Smithson (SSON) has published its manager’s review for the year ended 31 December 2023, during which its net asset value per share (NAV) increased by 13.3% and its share price increased by 8.2%. In comparison, the MSCI World Small and Mid-Cap Index (‘SMID’), SSON’s reference index, increased by 9.1% during the same period.

2023 saw SSON reach the fifth anniversary of its launch and over the last five years it is the best performing trust in the Association of Investment Companies Global Smaller Companies sector and is more than 20 percentage points ahead of the average performance of the sector. The manager says that, while SSON’s NAV compound return of 9.4% is ahead of the reference index over the last five years, given the current low point in the market it would hope for greater absolute performance in the future should the market provide the backdrop to achieve this.

The manager says that it is disappointed that the share price performance of SSON has lagged the NAV performance during the last couple of years, noting that the average trust sector discount during the depths of the financial crisis in 2008/09 did not get to the level reached in 2023. It comments that SSON has not been immune to this derating, which it says is an indication of the recent bear market in equities, but says that it believes “there will come a future period, unknowable in advance, when market sentiment allows Smithson to once more trade at a premium” provided that its performance remains satisfactory.

Portfolio developments

SSON’s manager says that 2023 was busy, with it taking advantage of low prices during the weak market to improve and diversify the portfolio. It says that, after these changes, it is “unashamedly enthusiastic about what we now own”, arguing that the portfolio is without doubt in the best shape it has been since inception. The new companies invested in this year were Graco, Exponent, Oddity, Croda and Clorox and those sold to facilitate this were Domino’s Pizza Group, Rightmove and Masimo.

Graco is a US company which designs, manufactures and markets systems and equipment to measure and dispense fluid and powdered materials. SSON’s manager says that it was attracted to the market leading company by its stable operating margin of over 25% and high return on invested capital of 40%. It adds that these metrics have been achieved over a long period of time, and hopes these will continue long into the future, thanks to the fact that its products are of very high quality and are sold under brands which are trusted by customers to help solve manufacturing problems, increase productivity, conserve energy, save material, control environmental emissions and reduce labour costs. It feels it achieved a good entry point in terms of valuation as worries about a recession in the US, had caused share price weakness.

The addition of Exponent took the fund into a new sector of consulting. This industry can be highly competitive and doesn’t often have the ability to grow quickly and profitably through operating leverage as they need more staff to bill more hours. SSON’s manager says that, as is often the case in human capital businesses, the humans tend to take the majority of the returns at the expense of the business (think investment banks). However, it thinks that Exponent is different. It focuses on highly technical areas across a broad range of scientific disciplines, often in response to disasters or litigation. For instance, they did investigative work for the Challenger shuttle explosion, the Piper Alpha oil platform disaster, the 9/11 World Trade Centre collapse, the Exxon Valdez oil spill, Samsung’s exploding tablets, and the preliminary fire investigation into Grenfell Tower. The manager comments that Exponent has assembled the largest group of PhD scientists in the industry for this purpose and are the clear number one player, able to command healthy fees for such specialist projects which do not get passed straight on to the employees. They are mainly being used to defend companies against litigation (which also tends to be price insensitive) or by companies wishing to investigate their own products before launch, such as autonomous driving systems.

Croda is a UK company and the first chemical ingredients company SSON has bought. Founded in 1925 it wasn’t until after WWII that the company moved into cosmetics and fragrances, and now only produces substances from natural and renewable resources, unlike some competitors which still use refined fossil fuels. The company also provides ingredients for life sciences, including being the number one provider of a key component for mRNA delivery systems, which are finding many new applications since their well-publicised use for Covid vaccines. SSON’s manager says that it is the leading market positions in niches such as these, where they produce small but critical components for larger, high value products that makes Croda so interesting to it.

One particular area of success over the last five years was investing in high quality companies that were going through what the manager calls a ‘glitch’ in their business. This includes companies like Equifax, the US credit data bureau, which was bought in the aftermath of a major cyber-attack which compromised over 150 million consumer records. Despite the large amounts of capital spent by management to improve the security of the company after the attack, and the recent headwinds due to lower mortgage origination, it has still proven to be one of SSON’s best performing investments. The manager says that it feels it may have just been given a similar opportunity with Clorox. The US household goods company suffered a cyberattack in August which closed down its operation systems for a few days and resulted in the shares falling over 30% from the recent peak. The manager started buying the company’s shares once the attack had been contained and it believes the attack has given it a rare opportunity to buy a high quality consumer staples company within its market capitalisation range at a very attractive valuation. Clorox produces branded goods from bleach to cat litter with a track record of strong profitability and steady growth. It is also quite different to anything else currently in the portfolio, in fact in numerical terms it has the lowest historical correlation with the fund of any company in its investible universe.

