15%.
The manager says that, as in the first half of the financial year, the strongest positive contribution over the full year came from international veterinary products business Dechra Pharmaceuticals. The company has reportedly enjoyed stable growth of its animal drugs portfolio and strong performance in North America. The market also welcomed the purchase of Putney, a leading developer of generic companion animal pharmaceuticals in the US. The manager says that many of the portfolios’ other internationally diversified companies performed well, for example software and IT services provider Micro Focus (c.95% ex-UK revenues), domestic home repairs and insurance provider HomeServe (c.55% ex-UK revenues) and specialist provider of marine services James Fisher (c.60% ex-UK revenues). The manager says that the market rewarded underlying growth and was also willing to attribute an additional premium to expectations of future benefit from overseas earnings exposure, relative to more domestically-focused holdings. Positive contributions also came from not holding stocks such as post-merger betting and gaming company Paddy Power Betfair, and London-exposed real estate companies Capital & Counties and Derwent London. However, not owning supermarket group Wm Morrison detracted from performance, as did the decision not to hold Rentokil Initial. From a sector perspective, our underweight position in mining and industrial groups negatively impacted performance as the market rotated into these stocks despite a failure to meet market forecasts in many cases.
In terms of portfolio activity, the manager initiated a new holding in online car classifieds business Auto Trader in November 2015. The manager says that, as the market leader, the company is well positioned to generate revenue from its data sources and drive up average revenue per retailer. The manager also bought self storage provider Safestore in November 2015 and added to the position throughout the first quarter of 2016. The manager believes that the company has considerable growth potential in both the UK and France (in Paris), where occupancy levels and pricing can be driven up. In January, a new holding was established in specialist buy-to-let lender Paragon, which the manager viewed as oversold following taxation and regulatory changes. The position was added to throughout the first half of 2016, due to the manager’s belief that the market will continue to see growth thanks to favourable supply and demand demographics in the UK.
A position in homewares retailer, Dunelm Group, was added in April 2016. The manager says that this organic growth story is driven by new space, margin gains and, more recently, new merchandising initiatives, which are driving improved sales per square foot. The manager says that the company is highly cash-generative and is benefiting from a fresh pair of eyes in the form of new CEO John Browett (formerly at Dixons and Apple). The manager also bought into Cranswick (pork and poultry processor), which reportedly has strong relationships across all supermarket chains, including the discounters and the higher end, is partially protected from pork prices through partial vertical integration and longer dated contracts with its customers, and is investing internally generated cash into the high-growth poultry market.
Post the referendum, the manager initiated a position in cash-rich Howden Joinery (manufacturer and supplier of kitchens) at what was considered to be a depressed valuation. A new position was also initiated in sports retailer JD Sports, which the manager says has strong relationships with suppliers, particularly Nike and Adidas, whose products it sells to relatively less price-sensitive customers, and which is exploring international growth avenues. The manager also added to existing holdings such as alternative asset manager Intermediate Capital Group.
The manager sold out of business service provider MITIE and funeral provider Dignity in April and May respectively. The manager says that the sale of the former was due to observed weakness across sector peers and likely cost pressure from the National Minimum Wage, and the latter due to concerns around higher death rates in previous periods, resulting in difficult comparables. The manager also exited Micro Focus in September, taking profits after a strong share price performance and the company’s promotion to the FTSE 100 Index. Other sales include performance materials company Alent following its acquisition by Platform Specialty Products in November 2015, and support services group DCC due to its promotion to the FTSE 100 Index towards the end of 2015. The manager also exited Cable & Wireless Communications in January following a recommended offer for the company from European cable group Liberty Global.
In terms of outlook, the manager says that a number of macroeconomic data points (GDP, consumer confidence, the Purchasing Managers’ Index) have emerged after the referendum suggesting that the immediate shift down by the markets was an over-reaction. The manager says that, whether the Bank of England should take credit for this apparent soft landing is a moot point, but the fact that both the FTSE 100 Index and the FTSE 250 Index are trading above pre-referendum levels suggests that the market is now more willing to believe that economic activity will be only marginally negatively affected by the Brexit process. The manager says that the market has been inclined to reward overseas earners with higher ratings after the referendum, whilst ignoring in some cases stronger fundamentals from domestic-facing companies. The manager says that they will seek to exploit opportunities presented by this mismatch.
Schroder UK Mid Cap holdings in UK domestically focused stocks drives underperformance : SCP