Henderson Smaller Companies significantly outperforms and maintains final dividend

Henderson Smaller Companies Investment Trust (HSL) has announced its annual results for the year ended 31 May 2020 during which it has significantly outperformed its benchmark (by 7.7%) and maintained its final dividend (leading to a 2.2% increase in the total dividend for the year to 23.5p). HSL also beat its UK smaller companies’ investment trust peers by 3.1%, although its NAV total return fell by 8.2% and share price total return by 6.9%, reflecting the impact of the pandemic and a narrowing of the discount to NAV.

Drawing on revenues reserves to maintain the final dividend

HSL Chairman, Jamie Cayzer-Colvin, HSL revenues have been impacted by the economic downturn: the revenue return per share over the year was 16.7p, compared with 23.6p for the previous year. HSL had revenue reserves of £19.4 million at the year end, and the Board proposes to draw on this year to maintain the final dividend of 16.5p per share, making a total dividend for the year of 23.5p (2019: 23.0p), an increase of 2.2%.

Outperformance driven by stock selection

HSL’s portfolio manager, Neil Hermon (pictured), says that HSL had a mixed year in performance terms. The share price fell by 6.9% and the net asset value by 8.2% on a total return basis, which he says compares with a fall of 15.9% (total return) by the Numis Smaller Companies Index (excluding investment companies). Neil says that the outperformance came from strong stock selection, partially offset by a negative contribution from gearing and expenses. This year marks the 15th year of outperformance of the benchmark in the 17 years in which Neil has managed HSL’s portfolio.

Top five contributors – managers comments

The table below shows the top five contributors to HSL’s relative performance during the year. The managers comments on these follow below the table.

Team17 is a developer and publisher of video games for PC, console and mobile devices. The company focuses on the independent games market and selectively works with developers and third parties to launch new content on multiple platforms. The business listed in 2018 and has had a strong period of growth driven by well-received new games releases, the monetisation of new content and improved profitability as the portfolio expanded. With a balance sheet in a net cash position the company is well placed to acquire complementary assets in the sector.

Learning Technologies is a provider of e-learning services and learning software platforms. The company has grown strongly over the last few years through a combination of organic and acquisitive growth. The market it operates in is in a growth phase as corporate learning transitions from the classroom to online, a trend likely to accelerate post Covid-19. With an ambitious management team and strong balance sheet one can expect additional accretive merger and acquisition (“M&A”) activity in the future.

Avon Rubber is a manufacturing business which specialises in the production of protection equipment, and ad-hoc products for the dairy industry. The company has a presence in the US, UK and Italy with long-term contracts with various military organisations globally. During 2019, the company undertook a large transaction acquiring Ceredyne, a designer and manufacturer of helmets and body plates for the US market. This deal has accelerated the company’s earnings profile, provided an improved longer-term growth outlook and given further earnings upside potential from acquisition synergies.

Intermediate Capital is an alternative finance provider and asset manager. It is a leading provider of mezzanine finance to leverage buyout markets. It also owns a highly successful mezzanine, property lending and credit fund management operation. Its portfolio of investments is performing well but the primary growth engine of the business is the fund management operation. This division is having real success in asset gathering due to the strength of its performance track record, the quality of the team and underlying demand for its product in an income-hungry world.

Impax Asset Management is an environmental and socially responsible focused asset manager based in the UK. The company was formed in 1998 by the current CEO Ian Simm, and has several funds spanning public equities, bonds and infrastructure assets. 2019 was a period of strong growth for the business as a result of large mandate wins, stemming from the increased appetite of investors for this asset class, and enhanced profitability as the company scaled. Performance within the funds was also strong which benefited asset gathering during the period.

Top five detractors – managers comments

The table below shows the top five detractors from HSL’s relative performance during the year.The managers comments on these follow below the table.

Cineworld is an international cinema operator. The company has market leading positions in the UK, Israel, Eastern Europe and the USA. The company undertook significant expansion in 2018 by acquiring Regal Entertainment, a leading US cinema chain. Cineworld also agreed to buy Cineplex, a large Canadian cinema chain, in later 2019. The combination of the high leverage taken on to acquire Regal, the debt-funded acquisition of Cineplex, and the closure of its entire estate due to Covid-19 caused the share price to drop. Recently Cineworld has agreed an increase in its debt facilities and a relaxation on covenants as well as terminating the acquisition of Cineplex, meaning it is highly likely to survive the current downturn and emerge in a strong position to recover.

Burford Capital is a provider of litigation finance. After a number of years of strong growth and positive share price performance the company came under attack from a short seller who published a negative report citing issues on liquidity, solvency and corporate governance. This report has had a negative effect on the market’s short-term perspective on Burford with the result that the company’s share price has fallen materially. We do not believe that most of the short report’s arguments hold any merit and continue to hold a position in Burford, albeit materially lower than a year ago.

