Outperformance but still a down year for BlackRock Smaller Companies

BlackRock Smaller Companies (BRSC) announced its annual report for the 12 months to 29 February 2024. The company’s NAV total return was -3.6% while shares fell 0.8%, outperforming the benchmark Deutsche Numis Smaller Companies plus AIM (excluding Investment Companies) Index which was down 5.8%

Commenting on the performance, investment manager Roland Arnold noted;

“For the second half of the financial year the company’s NAV outperformed the benchmark by 3.4%, producing a positive return of 4.6% against our benchmark return of 1.2%. This takes the company’s NAV return to -3.4% for the financial year, and although it is disappointing to be reporting another year of negative asset value, it outperformed our benchmark return of -5.8%.

“The largest positive contributor to performance was 4imprint Group. This is not the first time we have discussed the merits of the 4Imprint Group investment case, it has been a significant contributor to performance over a number of years, and acts as a case study to our investment philosophy; find a well invested market leader in a growth market, that converts profits into cash, continues to invest in both their product and people to maintain market leadership and pricing power, whilst increasing the dividends paid to shareholders.

“The second largest contributor was recently listed Ashtead Technology, the Aberdeen based equipment rental business focused on the Oil and Gas industry. Management have done a commendable job of positioning the group towards growth markets, whilst deploying the balance sheet towards accretive mergers and acquisitions (“M&A”).

“The third largest contribution has come from our holding in bowling operator Ten Entertainment Group, which received a bid from private equity. This was not the only bid we were on the receiving end of during the financial year, we also saw Ergomed, City Pub Company, and Numis leave us. Whilst takeover activity is obviously a positive to overall performance, it is often a bittersweet moment as we lose businesses we believe could contribute to the NAV growth of the Company over a number of years, and have to find suitable replacements.

“No year is perfect, there are always companies that weigh on performance. These loosely split into two camps; the ones where there has been a change in the earnings outlook, and those where shares have de-rated for other reasons but the outlook for the investment case is unchanged. Watches of Switzerland sadly sits in the first category, as the shares reacted negatively to the news that Rolex has purchased luxury watch retailer Bucherer, raising concerns Rolex will direct allocation to Bucherer over other retailers. We have to acknowledge the potential impact this has on the Watches of Switzerland investment case and have reduced the position to reflect what is now a wider range of potential outcomes. CAB Payments listed on the London market in July 2023, the first significant initial public offering (“IPO”) on the London market in some time. We recognised at the time the revenue model was inherently unpredictable, and likely to be buffeted by the vagaries of emerging market currencies. What we had not anticipated was the sudden change in market conditions in a number of their currency markets, which facilitated a significant decline in revenue and earnings expectations. Coming so soon after the IPO this raised serious questions about the controls within the group, and we exited the position. Finally, we need to address computer games developer Team17, which revealed a profit warning in November. The gaming industry had a tough year in 2023, with the demand for “triple A” games disappointing generally, and a number of revenue related disappointments across the industry. We spent a lot of time looking at Team17, analysing the best seller lists to gain comfort that volumes would not disappoint. Sadly, volumes were not the issue, and revenue forecasts were achieved, however management appear to temporarily have lost control of the cost base leading to a warning on profitability. We have reduced the position but have maintained a small holding in the belief a cost problem can be fixed more easily when there isn’t a revenue issue.

“There is a third category of shares that can weigh on relative performance; those that are a significant weight in the benchmark that we choose not to own. 2023 saw an unusually large number of “fallen angels” enter the top end of our benchmark. Accounting for 25% of the Numis Smaller Companies Index, the 2023 cohort of fallen angels is the third largest on record. Two of these, Burford and Carnival performed strongly in the year, rising 80% and 62% respectively. Typically, the “fallen angels” fail to meet our investment criteria. In the case of these two examples Burford’s revenue model is too unpredictable, and Carnival’s market cap was simply too large for a portfolio focused on small and medium sized companies.”

Regarding the outlook, he continued;

“Any discussion about the outlook for UK small and medium sized companies essentially revolves around three broad sectors, as consumer, industrials and financials form the vast bulk of the investment universe. If we once again circle back to the outlook discussed this time last year, we felt the risks of a significant recession were being overplayed, and there were opportunities in both the consumer and industrial markets. We see little reason to change our view at this point. As evidenced by the Asda Income Tracker, available household cashflow is finally starting to grow after nearly two years of pressure. At the same time food and fuel inflation is falling, increasing the amount of household cash available to direct to more discretionary purposes. With interest rates looking like they have peaked, and mortgage rates starting to fall, support for the structurally undersupplied housing market should also return. Our view on industrials also remains positive. 2023 has been a year of inventory unwind, as firms run through the stock built up to manage the post-COVID-19 supply chain disruptions. Much of this rightsizing has now happened, suggesting end market demand should be much more closely correlated to industrial company revenues. More importantly, going forward we still see many of the positive structural drivers of near shoring and supply chain duplication providing a multi-year tailwind for industrial companies. In summary we retain a broadly pro-cyclical outlook, with a view that the coming year could well see an earnings inflexion colliding with attractive valuations, typically a mix that leads to share price appreciation.”

BRSC : Outperformance but still a down year for BlackRock Smaller Companies