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The case for Aberforth Smaller Companies Trust

Hunt for tiny prey with Aberforth Smaller Companies Trust

Important: This article is not a recommendation to buy or sell shares in Aberforth Smaller Companies Trust. I am a private investor, storing and sharing my notes. Please read my disclaimer.

Name: Aberforth Smaller Companies Trust
Ticker: ASL
Business: Investment trust
More: Trustnet / Google Finance
Official site: Aberforth Smaller Companies

Many active stock pickers spend their days trawling in the lower reaches of the index, searching for small cap bargains to boost their returns.

As we’ve written many times on Monevator, most of these would-be Mini Buffetts will fail to beat the index. Stock picking is immensely hard (although that doesn’t stop me trying it). Most readers will be better off with index funds.

However UK investors looking to hang up their small cap Geiger counters face a stiffer challenge than mere self-awareness.

Whereas lucky US investors can choose from small cap index funds and value-based ETFs galore, here in Britain it’s like shopping for bread in Soviet Moscow during a farmer’s strike. Blindfolded.

Recent developments haven’t really helped matters. My co-blogger The Accumulator rejected Credit Suisse’s CUKS ETF as an expensive-ish mid cap tracker disguised as a small company affair, and the RBS Hoare Govett Smaller Company tracker got the thumbs down for being a synthetic exchange traded note (ETN) that suffers from a lack of transparency.

So whether you’re a small cap sniffer-outer tired of the game or a passive investor looking to bolt-on value via the little companies, what are you to do?

Enter the Aberforth Smaller Companies Trust

I’ve several times suggested that readers, friends – and The Accumulator for that matter – do some research into the Aberforth Smaller Companies Trust (ASCoT), to see if it can plug this gap in their portfolios.

As Aberforth reported its full-year results to December 31 this week, I thought I’d offer a quick summary here, too.

Now let me be very clear – this is no index fund. It’s a managed investment trust, and while the TER of 0.85% isn’t too bad compared to the worst of those beasts, this is no low cost vehicle scooping off market returns like an elegant crane dipping its beak into an unruffled lake to skim a sliver of water.

But it’s no hippo executing a belly flop, either.

Investing in smaller companies is always more expensive than buying liquid large caps, so you’d expect the TER to be larger than, say, the blue chip buying income investment trusts.

A TER of 0.85% is much less too than what the average small stock picker pays in dealing fees and spreads to execute their own trades – though buying either the trust or the companies it buys on your behalf will cost you the same initial 0.5% in stamp duty.

That TER doesn’t include the cost of interest. ASCoT’s portfolio was on average geared to the tune of 10% throughout 2011, and it’s currently running at 13%.1.

It also doesn’t include the underlying transaction costs paid by the fund manager in turning over the portfolio as it dives in and out of positions.

While the manager talks a good long-term game, the trust turned over 29% of its portfolio in 2011, so these costs will not be inconsequential.

They will ultimately be paid from out of your returns, either by reducing the underlying NAV, or through shareholders being paid a lower annual dividend yield if the costs are met out of income.

Enter the Hoare-Govett Smaller Companies Index

Costs are a drag on a trust’s performance, which means managers need to offset them through some winning picks if they’re not to fall behind their benchmark.

ASCoT’s chosen benchmark is that already-mentioned RBS Hoare Govett Smaller Companies Index (HGSC) (excluding investment companies).

Encouragingly (unless you’re a conspiracy theorist) the trust’s chairman Paul Marsh is one of the two professors who spend much of their working days monitoring this index. He should certainly know his small caps, as well as his benchmark!

Indeed, Marsh and his colleague Elroy Dimson spend a lot of time delving into past returns from Britain’s little companies. They tracked returns from the HGSC index back to 1955 and found that:

… if you’d put £1,000 into the HGSC index in 1955 and then reinvested your dividends thereafter, by the end of 2010 you’d have a pot worth £3.25 million.

That smashed the returns from the wider FTSE All-Share by 3.4% a year; playing safe and investing £1,000 then reinvesting dividends into the All-Share instead would have delivered just £620,000.

Nice returns if you can get them, although past performance isn’t a guarantee of future returns. And given the paucity of small trackers in the UK, unless you fancy that synthetic ETN mentioned I cited earlier there’s no way to easily capture them anyway.

In some ways then, we’re not even asking for ASCoT to beat the index in return for gobbling up some of our return as fees, like you’d normally demand (/hope!) for from a managed fund. Just matching the HGSC index would be nice.

So how’s it done?

