Lowland (LWI ) fund managers James Henderson and Laura Foll have added FTSE 100 stocks DIY chain Kingfisher and consumer goods giant Reckitt Benckiser to their portfolio to help minimise the drag from out-of-favour ‘mid-cap’ stocks outside the blue-chip index.

Recently published half-year results for the £345m UK equity income trust showed how its investments in smaller and medium-sized stocks outside the FTSE 100 held it back as investors flocked to the commodity weighted large-cap index.

In the six months to 31 March the trust’s net asset value (NAV) slipped 0.7%, trailing the 4.7% rise in the FTSE All Share.

The managers said the more domestically focused cyclical FTSE 250 ‘fell materially’. The mid-cap index has currently fallen 14% this year while the broader All-Share benchmark is flat, reflecting the better performance of the FTSE 100 heavyweights. 

‘Lowland has always invested across all sizes of UK business, with normally not more than half of the portfolio held in the largest 100 UK companies,’ they said.

‘It is our view that over the long term these smaller companies have greater potential for sales and earnings growth, as they are at an earlier stage of their life cycle with a longer pathway of growth ahead of them.’

However, ‘nervousness about the economic outlook’ and the impact of inflation had taken its toll on smaller companies, and four of the top-five best performers over the six months are all FTSE 100-listed: miner Anglo American (AAL), oil giant Shell (SHEL), HSBC (HSBA) and National Grid (NG).

One of their biggest disappointments was having to write off a 1% position in Studio Retail after it collapsed into administration in February. Supply chain delays meant the group suffered a ‘dislocation between inventory arriving and the peak Christmas selling season’.

‘This led to working capital issues that ultimately proved unresolvable as the company failed to secure additional funding from its banks,’ Henderson and Foll said.

With mid-caps struggling, the managers have mined the FTSE 100 for new additions to the portfolio.

They have added Kingfisher (KGF), owner of B&Q and Screwfix and a 0.9% position, as it benefited from a DIY boom with people spending more time at home.

‘Kingfisher has steadily improved its French business and continued to roll out Screwfix stores,’ he added.

Dettol-owner Reckitt Benckiser (RB), a 0.7% weighting in the 100-stock portfolio, also made the cut after seeing high pandemic demand, and investing in ‘sales, marketing and production development in order to improve its organic growth’.

‘In our view, these self-help measures will become more evident as consumer demand normalises following the pandemic,’ the Lowland duo said.

The trust swapped one housebuilder for another, ditching Bellway (BWY) over ‘concerns around housing affordability relative to average earnings, particualrly at a time of rising interest rates’. 

It was replaced by Scottish AIM-listed group Springfield Properties (SPR).

‘Scotland has not experienced the same level of house price growth as has much of England, therefore afforability looks less stretched,’ they said. 

‘Springfield also has a sizeable land bank that should give it a pathway to volume growth ahead of many listed peers.’

Despite the fall in share prices, investment income from the holdings came in at the upper end of expectations thanks to special dividends from the likes of flooring distributor Headlam (HEAD) and other companies reinstating payments after pandemic breaks. This allowed Lowland to nudge its payout 1.7% higher to 3.05p per share, putting the trust on a yield of nearly 5%.

‘Alongside better-than-expected dividends there has also been a trend for companies announcing share buybacks,’ said the pair.

‘It has been our view for a number of years that UK equities are undervalued relative to overseas peers and company boards have in some cases reached the same conclusion, choosing to use some of their surplus cash to buy back shares.’

While companies have confidence, markets do not and the managers predicted: ‘It will be dividend increases inspired by the earnings growth that reawaken interest in UK equities despite the concerns around the global backdrop’.

At 123p at last night’s close, Lowland shares stood 10% below net asset value, a wider discount than the one-year average of 6%. Recent years have been difficult for the trust, which at this depressed level has delivered a total shareholder return, including dividends, of just 1.6% against 20.2% from the All-Share index over five years. Even over 10 years the trust’s 107% return lags the benchmark by 2%, although the underlying investment return achieved by the fund managers of 117.5% does beat the index.