Register Log-in Investor Type

News

Smithson’s significant underperformance driven by growth sell off

230228 SSON Bear market

Smithson (SSON) has published its annual results for the year ended 31 December 2022. It is the company’s fourth set of annual results and the first in which it has reported a decline in NAV and while the drop is significant and SSON has underperformed its benchmark, it comes a against a backdrop of a steep decline in equity markets globally. During the year, SSON provided an NAV total return of -28.1% and a share price total return of -35.2%, reflecting the fact that the trust moved from trading at a premium to NAV of 3.0% to a discount to NAV of -7.3% (SSON traded at a discount to Nav for most of the year). In comparison, SSON’s benchmark, the MSCI World SMID Index experienced a far shallower decline of -8.7%.

SSON’s chairman, Diana Dyer Bartlett, makes the point despite the share price declines, SSON’s portfolio companies grew their businesses in 2022 despite the difficult market conditions and says that their financial key performance indicators were all materially better than those of the comparator index, demonstrating their characteristics as high quality companies. However, the progress made by the portfolio companies was not sufficient to offset the impact on growth company valuations of the hike in interest rates. Diana also notes that only two segments of SSON’s comparator index actually registered positive returns in 2022 (Energy and Utilities) and says that these two segments are therefore largely responsible for the index’s comparatively better performance. Given that SSON does not invest in either of these segments as they do not meet the manager’s criteria for potential long term shareholder returns, it is not surprising that the trust significantly underperformed its benchmark.

Diana also makes the case that the decrease in portfolio company valuations during the year was such that at the year end, they were trading on free cash flow ratings comparable to those at the time of the Company’s launch in 2018. She concludes that, by implication, the growth in SSON’s net asset value per share since IPO, which exceeds that of its benchmark, can largely be attributed to the underlying trading performance of the portfolio companies.

Performance

The performance of SSON, along with comparators, is laid out in the table below, which is taken from the company’s annual report announcement.

SSON’s manager, Simon Barnard, say that there was clearly one dominant factor at play contributing to SSON’s performance, and it impacted the portfolio consistently throughout the year: the rising market expectation for interest rates.

The table below, which shows the subsector performance over the year to 31 December 2022 shows that the worst performing sectors of the index were also those to which Smithson is most exposed and the positively performing sectors are commodity driven and therefore contain companies which the trust will never own.

Simon says that other factors weighing on share prices are the potential effects of cost inflation, and a likely recession brought about by the tightening of monetary policy. He goes on to say that, while recession holds some trepidation for the manager, the quality of the companies held in the portfolio, including their lower level of cyclicality and generally strong balance sheets, should enable them to weather the storm better than other companies in the market. Of course, they will still be susceptible to share price falls should the recession turn out to be worse than currently expected by market participants.

Simon says that he is not particularly concerned about the effects of inflation on SSON’s portfolio companies, especially compared to other companies in the reference index. The reason for this is that SSON’s portfolio companies tend to have high gross margins and low capital requirements, which mean that they are less susceptible to cost increases than other companies. They are also in strong competitive positions, which typically allows them to increase prices to offset higher costs, should they choose to do so.

Looking to the portfolio, Simon comments that not all of the underperformance against the market was inflicted upon SSON by macroeconomic factors; there were some mistakes too. Principal among these was not selling certain companies which were overvalued at the end of 2021. These included Domino’s Pizza Enterprises and Fortinet, two positions that the manager reduced in size due to its concerns over valuation, but on reflection, Simon says that these could have trimmed more aggressively or perhaps even exited. SSON remains a holder of these as the falling share prices quickly returned the valuations to more comfortable levels.

Simon also says that, save for a couple of positions, he is very confident in the fundamentals of the businesses held in the portfolio. While a recession may continue to hold back cash flow growth for a while, none of these companies will suffer meaningfully, and certainly not to a degree which would keep the manager awake at night.

Performance detractors

The following table shows the largest detractors during the year.