On a total return2 basis:

Period ASCoT NAV HGSC Index
1 year to 31st December 2011 -13.5% -9.1%
3 years (C.A.G.R) +16.5% +23.3%
5 years (C.A.G.R) -3.1% +0.4%
10 years (C.A.G.R) +8.0% +8.2%
15 years (C.A.G.R) +9.6% +7.9%

Note: C.A.G.R. is Compound Annual Growth Rate.

For my money, Aberforth has made a pretty good fist of at least tracking the index over the long-term.

In recent years though it’s clearly struggled, which is reflected in growing investor disenchantment with the trust.

Absolute performance relative to HGSC Index; rebased to 100 at 31 December 2001

The discount to NAV has widened to nearly 17%, and on a share price return basis, that’s meant an investment made at the start of 2011 had fallen even more than NAV in cash terms by year-end – you’d have been down some 18.5% on your initial stake.

Value shares out of favour

The managers claim their recent run of under-performance is due to the trust’s value investing style.

Over the long-term, they say, analysis by Paul Marsh’s London Business School points to value shares in the HGSC beating its growth shares by a thumping 5% per year since 1955.

Sometimes value stops working, however – one reason why people find it hard to stick with for the long-term.

During the dotcom boom, ASCoT did poorly as investors bought companies that weren’t even making profits, but then rebounded when those companies failed, for example. The managers claim that for whatever reason, the past five years have been similar, with their research showing HGSC growth shares have beaten value shares by 10% per annum.

Clearly that’s a big headwind to performance. But if you believe in mean reversion in markets then the trust should turnaround when the wind changes.

Cheap small cap value shares

We won’t run through all 89 companies that Aberforth Smaller Companies had invested in at the last count, but I will state I like its style.

The trust is currently particularly weighted towards the smallest small companies, where I agree valuations look most compelling.

What’s more these shares don’t look particularly imperiled. Some 43% of the companies ASCoT has bought have net cash, meaning that at the very least they’re unlikely to go bust any time soon.

You may think it’s bizarre that lowly-rated cash-rich companies are among the cheapest you can buy currently, given all the dire headlines about the economy.

The managers agree, stating in their annual report:

…during the bear market of the second half of the year, the correlation between balance sheet strength and share price performance within the benchmark was remarkably low – the relationship between the two was effectively random. This frustrating lack of discernment can probably be attributed to the prevailing climate of extreme risk aversion, which has, so far, out-weighed other considerations.

I concur, having seen various small cap shares pummeled in late 2011, and liquidity so constrained that I’ve had to buy or sell some investments in blocks of £1,000 or less to avoid moving the price. Bearishness still reigns in this stock market.

ASCoT’s holdings also look cheap on other measures. As of December 31st:

  • Their average P/E rating was just 9.0, compared to 11.8 a year ago and 10.5 for the HGSC index.
  • The companies’ dividend yield was 3.4%, compared to 3.2% for the index. This yield was 3.3x covered by profits.
  • On an EV/EBIDTA basis, the trust’s portfolio is valued at 6.9x, compared to 8.9x for the HGSC as a whole.

The trust was yielding 4% in December (thanks to the amplifying affect of the discount), and it’s still yielding 3.6% after a strong run in the share price in January.

Equally, the discount remains elevated at 15.3%.

The managers believe that the trust’s fortunes will reverse in time (and I agree) stating:

The present gulf between the valuations of value and growth stocks is exaggerated. History suggests that the relationship between the two groups will not stay at such stretched levels. The process of normalisation will be advantageous to the value investment style.

Investors who are prepared to wait can enjoy a decent dividend income, which in recent years has grown much faster than inflation:

Dividends versus RPI growth; Figures rebased to 100 at 31 December 2001

Why I hold Aberforth Smaller Companies Trust

I’ve almost always held Aberforth Smaller Companies Trust shares in the past 4-5 years, although residing in my active portfolio the position is liable to be trimmed and expanded as I see fit.

My current holding is the largest I’ve ever had, representing around 5% of my total net worth.

As with Caledonia Investments, I like the underlying companies, and the long-term record and approach of the managers. I think they’ll do well eventually. Both trusts are on large discounts, and I think in time they’ll close, which will amplify returns.

Passive investors looking for a straight proxy for the HGSC index shouldn’t be interested in such speculation, of course, and will rightly be wary of investing in ASCoT given its relatively high costs.

But I think one shouldn’t let perfect be the enemy of the good.

In the absence of a cheap small cap value tracker, I think a small deviation from the righteous passive way to invest say 5% of your portfolio in this small cap trust is likely to prove more rewarding than skipping past the small cap segment of the market altogether.

