Simon Barnard and Will Morgan are managers of the Smithson Investment Trust, which is from the same fund group as Fundsmith Equity. It has a focus on high-quality businesses that can ‘compound’ their earnings for the long term through a dominant market share in a particular niche, or by having hard-to-replicate brands or supply chains. The difference is that it focuses on small and medium-sized businesses rather than larger companies.
Launched in October 2018, the Trust got off to a good start, but the past couple of years have been more difficult as more expensive, growth businesses were particularly affected by rising inflation and expectations that interest rates would rise in response. As the Trust passes its five-year anniversary, I asked Simon and Will to explain the investment process behind the Trust, their thoughts on recent trends and the current environment, and their message to shareholders going forward. The views expressed represent those of the named fund managers only.
Fund manager Q&A
- Lots of investors are familiar with Terry Smith’s Fundsmith Equity. How does this strategy differ and in what ways is it similar?
The strategy itself is exactly the same: buy good companies, don’t overpay, do nothing. In that order. The only difference, other than it being an investment trust, is that Smithson invests in small and mid-sized companies, by which we mean those valued at between £500mn and £15bn.
- Can you explain what you look for in a company?
We want to invest in “good” companies, which means companies that can make a high return on the capital invested in their business, in cash, and with plenty of room for growth, so they can reinvest the cash generated into the business at those attractive returns. We also look for companies able to protect their businesses from competition, so that the returns on investment stay high and are not eroded over time. Good companies should also not be overly reliant on debt and, ideally, operate in markets that do not have excessive levels of economic sensitivity or ‘cyclicality’. Companies with these attributes should be able to compound in value over time, provided you do not pay too much for them in the first place.
- What does the portfolio look like as a result, by type of company and by sector?
Our approach means there are a number of areas we shy away from, such as financials, or heavily regulated or commoditised industries (those where products and services are pretty much identical no matter who you buy them from). Our companies tend to have strong brands, or dominant positions in specific high-growth niches. By sector, around 34% of the fund is classified as Industrials, 27% Information Technology, 11% Healthcare, and 16% Consumer. Companies classified outside of these tend to be data-driven businesses, for example, in financials where we have a 3.5% weighting in just one stock.
We want to invest in “good” companies, which means companies that can make a high return on the capital invested in their business, in cash, and with plenty of room for growth, so they can reinvest the cash generated into the business at those attractive returns.
Simon Barnard, manager of the Smithson Investment Trust
- How do you think the transition from a low interest-rate environment to a higher one affected the Trust and the companies in the portfolio? Has it had a permanent impact on valuations?
The transition from a low interest-rate environment to a higher one had a significantly negative impact on the prices of most assets. This was particularly true for growth equities, because of their higher ratings and because their greater future earnings have been discounted by the higher rates. It also affected smaller companies as investors consider them to be more volatile. It was therefore the biggest individual impact on Trust performance in 2022.
Absolute valuations are strongly influenced by the interest rate environment, but as interest rates are close to the long-run average, and valuations are reasonable, share prices should not keep falling unless rates continue to climb. But we know valuations can be moved by other factors too. So while it's unlikely that rates will go back to zero any time soon, we cannot say that valuations will be permanently held back. There may be other reasons in the future that we don't yet know about which could cause valuations to become elevated again. The dot com bubble is a perfect example of this.
- The fund is very focused with a relatively small number of holdings, but are you finding a greater opportunity set given recent difficult markets and changing economic environment?
The weak markets have created a lot of opportunities for us, and we have redoubled our efforts to look for great companies that may have been caught in the sell-off to capitalise on this. To put it into perspective, over the last 18 months we have added 12 new companies to our long list of potential investment candidates and 7 companies to the portfolio itself. This means that while 2022 was a difficult year, we have been able to turn it into an opportunity by buying fantastic companies which will serve to strengthen and diversify the portfolio, at very attractive valuations.
- You aim to invest for a long period and to be patient with companies, but what makes you sell a stock?
We would exit a position voluntarily if there was a fundamental change to the investment case, management makes bad capital allocation decisions, valuation becomes too expensive, or we identify a superior investment opportunity elsewhere. So far, the main reason for us selling positions is when we see management making poor investment decisions, which often involves expensive acquisitions outside of the company’s main area of focus.
- It’s often said, with reference to larger companies, that “elephants don’t gallop”, but we have seen impressive growth rates in larger tech-enabled businesses in particular over the past decade. Is this expression still valid, and is it still a reason to include smaller companies in a portfolio?
The law of large numbers, by which a constant percentage growth rate will require the addition of ever larger absolute numbers, means that while no companies will be able to grow quickly forever, larger companies will likely slow down before small companies. At any given time, there will always be some large companies growing quickly, and some small companies growing slowly, but there will always be many more smaller companies growing faster than large ones. We, of course, spend a lot of our time seeking out and buying those smaller companies that are not only growing quickly today, but which will be able to sustain the growth for several years into the future. And most importantly, won't require too much capital to fund this growth, so that it remains value adding to shareholders.
The weak markets have created a lot of opportunities for us, and we have redoubled our efforts to look for great companies that may have been caught in the sell-off to capitalise on this.
Will Morgan, manager of the Smithson Investment Trust
- Is it harder to avoid mistakes in smaller businesses given they are less mature and perhaps have less proven business models?
It is no harder to avoid mistakes with the small companies that we look at because we focus on those which already have a strong track record of growth and profitability. The average founding year of the companies we invest in is over 50 years ago, so many of them could be considered to have quite mature business models. The other point is that smaller companies tend to be less complex, with very strong positions in one or two niches, which makes them easier to analyse, and easier to run. And once we identify them it makes it much less likely that they have a part of their business which is unattractive to us.
- Investment trust discounts are generally wide at the moment versus their history, and Smithson is no different in this regard. Would you agree this indicates sentiment is low, and what might be a catalyst to change that?
We would agree that this is an indication of low sentiment, but clearly the re-emergence of cash savings as a viable alternative has been a major factor in investors pulling money out of equities recently. So it is not just a concern about the macroeconomic outlook or recession. There are things out of our control that could change this. For example, a general improvement in business conditions or inflation, and thus interest rate expectations, abating. But we don’t pretend to be able to predict them and, if we can’t influence them, we see little benefit to worrying about it too much. We are focusing instead on things we can control such as the quality of the companies in the portfolio. In addition, the Board began repurchasing shares last year and that is something they have continued to do while the trust has been at a discount.
- Smithson has just passed its 5-year anniversary. How would you characterise the period since launch, and what is your message to shareholders going forward?
Smithson initially had three very strong years of performance before a disappointing year in 2022 and a recovery year in 2023. While the last 18 months in the market have been difficult, we have worked very hard to turn them into an opportunity by upgrading the quality and diversity of the portfolio through adding several fantastic new companies at attractive valuations. Combining this with the great companies and valuations we now see across the rest of the portfolio, we are extremely optimistic with regards to the next 5 years.
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