Brown Advisory US Smaller Companies (BASC) has published its annual report for the year ended 30 June 2024, during which its NAV per share increased by 2.8% from 1,431.9p to 1,471.4p. BASC’s chair, Stephen White, describes this small gain as “somewhat disappointing” – not only in absolute terms as smaller companies in the US lagged their larger peers for the third financial year running, but also relative to its benchmark, the sterling adjusted Russell 2000 Total Return index, which BASC says increased by 10.7% over the same period. Over the same period, BASC’s share price increased by 5.1%, from 1,220.00p to 1,282.50p, which resulted in a small narrowing of the discount to NAV from 14.8% on 30 June 2023 to 12.8% on 30 June 2024.

Portfolio manager and continuation vote

Three years have passed since Brown Advisory took over the management of the portfolio in June 2021, which prompted BASC’s board to undertake a detailed review of the trust’s investment performance, its fee structure and its remit “to ensure that they remain appropriate and relevant”. Between 31 March 2021, the date from which Brown Advisory commenced management, and 31 March 2024 the trust’s NAV rose by 6.4%, compared to an increase in the benchmark of 8.9%, equivalent to annualised returns over the three years of 2.1% and 2.9% respectively. The board says that it had hoped for better, particularly given the manager’s “impressive long-term performance record in its US smaller companies strategy”, which attracted the board to them in the first place.

Over the three-year period, sector allocation was the main detractor to performance with an underweight position in the oil sector. Stock selection was more positive, particularly in the more growthy areas of healthcare and information technology. Key positive contributors to performance over the three-year period were Biohaven Pharmaceuticals, EVO Payments, Mimecast Limited, Waste Connections and Curtiss-Wright Corp., while detractors included Angi, Leslie’s, Azenta, Oak Street Health and Natera.

The board noted that, despite the more challenging market environment, the managers maintained their investment approach and their search for longterm compounders that offer durable growth, good governance and a strong ‘go-to-market’ position, even if this meant missing out on many of the more momentum-driven and speculative stocks which have led the smaller companies markets of late. The board says that it will continue to monitor closely investment performance, both absolute and relative, on an ongoing basis.

The board also considered the fees charged by the manager in relation to peers in the closed-end and open-ended sectors to ensure they remain both appropriate and competitive.

In accordance with its three-year cycle, a continuation vote was held at the last AGM with the resolution in favour of continuation passing with 3,885,193 proxy votes or 90.5 percent in favour. The next continuation vote will take place at the Annual General Meeting in November 2026. BASC’s board says that it has considered the company’s investment remit, strategy and performance and ongoing viability and believes that its offering remains attractive.

Revenue and capital returns

The net gain per ordinary share was 38.57p, allocated (6.11p) to revenue and 44.68p to capital. Dividend income was higher as some companies raised pay-outs as confidence returned and interest income benefited from the higher interest rates. With management expenses broadly unchanged, the net revenue loss was marginally lower than the previous year. The board still believes it appropriate to allocate all expenses to the revenue account. No distributable revenue is available for the payment of dividends.

Share price and discount to NAV

Last year, BASC’s board amended its share buyback policy, which had been in place for several years, and now the board is committed to using share buybacks with the aim of reducing discount volatility and working to reduce any discount to the extent that it is significantly wider than those of similar investment trusts. Given that for much of the period the discount was within the board’s “tolerated range” only 90,000 shares were repurchased. As at 30 June 2024, the number of shares held in treasury was 6,361,254 (2023: 6,271,254) and the total number in public hands was 11,862,159 (2023: 11,952,159).

Gearing

BASC’s board says that, with the rise in interest rates, a mixed earnings outlook and limited investor interest in the sector, it saw no good reason to deploy any gearing over the year, and indeed preferred to hold some cash in hand in case of market setbacks. However, going forward, should prospects for the smaller company sector improve and investor interest return, the board says that it will review its decision to gear, mindful that the ability to do so to enhance returns is one of the key advantages of a closed-end structure.

Investment manager’s comments on performance

“Our strategy has seen both highs and lows over the last few years. Our downside protection helped us endure the challenges of 2022, posting a smaller decline against the benchmark. However, in late 2023, it became increasingly difficult to keep up with our benchmark as market concentration accelerated and individual investors swelled.

