A guide to The Global Smaller Companies Trust

Veteran manager Peter Ewins stepped down from The Global Smaller Companies Trust (GSCT) at the of April 2024 and will retire in June. Nish Patel was appointed joint manager of the trust at the start of this year and has now taken over the reins. Nish has worked on the portfolio since 2008.

Nish is part of a 10-strong team that between them have almost 200 years of investment experience, the majority of which has been focused on this segment of the market. This has been boosted by further resources from the Columbia Threadneedle Investments (CTI) team following its acquisition of BMO (including this trust) in 2021 (see portfolio section).

What does this trust look to achieve?

This trust looks to strike a balance by tapping into the faster growth of smaller companies (developed and emerging markets) but with lower risk. To do this, Nish Patel and the team use a bottom-up, style agnostic approach to target companies with strong franchises and good quality; motivated management teams; and where share prices do not look expensive. By contrast, they try to avoid speculative stocks where the team do not have conviction in what the business looks like in the future. Ideas come from many different sources and each team member will contribute. The trust has an excellent long-term performance record and has also delivered 53-years of consecutive dividend growth to investors.

Why Global Smaller Companies Trust?

• Double discount: The trust is still on an attractive discount while small-caps are attractively valued across the globe
• Historical data indicates global smaller companies should perform well from this point
• The focus on quality businesses gives investors an added degree of security within a volatile sector

Manager views: the catalysts for change

Smaller companies have been out of favour across every region. However, they have a history of outperforming over the longer term because these businesses tend to have faster earnings growth and are not as widely recognised by the investment community – this means when a company is uncovered it tends to re-rate quickly.

Nish says global smaller companies normally account for 7-8% of the global stock market, but recent underperformance has seen this fall closer to 4%, with valuations at trough levels when compared with the past 50 years. Nish says this has historically been the threshold point at which we see a turn in the cycle where smaller companies start to perform better for a prolonged period. The most recent example of this was in the late 1990s when the large-cap tech stocks dominated, following this point global smaller companies outperformed their larger peers for eight years.

The manager believes there are currently three catalysts which could result in smaller companies coming back into favour.

1. 1. Challenges to maintaining large-cap growth
      Nish believes large companies, particularly in the US, have delivered such strong growth that it will be hard to replicate given how big many of those companies have become. He also believes the high margins these companies are making will attract further competition and that these companies are not valued for any slowdown in growth.
   2. Cashflow deployment
      Nish says the corporates in the small-cap universe have seen that their shares are undervalued, resulting in a significant pick-up in share buyback activity. There has also been a significant rise in M&A activity year-to-date, with the trust benefitting from seven takeover bids in its last financial year.
   3. Interest rate cuts
      Canada and the European Central Bank have already cut rates – with others expected to follow in the near future. Smaller companies are more sensitive to credit conditions and financing and are therefore likely to see more of the upside when rates are cut. In previous rate cycles, the average small-cap has outperformed large caps by over 10% in the following 12 months (26.6% vs.15.6%)*.

Investment process

Using a bottom-up approach, Nish and the team specifically target high quality business franchises at attractive valuations.

To cut down on their 8,000 or so universe of companies the team start by asking a series of questions. Can they understand the business model? Do they have conviction over what the company might look like in 10 years’ time? And whether they can value the business?

They actively avoid speculative stocks, for example a biotech company with one drug that is loss making; or a technology company with just an idea rather than a product or revenues.

Nish says if the team remove companies with 4x leverage it immediately brings their investment universe down from 8,000 to 3,000 companies. If you then take higher-risk companies and non-cashflow businesses out it whittles the number down to a figure that is far more manageable.

Portfolio activity

An evolution not a revolution

A series of changes have, and continue to be made.

Historically the team have used third party collective fund holdings for their Japan, Asia and emerging markets exposure, as they have felt they did not have the in-house expertise to look at direct equity holdings in these regions. This has changed following the move to CTI, with the team allocating half their Japan exposure to an internal strategy managed by CTI head of Japanese equities Daisuke Nomoto – this saw the team sell positions in abrdn SICAV I – Japanese Smaller Companies Sustainable Equity fund and Baillie Gifford Japanese Smaller Companies.

Nish says the internal Japan strategy has strong similarities with their own approach of having a “quality focus with valuation sensitivity”. The trust still retains five external managers, but it has brought the external allocation down from 25% to 18%**. An offshoot from this move is the number of stocks held has now gone beyond the 200 mark. Nish wants to bring this number back down to below 200 (the aim is to lose around 30 positions over the long term).

The trust has an underweight position in US equities with 50 holdings accounting for 40.4% of the portfolio; while Continental Europe accounts for 11.3%**, with the trust having recently cut positions in the likes of BE Semiconductors (Besi) and ASM International. Nish says the team are disciplined on taking profits on cyclical businesses when they reach fair value, citing the strong growth both Besi and ASM had seen following the rise of artificial intelligence.

The cut in stock numbers is likely to come from their exposure to UK equities. The team currently has roughly 25% of the portfolio in the UK**, across 80 holdings. Nish says the UK is not as liquid as other markets, so the team want to remain invested in these smaller companies, where you can get outsized returns over a long period of time. He say the process will take time and they are happy to wait for re-ratings and M&A activity to bring this number closer to 60 positions.

Nish says the UK remains an incredibly attractive market, following the uncertainty of Brexit and the poor fund flows, particularly from foreign investors and fund allocators, who have preferred the US. Similar companies in the same industry have been getting much higher ratings purely because they are not based in the UK.

The desire for quality growth and the cyclical opportunity

The team have been actively focusing on three buckets of the portfolio.

