Smithson Investment Trust (LSE:SSON) raised the most amount of money for a UK-domiciled investment trust in its initial public offering (IPO) when it entered the stock market over five years ago in October 2018.
In total, £822.5 million was raised, driven by strong demand from private investors keen to gain a different type of exposure to the investment philosophy of Terry Smith’s open-ended Fundsmith Equity fund.
Smithson focuses on global smaller companies deemed too small for the original Fundsmith fund. But, in common with Fundsmith Equity, it is high conviction in its approach, with around 25 to 40 companies in the portfolio. Also in line with the Fundsmith philosophy, Smithson aims to buy and hold for the long term and not overpay in terms of valuations.
While the trust is not managed by Smith, and is instead overseen by Simon Barnard and Will Morgan, as chief investment officer Terry Smith does get involved to provide support and advice. Moreover, he has plenty of “skin in the game” as he invested £25 million of his own money at the outset.
How Smithson has fared five years on
Barnard and Morgan, who both sharpened their investing spurs at Goldman Sachs, were not household names for retail investors when the trust launched. Today, the duo are more familiar names with the investing public, and they have a five-year track record.
In a recent interview with interactive investor, Barnard and Morgan said their assessment of performance since launch is that “outperformance over the index has been achieved”, but in future they would like to “generate more”.
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From launch on 18 October 2018 to 31 October 2023, Smithson has outperformed in net asset value terms. It has returned 37.8%, which translates to 6.6% on the annualised measure. Its benchmark, the MSCI World Small and Mid (SMID) Cap Index, has annualised returns of 4.96% over the same time period.
However, in share price total return terms, the returns are less favourable, with a gain of 11.1% over the period, or 3.3% annualised. This is ahead of the global smaller companies investment trust sector return of 5.9%. This sector contains five trusts.
The gap between the NAV return and share price return is sentiment driven. As Barnard notes, it has been “a tough couple of years” for the mid-cap and small-cap part of the market he invests in.
Interest rate rises have been a big headwind for smaller companies
Performance in 2022 was a tough period for shareholders. Smithson’s share price dropped 35.2% and the net asset value (NAV) of its companies fell 28.1%. For comparison, the benchmark index declined 8.7%.
Interest rate rises, which begun at the end of 2021, caused many investors to dial down on risk as the returns on safer assets, such as cash and government bonds, rose. In such an environment, smaller company shares naturally suffer.
Barnard says: “People tend to seek safety in times of market stress, with larger companies seen as safer. As a result, we sit here today at a relative low point for mid-cap and small-cap stocks.
“Over the past couple of years, there’s been a huge drawdown for smaller companies versus larger companies.”
Plenty of opportunities to buy on the cheap
Rather than being down in the dumps, Barnard is enthused by the opportunities he sees among the companies that meet his investment criteria. He looks for companies with established track records of success and those that can compound in value over the long term. Attributes he likes to see in a business include brands and patents that competitors cannot, or will hugely struggle, to replicate.
A recent purchase made to take advantage of valuations falling to low levels was Croda International (LSE:CRDA), a UK chemical ingredient company focused on the personal care and life sciences sectors.
Barnard says: “While markets have been difficult, for me as a fund manager it is a really exciting period as we are seeing so many opportunities. We have some of the best names in the portfolio that we’ve ever had, as we’ve been able to take advantage of low valuations, which have been dampened by interest rate rises.”
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Fundsmith tends not to pay too much attention to macro events, market index movements and what’s going on in other asset classes. But Barnard thinks a potential catalyst for reviving the fortunes of mid- and small-cap stocks will be the peaking of the interest rate cycle.
Data from Martin Currie shows that when interest rates peak, it has historically led to notable outperformance for mid-cap shares. The research found that between 1985 and 2022, the average FTSE 250 index return after rates peaked was 12.3% over one year (2.1 percentage points ahead of the FTSE All-Share Index); 20.3% over three years (5.5 percentage points); and 31% over five years (10.9 percentage points).
However, the elephant in the room is the risk of a recession. Commentators appear divided over whether the much-predicted recession for 2023 has been delayed for 2024, or is now off the table.
Barnard says talk of recession risk may already be reflected in valuations, and if a recession does materialise, it could prove to be “the final nail that ends and resets this bear market”.
With Smithson trading on a discount of 11.9%, its shareholders will be hoping for sentiment to improve.
Barnard points out that the board are keen to buy back shares to try to control the discount.
Patience is core to the investment trust’s proposition. Barnard remains as confident as ever that once he has the right companies, all he has to do is wait.
He says that owning high-quality companies capable of sustainable growth is a strategy that has worked well over the long term, through many economic cycles, including a higher interest rate environment.
Smithson shareholders will be hoping he’s right, and that their patience over the past couple of years following performance coming off the boil will be rewarded.
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