Smithson beat its benchmark in 2021

Smithson beat its benchmark in 2021 – Over the course of 2021, Smithson generated a return on NAV of 18.9% and a return to shareholders of 18.1%, both a little ahead of the 17.8% return on the trust’s benchmark, the MSCI World SMID (small and mid cap) Index. There is no dividend (the fund is not managed to produce income). The trust issued over £530m worth of new shares over 2021.

The way that the trust is managed is not changing, but the board want to clarify the investment policy and so plan to tweak the wording so that it reads “The company’s investment policy is to invest in shares issued by small and mid-sized listed or traded companies globally with a market capitalisation (at the time of initial investment) of between £500m to £15bn.”

Extract from the manager’s report

“Our portfolio only holds high quality companies – more on which later – but included in these are a number of high growth companies which naturally have higher ratings than the market average. This means that in a year when US 10 year treasury yields increased by 66%, from 0.91% to 1.51%, we should theoretically have underperformed the broader Index. This is because high interest rates reduce the value of the future earnings of these companies once discounted back at the higher rates. The slower growing companies in the Index are less affected by this phenomenon, which is why many commentators have been discussing a stock market ‘rotation’ into lower rated companies, or ‘value’ stocks.

What enabled the portfolio to keep up with the Index then? The answer is that on this occasion there were a number of companies that performed well for individual reasons. It is also the case that sometimes financial theory proves to be just that, a theory, which doesn’t actually play out perfectly in the financial markets, driven as they are by millions of fallible, emotional people. Indeed, our highest rated company was one of the best performers last year, up over 30%. This also serves to remind us that ‘highly rated’ does not automatically equate to ‘expensive’ – it always depends on what you are getting for the price. Having said all this, we still consider ourselves fortunate to have outperformed in this environment, and if this trend of increasing interest rate expectations persists, we may not continue to be so lucky.

One might then ask, if interest rates are so obviously on the rise, and this so obviously creates a more favourable environment for value companies rather than quality or growth companies, shouldn’t we adapt our strategy to buy the companies which stand to benefit? Well, no. Owning high quality companies with sustainable growth is a winning strategy over the long term, has been shown to work through several economic cycles, and is one which we know we can execute successfully. Whilst other managers may be able to run a value strategy, we believe it is inherently more difficult, as you cannot hold value companies for the long term if all you are doing is owning a poor quality company at a low price, which you hope will re-rate in the future. If this does happen (there is no guarantee), you then have to sell the company to find another such investment, and so on. This means that unlike our strategy, time is not your friend, because the longer you are holding the company and waiting for it to re-rate, the lower your annualised returns become, and if you’re particularly unlucky, the worse the company becomes. On the other hand, it matters less if it takes more time for the market to appreciate the value of the type of companies we hold in our strategy, because the highest quality companies are constantly getting better, or at the very least bigger, owing to their growth. So, once we have found the right companies, all we have to do is wait. We think that patience is one of our competitive advantages, because with the strategy we employ, it tends to pay off.

Imagine a dog walker crossing a field, their dog wildly zigzagging around them. We would relate the companies we own to the walker, clear in direction and making steady progress across the field, while the daily market price is like the dog, moving back and forth quite randomly. Now, the current economic storm may well send the dog cowering for cover, but given enough time, we know that the price and value will eventually meet again, just as the dog and walker will ultimately leave the field together. We also know that, as well as making constant progress, a high quality company, if it trips during the storm, will rise again and keep going. Low quality, value companies on the other hand, may never get back up.

Of course, interest rates are on the rise because central banks are trying to contain inflation, which many fear may not be transitory, as first thought. It is worth mentioning that we do not fear moderate inflation, which by itself would likely not cause a significant problem for our companies. This is owing to a couple of reasons. First, the companies we own have high gross margins, and therefore low raw material costs. They also tend to have low capital requirements, which allows them to generate high returns on that capital. As inflation affects 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 relatively less impacted by cost inflation. On top of this, the market structure and competitive positioning of many of our companies mean that they would also be in a position to raise the prices charged to their customers should the costs of the business increase. This is not necessarily something we want them to do unilaterally; as a market leader raising prices can often create an ‘umbrella’ under which competitors can flourish by charging slightly lower prices while still maintaining a good margin. But if inflation is creating a cost issue for the whole industry, it is comforting to know that our companies have the market power to increase prices should it become necessary.

To highlight some of the individual companies responsible for the fund outperformance, the top five contributors are listed below.

Fortinet is a cyber security company specialising in firewall appliances and security software. The shares have been strong ever since the SolarWinds hacking attack was discovered in December 2020, after which many corporate technology departments made clear their intention to increase spending on cyber security. This has been reflected in the growth of Fortinet’s revenue, which at 33% in the last reported quarter, was the fastest since 2016, and has resulted in the share price increasing by over 140% during the year.

Nemetschek sells software for construction design and entertainment. There were concerns regarding the construction industry during the initial stages of the pandemic, but by the middle of last year it became apparent that industry growth was as strong as ever. This development also benefitted AO Smith, at the bottom of the list, given it sells residential and commercial water heaters and boilers, which are also somewhat affected by the construction industry cycle.

Equifax is a credit bureau which supplies consumer credit details to banks and other lenders, as well as social security data to employers. As 2021 progressed, it became clear that mortgage and other loan applications would remain strong and a high number of workers would be hired in the US economy. This meant that the demand for Equifax services accelerated to a growth of 26% by the mid-point of the year, and after a strong year in 2020, revenue was 42% ahead of the pre-pandemic level in mid-2019.

Almost all the share price performance in Domino’s Pizza Group came at the end of the year. For some time, the management of the company has been at odds with its franchisees, who were requesting more investment by the company into menu and technology development and a reduction in food costs. This was hampering the growth of the company, as many franchise owners were refusing to open new restaurants until their demands were met. This issue was finally resolved in December, when management reached an agreement with the franchisee association, providing some of what they demanded, in return for a commitment to open new restaurants. This was taken well by the market, sending the shares up 22% in one day, and we are optimistic that the deal could further unlock the potential of the attractive UK market.

The five worst detractors to performance are below.

Sabre, the provider of software to the travel industry, had a strong start to the year as countries began lifting COVID-19 restrictions.

However, that proved to be short lived, as the Delta and then Omicron variants caused travel restrictions to be reimposed, to which the shares reacted negatively.

Ambu, which manufactures medical devices including single-use endoscopes, often required for COVID-19 treatment, underperformed in 2021 after an extremely strong performance in 2020. Although we continue to like the long-term outlook for the company, it was always quite unlikely that profits were going to match the extraordinary levels of the prior year, despite further infection waves.

The manufacturer of industrial lasers, IPG Photonics, had a successful year in 2021 after a weak 2020, with reported revenue up 26% year to date. Unfortunately, as ever, this improved operating environment was anticipated ahead of time by the stock market, meaning that once better profitability arrived, it was not actually enough to please the market. Similarly, Paycom was another victim of high market expectations. Despite strong revenue growth, currently running at 24%, this was regarded as a disappointment at the most recently reported results.

Simcorp, on the other hand, has simply struggled to sign many new clients this year. As a producer of asset management software, each deal it signs tends to be large, so it often requires a series of face-to-face meetings for clients to feel comfortable taking on a new licence. This has proven to be difficult to arrange given the restrictions in different countries in 2021, and so sales have slowed.“

SSON : Smithson beat its benchmark in 2021