Note: As with all our specific share write-ups, I can take no responsibility for the accuracy of this post. Please do your own research on Aberforth Smaller Companies Trust and read my disclaimer.

  1. Using debt to buy shares will boost returns when the markets do well, but exacerbate losses in a downturn []
  2. Total return is underlying net asset value growth plus dividends paid. []

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{ 20 comments… add one }
  • 1 Alex January 27, 2012, 6:58 pm

    1. Hi TI, all very persuasive.

    2. Nevertheless, I just don’t want to be exposed to fund manager risk – let alone high costs.

    3. I learnt how significant fund manager risk can be when in a past life I was using active funds. Thanks, Bill Miller, and a host of other ‘stars’ for those lessons: painful but instructive.

    4. Thanks, too, to those ‘experts’ constantly quoted in the media who told me they could reliably identify ‘star’ fund managers. They couldn’t then, and they can’t now.

    5. Fund manager risk is avoidable, of course. But passive investing isn’t as exciting as trying to identify a potential winner, is it?

    6. Now, where are those UK smaller companies trackers? Er…

  • 2 The Investor January 27, 2012, 7:34 pm

    @Alex – Yes, you pays your money and takes your choice. Obviously I don’t really subscribe to star manager theory, or at least I think it’s very, very hard to identify persistent winners (/impossible) and certainly harder and less fun then stock picking and that’s already ready disreputable enough. (Unlike some, possibly yourself, I don’t think they’re all scoundrels. I just think they’re playing a losing game).

    Strategy picking and reversion to mean is a slightly different kettle of fish, and why I focused on the underlying metrics here. I’m comforted by the discount, too, and the growth in the dividend of the underlying portfolio.

    Anyway, I’ll always be chiming in with active stuff from time to time now T.A. has been passed the mantel of Monevator‘s Passive Indexer in Chief, but I fully agree most of the time most readers should stay passive.

    This one is just a bit different due to the dearth of small cap trackers. I suppose you could add a US or European small cap tracker, but then you’ve got currency risk into the bargain, too. Perhaps then underweight that region’s large cap in your portfolio? (It’s here that a super computer would come in handy if you’re a perfectionist! I’m much more gung-ho 😉 ).

  • 3 ermine January 28, 2012, 12:48 am

    I am intrigued that you list their official website as Caledonia Investments. I haven’t yet been able to substantiate why?

    Other than that, most interesting post, for those of us that occasionally travel on the dark side of the tracks….

  • 4 The Investor January 28, 2012, 9:59 am

    @ermine — Simple mistake I’m afraid! They are nothing to do with Caledonia, I just used the disclaimer from my article on the latter as a template for this one, changed the underlying link, but had some sort of blindness to the words on top! 😉

    Fixed now, in case you wish to venture further down this dark path.

    They could be a potentially good play for an income seeker like yourself – in the last few years the dividend has advanced at quite a clip, and the dividend reserve is adequate despite cuts from companies in the downturn.

  • 5 ermine January 28, 2012, 10:50 am

    Thanks! I thought I was going barmy, I turned over their website looking for evidence of the Cayzer family and failed miserably.

    I’m having a sector/geography review and small-cap, the US and oil are showing up as big no-shows in my holdings to consider so this is timely!

  • 6 noiseboy January 28, 2012, 11:47 am

    The Trust appears to have bought a chunk in Game PLC (GMG) this week at an all time low of 5p. Could be a shrewd move!

  • 7 The Accumulator January 28, 2012, 1:01 pm

    Passive investor though I am, I’m not fanatical about it. I hold ASL because I want exposure to UK small caps and can’t find an appropriate tracker alternative. The TER is good value in comparison to rivals and I’m comforted by the discount too.

  • 8 Rob January 28, 2012, 1:01 pm

    There are a lot of good small UK companies out there, but they are volatile to the extreme. It’s a tough and not very understanding market for them and as such many get starved of capital at critical moments. Hence you can buy at great prices but you have to be willing to ride out a big loss of capital in many cases.

    A skilled manager should be able to work with this volatility, but they’d need to be brave, gutsy and sure of what they are doing. If they do that they should get above average performance. The quality of the fund is important there though since if they get it wrong the downside will be amplified.

  • 9 OldPro January 28, 2012, 7:29 pm

    On the matter of a ‘Caledonia Connection’, I believe both trusts are run out of Edinburgh… or certainly they were? A stretch and no official link except to the Scottish Money Mafia… (I jest!)

