Three UK small-cap trusts and funds of Edinburgh-based 'value' boutique endure perfect storm in first half of year as their style comes unstuck in the pandemic.
Aberforth Partners, the Edinburgh-based investment boutique, has said the valuations of the small UK firms held in its trio of trusts and funds are exceptionally cheap after they endured a horrendous first half of the year.
The coronavirus pandemic has seen losses mount for already struggling ‘value’ investors, who try to buy out-of-favour, high-yielding companies, with the additional headwinds of a UK and smaller company focus adding to Aberforth’s pain.
The manager’s pair of investment trusts, £730m Aberforth Smaller Companies (ASL ) and £93m Aberforth Split Level Income (ASIT ), both unveiled dire results last week after enduring the most difficult start to a year for small-cap value stocks in over six decades – or since the Numis Smaller Companies index began in 1955.
ASL’s assets plunged nearly 36%, with the shares faring slightly worse, underperforming the Numis index which dropped 25%.
The very similar portfolios of ASIT and the open-ended £106m Aberforth UK Small Companies fund performed as poorly, although as a ‘split capital’ trust, holders of ASIT’s ordinary shares are exposed to a high level of gearing, or borrowing, which accentuates losses in falling markets. Its assets tumbled 47.9% in the first six months of the year.
This leaves their three-year returns in sorry shape: ASL’s shareholders have seen their stakes fall 31.5%, and owners of ASIT’s ordinary shares are down 40.4% compared to the index’s 13.9% decline.
Meanwhile, Aberforth’s open-ended fund has suffered annualised losses of 11%, amount to around a 29% loss over three years.
After the Conservative party’s general election win in December dispelled some of the Brexit uncertainty, this was not supposed to happen.
Aberforth Partners wrote in both sets of results that it was ‘frustrating’ that the year had begun positively before the pandemic took hold.
‘A second frustration is that the stock market rebound has so far not been led by the value style, as might be expected from experience of previous downturns,’ they continued.
‘The reason for such underperformance is that, for much of the past decade as companies with secular growth prospects have been re-rated, the value cohort has become increasingly dominated by economically sensitive businesses.’
While a big position in CMC Markets (CMCX), a spread-betting company, had benefited from customers with too much time on their hands at home, many other top holdings like auto parts manufacturer TI Fluid Systems (TIFS) and property developer Urban&Civic (UANC) struggled with their fortunes more closely tied to the economy and the free movement of goods and people.
A skew towards companies doing most of their business in the UK – on the expectation of that post-election re-rating – has been another factor. Beginning the year ASL was nearly two-thirds exposed to domestic stocks, about 10% higher than the index, with the managers noting sterling had led ‘the foreign exchange unpopularity contest’.
The confluence of these factors meant the value cohort of the index lagged growth peers by 17% in 2020’s first half, according to the London Business School.
‘Margin of safety’
But that’s the past and looking forward Aberforth managers believe the outlook is ‘far from bleak’ because shares in the companies they like are so cheap.
At the end of June, the price-to-earnings (PE) ratio – a common valuation metric – of ASL’s portfolio stood at 6.1 times. That was 41% less than 10.3 for the index, compared with a 30% discount 12 months prior.
The managers acknowledged the ratio would rise ‘more meaningfully’ in coming months, as lockdown’s impact was reflected in earnings, but argued that displayed a ‘significant margin of safety in the valuation to accommodate an uneven recovery’.
The average PE multiple of the portfolio over the trust’s three decades has been nearly twice as high, at 11.7 times.
The news did not get better on income, with the managers saying a 60% dividend decline – three times worse than 2009 – across the smaller company universe in 2020 was plausible and that they had ‘felt the force’ of cuts. Only 32 of ASL’s 81 holdings are likely to pay a dividend in 2020.
ASIT’s board said that ‘regrettably’ this backdrop made a dividend cut necessary, with its revenues for the financial year to 30 June down by a third, although that cut will be deferred until next year.
It declared a second interim dividend of 2.71p per ordinary share, taking the total to 4.22p per share, a 1.4% increase on last year.
ASL, which yields 3.9%, was able to declare an interim dividend of 10.4p, a 4% increase on last year. The trajectory for payouts is bolstered by its pot of revenue reserves, built up over 30 years, standing at more than double the dividend.
As a younger trust, launched three years ago, ASIT has more modest reserves, less than a quarter of the dividend after the latest payout.
Reflecting their confidence in the portfolio’s recovery, the manager deployed gearing in ASL for only the fourth time in its history and the first time since the financial crisis. However, this stood at a relatively cautious 2.5% at the end of June and the plan is to use the borrowed money to buy back some of the trust’s shares.
These trade 13.5% below net asset value, a wide discount that the buybacks may narrow, which would be a good thing, though doing so indicates the managers think their shares offer more certain value than any of the trust’s holdings right now.