The UK small-cap bargains I’ve been buying

Star stock picker Neil Hermon has outperformed the market in 16 of the last 19 years he has managed Henderson Smaller Companies (LSE:HSL) Investment Trust. Here, he explains why in the latest financial year it was a rare year of underperformance, names the shares he’s been buying to take advantage of the steep sell-off among UK smaller companies in 2022, and explains why the ability to gear (borrowing to invest) helps boost returns over the long term.

Henderson Smaller Companies Investment Trust is a member of the interactive investor Super 60 investment ideas list.

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider interview. Today I am joined by Neil Hermon, fund manager of the Henderson Smaller Companies Investment Trust. Neil, thanks for coming in today.

Neil Hermon, fund manager of the Henderson Smaller Companies: Thanks for having me, Kyle.

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Kyle Caldwell: Over the last financial year for the investment trust to the end of May, the trust underperformed its benchmark, but over the past 19 years that you've been managing the trust you've only underperformed in three of those years. So why was it a rare year of underperformance?

Neil Hermon: Yeah, clearly, obviously a difficult year for us in the context of performance. Last year, you said it was the third year of the last 19 that we've underperformed, outperforming obviously 16 of them really. A challenging year for equity markets in 2022 particularly. Why is that? A number of reasons, first off, clearly the zero-tolerance policy towards Covid in China led to slow economic growth there as well.

A war never really helps, so the Ukrainian conflict which kicked off at the end of February. The impact there was clearly a geopolitical crisis and particularly a rise in raw material costs around metals and oil and particularly to the Western consumer.

Gas prices remained very high as Putin weaponised that. That's obviously exacerbated the cost-of-living crisis, which you're aware of in Western Europe and the UK in particular, led by very high energy prices, but also around rising costs in all things, including food, etc.

Probably the key thing why markets have been very difficult this year is around central bank policy. Towards the [end of] 2021 we were looking at a pretty dovish policy regarding interest rates and inflation and quantitative easing. As we've gone through 2022 that's become more challenging. Central banks [have] become more and more hawkish. We've seen a rapid rise in interest rates, as they try and essentially control inflation by destroying demand.

So yeah, that has been a very difficult economic period for markets overall. And in terms of our own performance, we are very much a growth-based trust, growth at the right price, growth at a reasonable price. And markets have been very much out of favour from a growth perspective because interest rates have been rising, [and] value outperformed growth quite materially.

So, our portfolio has performed well operationally. The companies have been de-rated from an earnings perspective, and we've underperformed on that basis. So yeah, a challenging year overall, but clearly, we're obviously on track to hopefully get it back in future years.

Kyle Caldwell: Around two-thirds of the portfolio is in UK mid-cap stocks. Why has the mid-cap part of the market fared just as badly as the smaller company part of the market?

Neil Hermon: Yeah, I think if you look at it in terms of the make-up of how the UK markets performed this year. Mid- and small-caps performed quite poorly, down around 20% year-to-date, and the FTSE only down to 3% or 4%, clearly materially outperformed. Interestingly enough, it's not really the FTSE in its totality that's performed better, it's actually been very much the big mega-caps. So, [in] the FTSE 20, so AstraZeneca (LSE:AZN) is GSK (LSE:GSK), British American Tobacco (LSE:BATS), Shell (LSE:SHEL), BP (LSE:BP.)'s have done very well. The FTSE 80, companies below the FTSE 20 have underperformed, basically in line with the mid-cap and small-cap. So yeah, clearly a year mid and small-caps underperformed materially.

It happens occasionally, and why is that? Really around there's a degree of flight to liquidity and safety of large-cap compared to small-cap in times of economic difficulty and market movements. And also, the sectoral bias of the FTSE, is clearly more defined towards things such as oils and pharmaceuticals and staples, which do better in times of an economic downturn. So unusual, but the reasons are reasonably understood and, clearly believe longer term that mid and small-cap can skip back to outperforming above the FTSE 100.

