Although academic studies generally support the claim that smaller and medium-sized companies provide better returns than larger ones they are generally less well explored by investors. Top-tier firms dominate analyst research, and in the US the median mid-cap stock is covered by 45% fewer analysts than the median large-cap stock. It therefore stands to reason that there may be less known about the mid cap stocks and consequently more discrepancies between price and value for investors to take advantage of.
It opens an opportunity for longer term investors willing to look past the greater volatility smaller and medium-sized companies usually exhibit to uncover businesses that have strong growth potential but are less widely appreciated. Smaller businesses are frequently dynamic and can exploit niche areas to grow.
One investment that looks to adapt an already-successful investment process to the world of smaller companies is Smithson Investment Trust. Most investors will already be familiar with Terry Smith and his popular Fundsmith Equity Fund, but perhaps less so with this Trust launched in October 2018 that invests in shares issued by small and mid-sized companies on a global basis.
The approach of investing in high-quality, resilient companies that ‘compound’ their earnings over time to produce superior growth is very similar but applied to a different universe of stocks. The trust is run by Simon Barnard and Will Morgan, rather than by Terry Smith himself, although the Fundsmith founder is an important sounding board for the two managers.
The managers have a very wide opportunity set, which is important when seeking a very specific set of characteristics. The selection criteria are the same as with the Fundmith Equity Fund, and thus far the output of initial research produces a shortlist of 80 to 90 companies that have the qualities the managers are looking for and are deemed worthy of in-depth analysis. From this 25 to 40 are chosen to reflect the managers’ views of obtaining the best quality businesses at the best possible price.
The managers believe the long-term quality investment approach adopted by Fundsmith lends itself well to global small and mid-cap companies. Fundsmith’s philosophy is that the market fails to properly value a small subset of companies that are able to continually compound earnings over the very long term. Due to the lack of research and insight of the investment community the anomaly ought to be even larger for smaller firms.
The approach is centred around identifying high-quality companies valued at between £500m and £15bn at the time of purchase, which are defined by the following key attributes:
- a long history of delivering consistently high returns on capital employed and growth in free cash flow
- a long-term growth opportunity into which the business can re-invest cash it generates
- a competitive advantage that allows it to protect and grow future returns on capital
- a balance sheet with net cash or minimal debt
Once superior companies are identified the team will seek to buy them at a fair valuation, using free cashflow yield as the primary valuation metric. After purchase, successful positions are left to compound over the very long term. Portfolio turnover will be very low in line with the long investment horizon and winners will usually be run and losers cut.
The managers tend to be drawn to business models that are hard to replicate and have strong pricing power. These can come from a variety of sources, ranging from sellers of small ticket items that are consumed regularly, dominant operators within a niche, franchisors and businesses with strong brands, among others. Among the current top ten holdings are premium tonic-maker Fevertree, estate agent portal Rightmove and Domino’s Pizza.
Performance and portfolio characteristics
The Trust launched in October 2018 and has made a strong start. It has turned a £1,000 investment at outset into £1,498, a return of nearly 50%. This is a remarkable achievement given the time period includes the hostile first quarter of 2020 that saw smaller companies underperform large markedly. However, past performance is not a reliable indicator of future returns. The trust is run without reference to any index, but for context, the MSCI World SMID (small and mid) Cap index has risen 8.0% in the same time frame. MSCI World SMID Growth has represented a much tougher comparator, but even that has only produced 24.1%. Source for data: FE Analytics, total return basis, data to 31/08/2020.
Table: Discrete annual performance
We would certainly caution against extrapolating of this level of outperformance. The Trust has made a flying start but with this type of concentrated portfolio, a single position can make a significant impact to returns, both on the upside and the downside. The managers are prepared to pay up for stocks that are quite expensive when measured on current or one-year forward earnings, as they are looking at the company’s ability to grow and compound earnings on a much longer time frame. Indeed, manager Simon Barnard describes their longer time horizon as their key edge. However, stocks on a ‘premium’ rating that do end up seeing their excess returns competed away would likely get punished.
The managers’ job is to identify the true long-term compounders and avoid those that find their returns are eroded by competition or a shrinking market. The dominant driver of the trust’s performance will undoubtedly be stock selection, although the process means there will be a bias towards growth-orientated businesses. At a sector level, there is considerable exposure to industrials, IT and Healthcare. The allocations are purely an output of the team’s company research rather than a deliberate tilt in any direction.
If judged versus a benchmark, the Trust may look sluggish if there were to be an environment with more support for economically sensitive areas, especially if banks and commodity stocks are leading the market for any sustained period. In this environment, the resilience of the portfolio’s growth would be less prized and premium stock ratings could come under pressure.
The Trust was created to take the successful long-term quality investment approach of Fundsmith Equity Fund and apply it to small and medium-sized companies because over time these have been shown to outperform large companies. We believe this makes sense, and with a wider universe and a permanent capital structure, Smithson is the ideal vehicle for the managers to direct the ‘Terry Smith approach’ to a less well-researched investment universe. While the philosophy does not guarantee success, we are optimistic about the Trust’s long-term prospects and add it to the Direct Investment Service Preferred List.
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Smithson Investment Trust - Big opportunities in smaller companies?
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