  • 10 Oliver January 29, 2012, 1:49 am

    You make a good case, and the analysis is itself instructive. I have no quibble with the general principle: I too am a bit of an IT fan, and see that the sizeable discount does offer a helpful margin of safety. But you have not addressed a key question: I am interested in why you (and TA) plumped for Aberforth rather than any of the other small company investment trusts? Is it the size and record of the dividend? the larger size of the trust? Others have better long term records…

  • 11 The Investor January 30, 2012, 10:39 am

    @Oliver – Fair point. I treat Investment Trusts partly as quantitative affairs – assets / discounts / cash flows. That’s what I focused on in this post (valuation / discount / dividends) and it’s why I think it’s good value now.

    But you’re correct in saying there are other options, and here it’s a more qualitative issue for me. Basically, I like how its strategy – long held, and clearly enunciated – turns a risky, volatile sector into a high-ish, very steady, increasing dividend payment. I think the sort of companies it buys underwrites this income stream for the future. The size of the trust and the cut of the manager’s gib is the icing on the cake.

    I agree there are other competent trusts out there. As detailed in a post in 2009, I bought pretty heavily into three small cap trusts as we came out of the trough that year, including Black Rock Smaller Companies, which did very well for me and moved from a big discount towards fair value. Aberforth is my current preferred small cap Trust, however, and the only one I currently hold.

    Cheers for question!

  • 12 gadgetmind January 30, 2012, 10:54 am

    I’m currently over-weight small caps via the Vanguard global small cap tracker, but that Aberford discount, underlying p/e, and yield do all look tasty!

  • 13 gadgetmind January 30, 2012, 11:12 am

    Or even Aberforth!

    Interesting thread on Motley Fool, which even links back here.

    http://boards.fool.co.uk/aberforth-smaller-companies-it-12465131.aspx?sort=whole#12465131

  • 14 The Investor January 30, 2012, 1:32 pm

    @gadgetmind – “Even”? I’d hope we’re not so disreputable. 😉

  • 15 Peter February 4, 2012, 11:52 am

    I also note the trust was mentioned as having a significant holding held by the managers of trust.

  • 16 gadgetmind February 4, 2012, 1:39 pm

    I was looking to buy just after it went ex divi, but it sprang back up the same day, and every day since. Still, I’m sure some Euro leader will do something crazy next week and it will all crash again.

  • 17 Oliver February 5, 2012, 3:18 pm

    There is a smal companies index tracker out there!

    Have a look at the Henderson Fledgling IT. I quote from their publicity material: ‘The Company is managed using a hybrid investment style, whereby at least 65% of the portfolio passively replicates the [FTSE Fledgling (ex. Investment Companies) Index] with an active overlay applied to the remainder’.

    However, I’m not sure that their active overlay has resulted in any great benefit; rather they have trailed the benchmark by 12% over 10 years. Still, perhaps c.1.1% p.a. ‘tracking error’ might be acceptable for tracking a large und illiquid market over that time span.

    Fledgling companies might be even smaller than some investors might be looking for; I don’t think I will find a slot in my portfolio at the moment, but this might be of interest to others. Put simply: passive investing at a 20% discount and with a c.3% yield could be quite attractive.

  • 18 gadgetmind February 5, 2012, 3:27 pm

    @oliver – Yes, I looked at Henderson, and a few others, and then started to lose interest in smaller companies ITs. Yes, there is good evidence of long-term out-performance, but the volatility is such that I’d invest such a small sliver of my portfolio that it would make little difference.

    I hold some RIT in my SIPP (snapped up when they were on a discount) and this gives a fair bit of private equity exposure, and my global small cap tracker is also along the same lines.

  • 19 The Investor February 6, 2012, 1:41 pm

    @Oliver — Thanks for sharing your views on that one, and I should take a closer look at some point again, as I happen to think fledgling is really interesting, at least looking at Elroy and Dimson’s back history of small cap outperformance.

    However, 65% passive tracking is not even close to being a passive tracker, IMHO. There are plenty of large cap ‘closet tracking’ funds that probably track more like 80% without even writing it on the tin!

    So I think the search goes on. Interesting suggestion though, thanks for reminding us of its existence. 🙂

  • 20 tony collins February 6, 2012, 3:44 pm

    Interesting post. I bought into Standard Life Smaller Co’s Trust just before the fall last year, and have lost 26% of my investment. I’m ok with that. Long haul etc. – I’ve never considered selling up.

    I’m itching to buy some more small caps, and I’m wondering whether to add a lump more into Standard Life, given that it is still bumping along the bottom and does have a pretty good record, or whether to plump for something like Aberforth. It’s rallied by so much just in the last month!

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