“Individual investors, also known as retail investors, are non-professional market participants who trade securities for their personal accounts. The surge in their activity can significantly impact market dynamics, leading to increased volatility and price shifts.

“These market dynamics led to a small-cap benchmark that had become somewhat distorted, with the largest constituent of the Russell 2000 Index, SMCI, valued at $46bn by the end of May 2024. The index was rebalanced in late June 2024, removing some of these outliers. Following SMCI’s exit from the index, the maximum market capitalisation drops to just under $11 billion. This results in an index more aligned with our present portfolio weights. We are modestly underweight in healthcare and closely aligned with the benchmark in information technology. Additionally, we are overweight in Industrials, including a 5%+ position in waste management companies, which are likely better mapped as utilities or consumer staples.

“Our strategy’s monthly tracking error has risen from around 1.5% pre-COVID to nearly 2.4% post COVID. Tracking error measures the difference between the performance of a portfolio and its benchmark. It is often used to assess how closely a portfolio follows the index to which it is benchmarked. A higher tracking error indicates more significant deviations from the benchmark, while a lower tracking error suggests the portfolio is closely aligned with the benchmark.

“Despite this increase, we remain committed to our philosophy and process. While our portfolio’s relative swings can be significantly positive or negative over short periods, our portfolio’s long-term fortunes will be governed by the fundamental progress of the companies in which we invest. We continue to remain active, adding to our winners, reducing or selling poorer performers, and adding new positions with favourable risk/reward profiles.”

The managers comments on key factors impacting performance

“Most of our fiscal year relative underperformance occurred in the final weeks of 2023. Our strategy was ahead of the Russell 2000 Index and roughly tied with the Russell 2000 Growth Index for the calendar year as we entered the month of November last year. However, people became excited about the possibility that the Federal Reserve might switch to a less strict policy which prompted a classic, lower quality, risk-on rally – where investors flock to higher-risk assets hoping for greater returns – resulting in our higher quality portfolio struggling. This led to us lagging the Russell 2000 Index by about 5% during the November-December rally.

“The absence of Super Micro Computer (SMCI) and MicroStrategy (MSTR) in our portfolio hurt results. Despite examining these stocks over the years, they did not align with our “3G” investment filter. Russell’s decision to retain these high market cap stocks in the benchmark until very recently proved detrimental, negatively impacting our relative returns.

“Subpar results in healthcare dampened returns. Compared to the Russell 2000, we had our largest sector overweight in healthcare during the fiscal year, and our healthcare stocks returned roughly -10.4% vs. the -1.8% return for those in the benchmark. Although a few companies underperformed our expectations, some holdings fell on little negative news.”

Manager’s comments on additions and disposals

“Over the twelve-month period, we saw a roughly equal number of additions and deletions in the portfolio. Much of the turnover was driven by M&A activity and our decision to exit positions where our investment thesis was no longer valid or where we saw poor risk/reward dynamics.

“Over the twelve-month period, we made several strategic exits from our portfolio, driven by mergers and acquisitions (M&A) activity, invalidation of our investment thesis, or again poor risk/reward dynamics.

“Specifically, we sold agilon health, Bentley Systems, Knight-Swift Transportation, XPEL, Inc., Choice Hotels, Genpact, Karuna Therapeutics, Abcam, Denbury Inc, and Angi Inc. These sales were made to ensure our portfolio remained aligned with our investment philosophy and to focus on positions with more favorable risk/reward profiles.

“We also exited Definitive Healthcare, Sprout Social, Alignment Healthcare, Azenta, and Leslie’s due to disappointing performance or concerns about future profitability. Astera Labs and Loar Holdings Inc. were sold after significant price increases following their IPOs. MakeMyTrip was sold after strong performance, but we remain cautious about future competition.

“We were able to redeploy the proceeds from these sales into a diverse collection of businesses that we hope to own for the next several years.

“Notable additions include Applied Industrial Technologies, a leading distributor of industrial machinery with strong market positioning; Haemonetics, which is using its strong cash flow to drive significant earnings growth through acquisitions; Kadant, a high-quality industrial company with a proven management team; and Vaxcyte, a biotechnology firm with a promising pneumococcal vaccine. We believe these companies offer strong long-term growth potential and align well with our investment philosophy.”