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Kyle Caldwell: Given there's been a sell-off in the part of market that you invest in, are there now plenty of buying opportunities? What have been the newest names to enter the portfolio?

Neil Hermon: Yeah, we are a low turnover portfolio. The average holding period of stocks in the portfolio is around five years. So, we're not churning and burning the portfolio. There's always a reasonably limited number of names that come into the portfolio in any one year. But as you said, it's been a year when clearly share prices have come down a lot and provide a lot of opportunity for looking at new ideas. So, a number of ideas we've added to the portfolio this year would include companies such as Workspace Group (LSE:WKP), a provider of short-term leases and rentals in London and the South East. Haworth, a land regeneration specialist in the Midlands and the North, QinetiQ Group (LSE:QQ.), the defence services business clearly benefiting from the increase in defence spend from what's happened in Ukraine. Trainline (LSE:TRN), the online app for buying rail tickets, and Rathbones Group (LSE:RAT), a private client wealth manager. We think the long-term structural demand for wealth is clearly going to increase. So, a number of new names in the portfolio during the course of this year.

Kyle Caldwell: And among your existing holdings, have you been seeking to top up positions and share prices that you think have fallen too far?”

Neil Hermon: Very much so. So, I talked about a few new names we added to the portfolio and [in] the context, we are low turnover and there's not a huge churn. I would say this year we've added fewer new names then normal. So, I think I went through four or five with you a minute ago. Typically, we add about 15 new names, in any one year, and this year is about six or seven. So, much lower levels of new purchases. And why is that?

Well, because we think there's a lot of value in our existing portfolio, share prices have come back a long way this year, I said before that the operational performance of our portfolio has remained very sound. They delivered the growth we expected, the earnings growth and performance generally, but the share price has come back a long way because of that de-rating by the market of growth stocks.

So, we're seeing a lot of value in our existing portfolio. So, if anything, we've been gravitating to buying what we already know and like, and what has done well for us where we think the valuations have become too compressed.

Examples of companies where we've added to the share would be some of our top 10 holdings, things like Impax Asset Management Group (LSE:IPX), the ethical fund manager; Future (LSE:FUTR), the B2B and B2C consumer magazines and information provider; Ascential (LSE:ASCL) a media services business; and IntegraFin Holdings (LSE:IHP) a platform for wealth providers. So, there's some new names in the portfolio. But a lot of our focus has been about adding to things we already know that we think are too cheap.

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Kyle Caldwell: The ability of investment trusts to borrow to invest is known as gearing, [and it] is a double-edged sword as 2022 has proven. But over the long term, it tends to be a benefit to investment trusts. Does this ring true for Henderson Smaller Companies? What are the current gearing levels, and how do they compare with the start of the year?

Neil Hermon: Yes, I think it's a very valid point. The differentiation between an investment trust and an open-ended vehicle is that we can gear, and clearly that will be a benefit if markets go up and our portfolio rises, you'll get that gearing benefit.

As you pointed out, 2022 has been a year when gearing has been a negative contributor because markets have fallen. But if you think [about] the long-term performance of the trust, over the last 20 years we've produced like 13% compound returns, a portion that's come from the fact that we've been gearing over that period of time.

So, we think gearing is a positive thing. Ultimately markets do tend to rise. They are essentially proxies or betas on GDP growth. This year, we started 2022 with gearing at around 9%. We're now about 11%. That’s really a function of the fact that as the value portfolio shrunk this year, unless we sell the portfolio, gearing will rise, it’s more a function of not taking a deliberate decision to buy more and more. It’s more the fact the markets have fallen. So yeah, this year has not been the year to have that gearing in place; it's been detrimental to performance. But fundamentally, with the long term, it's the right thing to have.

Kyle Caldwell: That's all we have time for today. For the rest of our Insider Interviews, you can check out our YouTube channel, where you can like and subscribe. Hopefully see you next time.