Centamin is an Egyptian gold miner. The company reported stronger production output after a period of disruption. In addition, the gold price rose as fears over Covid-19 led to investors buying perceived safe assets.

Plus 500 is a provider of CFD services for investors. The spike in market volatility resulted in increased volumes and profits for the business. Additionally, as Plus 500 does not hedge positions, they benefited from investor losses as markets fell. These factors are expected to fade over the course of the year.

Domino’s Pizza holds the exclusive master franchise to own, operate and franchise Domino’s Pizza stores in the UK and Ireland. Domino’s also operates pizza delivery stores internationally. The business has been going through the process of management change and disposing of its loss-making international operations. In addition, the company has benefited from increased demand during the Covid-19 crisis.

Portfolio activity

NEIL says that trading activity in the portfolio was consistent with an average holding period of six years (his approach is to take a long-term view and to avoid unnecessary turnover). His focus has been on adding stocks to the portfolio that have good growth prospects, sound financial characteristics and strong management, at a valuation level that does not reflect these strengths. Similarly, he says that he has been employing strong sell disciplines to cut out stocks that fail to meet these criteria.

During the year, Neil has added a number of new positions to HSL’s portfolio. His comments on these are as follows:

Chemring is a defence business which manufactures products and provides consultancy advice in the areas of countermeasures, defence security and safety markets. The company has a number of large-scale contracts with the US military and other governments globally. Our investment in Chemring provides us with exposure to a business which has increasing revenue visibility with the potential to improve profitability through tactical investments in manufacturing.

Frontier Developments is a developer and publisher of video games. Over the last few years the company has transformed from a work-for-hire business to a product-based company focusing on the development of simulation games which targets a range of audiences on multiple platforms. To date, the company has released 4 different titles and several expansion packs which has resonated well with consumers. Frontier is a company with high quality games, a rapidly expanding portfolio and the potential to expand further through tactical acquisitions.

Inspecs is a manufacturer and distributor of eyewear frames. The business supplies both branded and non-branded frames through production facilities in China and Vietnam to opticians globally. The company has a strong outlook as a result of the potential to sign new licence agreements with brands, acquire other similar businesses in this fragmented industry and grow with their existing set of customers. Management has also stepped up capacity in their Vietnam facility to allow for the strong growth potential of the business.

Knights is a UK regional legal services company. The business listed in mid-2018 and has since shown strong growth through a combination of organic growth and selective acquisitions. These acquisitions have been integrated into the regional network, and with operational improvement, cost efficiencies and acceleration of revenue growth, have achieved excellent returns on investment for Knights. The ambition is to continue the successful strategy aided by a market that is rapidly moving to a corporate, limited liability model.

Liontrust Asset Management is an asset manager based in the UK. The company is segmented into large franchises including Economic Advantage, Sustainable Investments, Global Equity and Multi-Asset. To accelerate growth, the company has historically made acquisitions to add scale to their assets under management (“AUM”). Acquired AUM is integrated into the Liontrust network and sold through their highly effective sales network. Liontrust has a solid growth outlook with a good performance track record, significant capacity to grow their existing business and potential for further deals in the future.

Volution manufactures and distributes ventilation products. Around half its sales are in the UK with the other half across numerous overseas territories including the Nordics, Germany, Belgium, Australia and New Zealand. The business is capital light and strongly cash generative allowing surplus cash generation to fund acquisitions, a strategy which has driven geographic diversification. Ventilation is a growing market driven by higher building standards and a desire for clean air. The company is well positioned to continue to produce solid growth in the future.

The manager’s comments on portfolio sales

To balance the additions to our portfolio, we have disposed of positions in companies which we felt were set for poor price performance. We sold our holding in Lookers, a car retailer, where the company was hit by a combination of the loss of its CEO and finance director, difficult trading, a FCA investigation into its credit finance operations and a fraud at one of its subsidiaries. We also disposed of our holding in SIG, a building materials distributor, as the company removed its executive management team after failure to hit financial targets. Other companies that we sold due to a belief that they were structurally challenged or suffering from poor operational performance included: Costain, a building contractor; Xaar, an ink jet technology business; Jupiter Fund Management, a fund manager; and Ibstock, a brick and concrete products producer. We also sold our positions, in line with our stated policy, in Aveva, an engineering design software company, as it was elevated to the FTSE 100.

There was a reduced level of takeover activity in the portfolio in the year. This was consistent with the wider mid and small cap equity market where M&A activity decreased due to election and Brexit uncertainty. A takeover bid was received for Consort Medical, a medical device company, from Recipharm.