1. Quality businesses – these can grow reliably and have stable end markets.Nish and the team have made a swathe of recent additions and top-ups in this area. These range from a well-known business like Domino’s Pizza, which Nish says had lost it way, with management turnover and disagreements with franchisees. However, it still commands a dominant position in the UK market (it is three and a half times the size of its nearest competitor) and has just under 50% share of the pizza delivery market. He believes it is starting to revive, with new stores opening, a partnership with Just Eat, a new loyalty scheme as well as returning cash to shareholders. Having bought the business at 14x earnings, he feels it could easily trade in excess of 20x.At the lower-end of the market is Kitwave, an independent wholesale business with depots and delivery throughout the UK. Nish says the firm has got a full-scale offering to their convenience stores across a wide range of brands – as well as perfecting the model to the small convenience store. This is hard to pull off because the order sizes are low (they are typically below £300, but they do so many of these drops, larger competitors don’t want to compete). This allows Kitwave to take market share from smaller distributors servicing their local regions.
2. Cyclicals with low expectations – these businesses have downside protection due to low valuations. This is an area of focus with attractions in the likes of industrials, real estate and housingExamples include Bodycote, a provider of heat treatment services and specialist thermal processes. They strengthen metal structures that go into a variety of different applications. For example, Rolls Royce will send their aircraft engine blades to Bodycote to be heat treated – so they can withstand the pressures of being 20,000ft in the air. The advantage Bodycote has is they are the lowest cost producer of these treatments.

   Another is US pool and spa equipment provider Hayward Holdings. The US is the largest swimming pool industry in the world with Hayward part of an oligopoly of four companies dominating the market. Nish says a lot of the pumps, filters and components that go into the equipment are plumbed in a certain way. If you have a Hayward filter or heater – you can only replace like-for-like unless you want to strip out all the plumbing and incur a huge amount of labour cost. This leads to recurring revenues.

   While Covid resulted in an significant uptick in demand, the return to a semblance of normality meant the industry underwent a significant restocking and then de-stocking cycle, the latter has been uncomfortable for the company

   Nish says inventories are now at normalised levels, while the pool base is very aged in the US, so lots need upgrading. Newer pools and equipment are more energy efficient, meaning a natural replacement cycle in the coming years. This makes it a strong story for recovery in earnings and long-term compounding from here as the company introduces new products and upgrades the aging pool base.

3. Commodities related businesses – the trust is buying the lowest-cost producers of commodities. The commodity industry has been starved of capital over the past 10 years and the team believe the demand side is quite attractive because of factors like infrastructure spending.Vitesse Energy is a royalty company which does not own, nor is responsible for the drilling of oil wells, but they collect royalties as their partners drill for oil in the Williston Basin. It has partnered with some of the best operators in that basin in low-cost assets.

Portfolio turnover typically stands at around 25%. The team are disciplined on taking profits in cyclical businesses as they reach fair value; they are willing to let the compounders run as long as the valuations don’t become egregious. They have held companies in the portfolio for 10 years or more, a good example of which is 4imprint, a distributor of promotional gifts.

Performance

The attention to risk and quality has been borne out in performance. At a time when small-caps have been out of favour the trust has produced a positive NAV total return over three years (5.1% vs. -13% for the AIC Global Smaller Companies sector); while the share price total return is up 2.1% (vs. -20% for the sector)***.

The trust is also marginally ahead of its composite benchmark, the 20% Numis UK Smaller Companies Ex. Investment Companies Index and 80% MSCI ACWI Ex. UK Small Cap Index to the end of April 2024 (5.56% vs 5.51% on an NAV basis)**.

What else should investors know?

Discount: The trust is currently operating at a 9.6% discount (marginally above the 10% average discount over the past five years)****. The board has employed an active buyback policy in recent years, with a view to keeping the discount narrower than 5% in normal market conditions. The group has looked to step up marketing activity with a view to generating more interest from both existing and new investors to help manage the discount over the medium term.

Gearing: The board believes borrowing powers over the long term will serve to bolster shareholder returns. This gearing can account for up to 20% of shareholder funds, but has typically been low single digits (4.6% at 30 April 2024)**.

Dividends: The trust has also delivered 53-years of consecutive dividend growth to investors. It paid a dividend of 2.30 pence in the 2023 financial year, up from 1.84 pence in 2022^.

Summary

Smaller companies have traditionally outperformed their larger counterparts over the longer term and GSCT offers investors the opportunity to participate in this potential growth. Nish and the team have a repeatable process, which has proved consistent over many years.

The philosophy is clearly demonstrable in the portfolio, when comparing the underlying companies with the benchmark. It has a better gross margin (33.5% vs. 31.8% for benchmark); operating margin (12.8% vs. 9%) and return on equity (10.3% vs. 7.7%); it also has lower leverage (0.7x vs. 1.1x). The portfolio also has a basket of companies available on a cheaper price-to-earnings ratio than their benchmark (17.3x vs. 18.2x) and a higher dividend yield (2.1% vs. 1.5%)*.

The final point is timing, while it has been wider, we feel a discount of 9.6% is still attractive for the trust, particularly as the Board has been keen to narrow this to 5% in normal market conditions, through buybacks and generating further interest in the trust. The kicker is just how out of favour global smaller companies continue to be. Should there be any catalyst for change, this trust is a strong core consideration given its quality, valuation driven process, with a careful eye on risk.

*Source: GSCT presentation, June 2024

**Source: fund factsheet, 30 April 2024

***Source: AIC, 12 June 2024

****Source: FE fundinfo, 11 June 2024

^Source: GSCT, 2023 Annual Report