interactive investor’s Kyle Caldwell talks to Smithson Investment Trust’s (LSE:SSON) Simon Barnard about the fund’s outperformance, large cap versus small cap, stock-market volatility, presidential elections and the effects of a second wave of coronavirus.
Kyle Caldwell, head of collectives at interactive investor: “In terms of performance, we are almost two years on from Smithson Investment Trust (LSE:SSON) launching, and since then performance has impressed. The trust is comfortably ahead of the average global smaller companies’ investment trust performer since launch, so I just wanted to ask you, what do you think have been the key drivers since November 2018?”
Simon Barnard, portfolio manager of the Smithson Investment Trust: “Well, I mean, it's clear, I mean performance is entirely driven by our stock selection, you know, a very highly concentrated fund, which means that we have high active share and that always means that our returns are going to be quite different to the reference index. So, as you know, our strategy is first and foremost [about] finding those high-quality companies, and then we focus on the valuation before we buy them. So, we're trying not to overpay for those great companies and then we just try and hold them for the long term.
“So really all of that work that we did before launch, which, as I said, was over a year, really meant or made a big difference. I think also that what we discovered was even before the Covid crisis, the portfolio was doing quite well because the companies were growing strongly and further penetrating their own markets. We also saw, though, that during Covid itself, because our companies in general have very little debt and, as I said right at the start, we only look at fairly non-cyclical industries, when the pandemic hit, these companies were pretty resilient and held up very well.
“And when I look at the statistical analysis, you know, since launch, about 80% of our companies have outperformed the market, which is a great hit rate and we're very happy with that.”
Kyle: “Yeah, that is a very high hit rate indeed. And I just want to also stick with performance and point out that two years on from launch, Smithson Investment Trust has also outperformed Fundsmith Equity. In terms of your focus on medium and smaller-sized businesses, do you think over a full market cycle of, say, 10 years that the trust is sort of set up in a way to potentially outperform a fund or an investment trust that invests predominantly in larger companies?”
Simon: “Well, I guess the first thing to say is two years is actually quite a short time to compare the two funds. And also, you know, it's impossible for me to predict future performance. However, what I would say is that the small-firm phenomenon is quite well researched and documented and that suggests that small caps do tend to outperform large caps in the longer term. And, in fact, before we launched to do our own analysis, we did look at the MSCI World Small & Mid Cap Index, which is actually our reference index, compared to the MSCI World Large Cap Index over 20-year periods. And again, the small caps did tend to outperform the large caps.
“So, you know, one might conclude that over long term that that could be the case. The final thing I would say also is that there's been some quite interesting research out of Arizona State University, which suggests that the long-term data that they had, which is since 1926 in the US, shows that even though the US stock market outperformed US treasuries over that period, in actual fact, the vast majority of equities underperformed Treasuries, and it was only 4% of equities performing so well that dragged the overall performance above that of Treasuries over that period, and that is for the whole market.
“But then if we start splitting that down further, we can see that the effect is even more pronounced in small cap, so that, again, the average performance of small cap over certain periods does tend to outperform large caps, but that concentration is even more pronounced. And so, it becomes even more imperative to follow a highly selective process such as Fundsmith and Smithson to try and get hold of those stocks that vastly outperform, and obviously avoid those majority that tend to underperform over time.”
Kyle: “I wanted to ask you a macro question. I know that you are an out-and-out stock picker and Fundsmith, as a house, tends to not pay too much attention to macro events, but given the US election is coming up and Smithson has around 45% exposure to the US in terms of its country weighting, what impact do you think the different potential outcomes will have on stock prices and your portfolio specifically?”
Simon: “Well, I mean you're absolutely right; we don't focus on macro and certainly don't base any decisions on it simply because it's impossible to predict. But in this particular case, actually, there is, you know, 100 years of data that we can look at to try and work out what could happen. And, interestingly, there is a very pronounced cycle around the presidential election cycle in the US, which of course affects the US stock market, but because markets are so integrated it does also have a secondary impact on global markets.
“And what that data tells us is that generally what tends to happen is that if a Republican, i.e. Trump, is re-elected then what we tend to see as a market [is] an equity market bounce that year, simply because Republicans tend to be pro-market, but then in the following year, as that exuberance wears off and you realise that, actually, there hasn’t been all that much done to help the market, then the stock market tends to underperform the following year.
“But on the flip side, if a Democrat is newly elected then markets tend to sell off normally ahead of this time because they anticipate it, and that, again [is] because Democrats tend to be seen as pro-regulation. But then the flip side, on the subsequent year, is that the market tends to recover and normalise, again because you find that the president hasn’t actually had that much effect on the market overall, and those fears subside.
“You know, which of those is going to pass, I don’t have any idea. And, like I said, we do tend to ignore macro events. What we would do, if either of those came to pass, of course, is try to look out for opportunities just as we did during Covid. But certainly, at this point and ahead of time, it wouldn't really be affecting our decisions.”
Kyle: “I'm going to ask you another macro question. A lot of investors at the moment are fearful that a second pronounced stock-market correction may happen in 2020. There's obviously a lot of uncertainty about, related to Covid-19, and also what shape and form Brexit will take. Do you anticipate in the coming months, perhaps on a six-month view, that there'll be a greater level of volatility in the market?”
Simon: “Well, while all those things could happen, of course, I really don't know whether they will. Again, it doesn't really affect the way we run the portfolio. We buy these great companies and hold them through thick and thin, as long as nothing has changed with the actual companies themselves. So, while that may be the case, and certainly if those things do happen, then, yes, there would be a volatility uptick. It's really hard for any of us at this point to say whether that's actually going to happen or not.”
Kyle: “And, finally, I wanted to ask whether you will at some point in the future make use of the trust's ability to gear. And I asked this because over the long term, over a full market cycle, the ability to gear is viewed as one of the key advantages of the investment share structure over open-ended funds.”
Simon: “Yeah, well, I mean that's actually a board decision rather than one for me as a portfolio manager. But what I can say is that, yes, over time, while we haven't used any gearing yet, the board could well decide to use that to manage the discount. So, Smithson in general has traded at a premium since launch, but I think if we were to see a sustained discount, and I would think that would have to be in the double digits, then the board would begin discussing what they would want to do with the gearing potentially to manage that discount.
“But we as portfolio managers would never ask them to deploy any gearing just to buy into a low market because ultimately, you know, as we've been discussing, macro events are very difficult to predict. And even if the market feels low, it doesn't necessarily mean that we're at any sort of a bottom. So, we will never try to time the market, or ask the board to deploy gearing to take advantage of market lows, but I think that they may consider using it to manage the discount.”
Kyle: “Simon, thank you very much for your time today. Lots of interesting points made. Thank you.”
Simon: “It's been a pleasure. Thanks very much.”
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