The manager highlights Oddity as another atypical investment but one which it believes has substantial opportunity for growth. It is the first ever IPO SSON has participated in. SSON’s manager was approached directly before the IPO after Oddity had been made aware that the business exhibited much of what SSON’s manager looks for in a high quality, growing company. Oddity is a beauty and wellness company which creates its own brands and products to sell direct to consumers online. So far, the company has launched two brands, Il Makiage and SpoiledChild, both of which have been the fastest growing online brands in history, and now sell more online than large established beauty brands such as MAC. Traditionally there has been a large knowledge gap between consumers and beauty experts, requiring consumers to interact with a trained salesperson to match the myriad of beauty products to their needs and show them how to apply them at home. The large established cosmetics companies haven’t so far made strong attempts to sell products to new customers online (refill purchases are obviously easier) but Oddity has been able to build AI technology using data from their users – 1bn datapoints from 40m users – to ‘learn’ how to match the right products to consumers with inputs including online questionnaires and, increasingly, selfie photos. Their 90% skin match accuracy compared to 80% in-store equivalent has generated over 4m customers, with more than half of revenue now coming from repeat customers. This is not only a strong indication of the value of their service but is also much more profitable. SSON’s manager expects to see very high annual revenue growth for the next few years as the company’s technology is several years ahead of established competitors and addresses such an enormous potential market.

Rightmove was one company sold to facilitate these new investments. OnTheMarket, a weak third tier competitor to Rightmove, was recently acquired by the much larger US company CoStar, which has a history of competing aggressively in the new markets it enters. SSON’s manager says that even if Rightmove with its dominant number one position wins this war, there could well be a few years of bitter and expensive competition before it’s over and so the position was sold soon after the bid was announced.

Domino’s Pizza Group has also been sold. The manager says that Domino’s had caused it consternation for some time due to the fairly regular turnover of its senior management team. During the period of ownership, it counted four CEOs and four CFOs, and along with mediocre performance for many of those years.

Masimo is another company where SSON’s manager has been disappointed by management action, although this team has stayed in place as the CEO is the founder and a large shareholder. The company has a fantastic core business selling best in class sensors to hospitals but management decided to branch out into consumer medical devices, and bought an audio equipment business selling speakers, headphones and home theatre systems because of its access to retail outlets. The situation was further complicated by an activist investor who, after several meetings with SSON’s manager appeared quite sensible in its view, but whom the management team chose to oppose. The final straw came with a profit warning only a few weeks after management had reassured SSON’s manager that everything was ‘fine’.

Performance attribution

The top five contributors to performance are shown below.

Simcorp, the asset management software company, was the biggest contributor to performance in the year thanks to the share price moving up 38% in one day in April after the company was bid for by Deutsche Börse. The acquisition was completed in October.

Several companies whose share prices had been weak in 2022, despite the underlying businesses continuing to perform well, saw their price rebound in 2023. Nemetschek, the construction and media software company, up 66%, and Qualys, the cybersecurity software company, up 75%, were both examples of this.

Temenos, the bank software provider, is a company which did not perform as expected in 2022 but where fundamentals improved in 2023 after the CEO was replaced by the Executive Chairman. SSON’s manager says that things are now starting to move further in the right direction, both in the terms of the new contracts being signed with large international bank customers, and the underlying operating metrics of the business, including cash flow conversion.

Recordati’s share price rose steadily through the year, with the healthcare company posting double digit organic sales and profit growth, with improvement in both its rare disease and primary care drugs. This was bolstered by the acquisition of commercialisation rights for two urology drugs from GSK. It now expects 2023 results to come at the high end of its original guidance range, and to exceed the mid-term targets it previously disclosed.

SSON’s manager says that an honourable mention also goes to Verisk, just outside the list, as it is an interesting example of a company with an attractive core business, in this case insurance data analytics, surrounded by much poorer performing ancillary divisions (often built up, as it was in this case, through acquisition). 2022 was the year when management finally decided to sell the underperforming businesses, leaving shareholders with a much higher quality asset by the end of 2023. The market rewarded this action with a rerating in the company’s valuation over the course of the year.

The top five detractors from performance are shown below.

Sabre, travel software company, was the largest detractor in 2023 for two reasons. First, during the course of the year it became apparent that travel industry volumes, whilst still recovering, were growing slower than the rates seen in 2021 and 2022. Second, Sabre took on significant debt during the pandemic and the company’s profitability was therefore impacted by the sharp rise in interest rates. SSON’s manager continues to believe that the travel industry will keep growing, which will in turn enable the company to reduce its debt over time.

The manager’s issues with Masimo have been outlined above and although it made money on the position over the period of ownership, having sold shares at much higher levels during the pandemic, SSON lost money on the remaining holding during the course of this year.

Paycom, the US company providing human resources management software, underperformed after management reduced its guidance for revenue growth this year. With revenue tied to the number of employees enrolled in its software, the weaker US jobs market over the last 12 months provided a more difficult backdrop for the company’s short term growth.

Cognex, the US factory and warehouse automation company, suffered declining revenue and earnings throughout the year as its largest customers held back on building or upgrading their manufacturing and logistics facilities. Consumer electronics was a sector particularly hard hit. The manager says that, as it sees no fundamental issues with the company or its competitive position, it continues to hold as it waits for the expected upturn to arrive in the coming years.

The performance of Domino’s Pizza Enterprises was also disappointing in the period. This was primarily due to the fiscal half year results, released in February, indicating weaker sales after prices and delivery charges had been increased to offset cost inflation. Consumer price sensitivity was noted in Japan and Germany particularly. Fortunately, the company’s performance was much improved in the second half of its fiscal year, so management now appear to be resolving the issue.