Simon says that Fevertree suffered very strong cost inflation in logistics (until recently much of their product was shipped around the world from bottling plants in the UK and Europe) and packaging including glass and tin, compressing the gross margin from over 50% in 2019 to under 40% by the end of the year. This decline in margin has taken place because management decided not to put up prices, as they wanted to maintain the strong sales momentum that they are enjoying in large markets such as the US. Simon says that SSON remains a holder for now as he believes that over time the company can improve the margin, with his confidence boosted by the likelihood that margins in more mature markets such as the UK, which are not disclosed separately, are still very favourable. If this is combined with continued growth in revenue, the potential for future cash generation is substantial.

Simon says that Temenos has been going through a transition from selling its banking software as a perpetual licence, to selling it as a subscription or a service, otherwise known as ‘SaaS’. This should make little difference to the business structure over the long term, although some argue it could be a positive due to higher potential revenue from individual customers over time, but in the interim it causes a decline in profits and cash flow as the high up-front payments for licences are substituted for smaller annual or monthly subscription payments. On top of this, there appears to have been a slowdown in the number of new contract signings for the company, as its bank clients are hesitating to spend more on their IT systems ahead of a potential recession. Simon comments that, having spent some time with the CEO and Chairman to understand what was going on behind the scenes, the manager was growing concerned that these issues weren’t being managed as well as they could be, and so were not upset by the recent announcement of the CEO stepping down and a previous CEO taking over in the interim.

Nemetschek is a company selling design software to the construction and media industries and suffered from a combination of a high valuation owing to its fast growth, and market concerns regarding a future recession in the construction industry.

Rightmove, the UK online property portal, fell due to concerns over the UK housing market in an environment of rising mortgage rates, a cost of living crises and a potential recession. Simon highlights that Rightmove’s revenue, being generated by subscriptions from estate agents, has no direct link to house prices or sales volumes, and has actually continued to increase. However, should some estate agents go out of business, which tends to happen when the housing market declines, then they will lose subscribers and Rightmove’s sales will fall. He comments that, the positive to this is that a new estate agent only needs a laptop, phone and contact list, which means that the number of estate agents tends to rebound quickly after any market correction.

Domino’s Pizza Group declined due to market worries about a UK recession, although SSON’s manager is a little more sanguine. While a reduction in disposable income will put some sales at risk, it believes that those in the food industry most likely to suffer are casual dining outlets, while ‘better value’ takeaway options might prove more insulated from such pressure as people continue to treat themselves to ‘affordable luxuries’ when times are tough. The manager also suspects the men’s football World Cup will have provided a tailwind to sales into the end of the year.

Performance contributors

The top five contributors to performance are shown in the table below

Rollins, a US pest control company, was the best performer. Simon comments that this is a business with highly repeatable earnings given that in some parts of the US where it operates it is necessary to have frequent visits from pest control to keep buildings habitable. This leads to much of its revenue being paid on subscription and thus fairly dependable, which is almost certainly why the shares performed well in a period of concerns regarding inflation and recession.

Simon thinks that TechnologyOne is perhaps the most surprising performance contributor, given that it is a fast growing software company. However, the shares reacted well as sales and earnings continued growing strongly throughout the year, more than offsetting the downward pressure on market valuations. The institutions it sells to include governments, universities and the military, which are yet to be affected by the macroeconomic environment.

While Moncler’s share price declined during the year, SSON was fortunate to acquire the position at a relatively low point, which meant that it was a positive contributor to the fund by the end of the period. This was also the case for IDEX.

Qualys, the US cyber security company, did better than average as its revenue growth continued accelerating throughout the year. While the manager does expect a recession to weigh on companies’ information technology budgets, and therefore cyber security sales, it should still be more robust than other categories given the constant and increasing threat of cyber crime.

Leave a Reply

Your email address will not be published. Required fields are marked *

Please review our cookie, privacy & data protection and terms and conditions policies and, if you accept, please select your place of residence and whether you are a private or professional investor.

You live in…

You are a…