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Smithson lags benchmark during first half of 2021 but reminds investors of long-term growth

Smithson lags benchmark during first half of 2021 but reminds investors of long-term growth – Smithson (SSON) has published its interim results for the six months to 30 June 2021. During this time, its NAV return was 5.9% while its share price total return was 4.1%. This compares with a 12.4% return from its benchmark MSCI World Small and Mid Cap IndexThe trust has consistently traded at a premium to NAV and closed the period under review at a premium of 1.9% with an average premium of 2.3%.

One of the reasons listed by the board for SSON’s recent underperformance was the fact its dividend income was lower than its operating expenditure over the six months, resulting in a revenue loss, which was netted against the capital gains. However, the board said investors should remember that the Smithson portfolio has been constructed for long-term ‘growth’ rather than short-term ‘value’, and that since the original IPO in October 2018, SSON has recorded an NAV return of 74.7% compared with the MSCI World SMID Index which recorded 41% over the same period, representing an annualised growth rate of 23%.

Manager, Simon Barnard, said portfolio holdings did not keep pace with the rising benchmark due to a resurgence in economic growth combined with loose fiscal and monetary policy which led many market participants to expect a sharp acceleration in inflation, perhaps even to uncontrollable levels.

Statement from the manager:

“The MSCI World SMID Index rose steadily throughout the period but the companies we own did not keep pace. We believe this is for a couple of reasons. Primarily, the combination of a resurgence in economic growth combined with very loose fiscal and monetary policy led many market participants to expect a sharp acceleration in inflation, perhaps even to uncontrollable levels. This would, should it occur, lead to a meaningful increase in the level of interest rates set by central banks, and indeed, led to a sharp rise in US 10 year treasury yields from 0.9% in January to a peak of 1.7% in March. This, in theory, reduces the value of higher rated growth companies, such as those owned in the portfolio, because the future earnings of these companies would have a lower perceived value today, once discounted back at the higher interest rates. More lowly rated companies, that don’t grow as fast, have less of their earnings in the future to discount, and so are less affected by this phenomenon.

It is worth noting that inflation itself would likely not cause a significant problem for our companies. The companies we own tend to have low input costs, and subsequently high gross margins, as well as low capital requirements, allowing them to generate high returns on capital. As inflation will affect both the cost of raw materials and the cost of plant and equipment, those that spend less as a proportion of revenue on these items will be less impacted. On top of this, the market structure and competitive positioning for many of our companies mean that they would also be in a position to raise prices charged to their customers should the costs of the business increase. We therefore believe that a period of higher inflation is not a situation to be feared in terms of business fundamentals.

Interestingly, the underperformance pertaining to this increased inflation expectation by market participants seemed to reverse in June once the Governor of the Federal Reserve made comments indicating that they were aware of the current increase in inflation (so no one need be concerned it will be ignored and allowed to get out of control), they believe it to be transitory, and so won’t be raising interest rate targets any time soon.

The second issue, somewhat linked, is that in a world with resurgent growth, investors are less willing to pay high valuations for companies that can grow consistently through good times and bad, such as those in our portfolio. Instead, they buy ‘cheap’ or ‘value’ companies, because they will also grow in this improving environment – as the saying goes, a rising tide lifts all boats. This meant that such ‘value’ companies did relatively better in the first half than the types of companies we own.

Despite the underperformance relative to the index, the absolute performance of the portfolio in the first half, up 5.9%, was adequate compared to our own expectations, being an annualised gain of 12.3%. It is also the case that the underperformance was predominantly due to the macroeconomic factors discussed above and there were no serious underlying issues with any of the companies we own. In fact, we were very satisfied with the earnings reported by the vast majority of the portfolio companies during the period, given the obvious difficulties faced by many.”

SSON : Smithson lags benchmark during first half of 2021 but reminds investors of long-term growth

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