The fund aims to beat the Numis Smaller Companies ex-Investment Trusts Index over a 3 to 5 year period, after fees and costs, with a high conviction portfolio of 40-50 companies.
At least two thirds of the fund must currently be invested in constituents of the Numis Smaller Companies ex-Investment Trusts index or AIM (a sub-market of the London Stock Exchange). To improve liquidity, around 20% of the portfolio is invested in companies with a market capitalisation of £1-2bn, with the remainder in companies worth £100m-£1bn.
This is a long-established specialist small cap team which worked at Rensberg Fund Management before its acquisition by Franklin Templeton in 2011. The Leeds based 8-strong UK equities team works closely together and is able to draw on the wider Franklin group for economic and market research.
There are 4 managers named on the fund. Richard Bullas joined the UK team in 2000, while Paul Spencer has chalked up 32 years in the small cap field. Mark Hall is a dedicated analyst with 31 years of experience and Dan Green brings a further 9 years of industry knowledge.
Investment philosophy & process
The core philosophy is that a long-term approach to small cap investing should focus on quality companies and have a fixation on valuations. This approach is known as ‘Growth at a Reasonable Price’ (or GARP).
The managers are not afraid to take contrarian views and describe themselves as natural sceptics, always looking for hidden downside risks. Companies must be able to demonstrate robust business models that can weather a tougher trading environment.
The team employs a disciplined and rigorous process for assessing businesses and their associated risks. First, this involves an initial valuation screening using financial metrics including enterprise value to earnings, price to book ratios and free cash-flow yield.
Next comes a meticulous appraisal of business risk, management risk and balance sheet risk. To exploit market inefficiencies, they investigate both companies and the industries they operate in. This is a hands-on approach and involves a large number of company visits and meetings every year.
The managers interact with chief executives and finance directors to gain insight into their markets, competitors and new products in order to evaluate the opportunities and threats. Asking probing questions helps them formulate an opinion on the outlook for a business. An investment must have conservative accounting, strong cash flow and good corporate governance.
The flexible strategy aims to blend quality growth, undervalued and overlooked companies, and cyclical/recovery situations. The over-riding factor is that the share price does not sufficiently reflect the inherent quality of the business, profitability and longer-term growth potential. Hence the price paid is paramount.
The managers try to limit risk by ensuring the fund is diversified and individual holdings are not usually permitted to exceed 5%. At the end of September 2019, AIM stocks represented 37.7% of the portfolio and the fund will not include unlisted holdings. The fund will, however, take significantly overweight positions in sectors where there is high conviction.
Currently, approximately 46% of the fund is in industrials against 22% for the benchmark. However, individual holdings may actually have very little overlap and it is stock selection that determines the sector weighting rather than a macro view. Other overweight positions are in technology and healthcare while the fund is very underweight in financials.
The top 4 holdings illustrate the diversity of the fund. Vitec is a specialist camera equipment manufacturer which has benefited from a recent rotation into value stocks. Entertainment One is a multinational media company which distributes music, films and TV series. Some profits were taken after it received a £3bn bid approach.
Restore is an AIM-listed company providing support services, such as document storage, to workplaces in the private and public sectors. DiscoverIE designs and manufactures innovative components for electronics applications.
Recent transactions include new positions in racing games developer Codemasters and construction business Watkin Jones. Smart Metering Systems was topped up when the managers felt the share price was oversold following a downgrade.
Performance & charges
The fund has outperformed the benchmark FTSE Mid Cap (ex IT) index during the tenure of Bullas and Spencer. From 22nd June 2012 to 18th October 2019 the fund delivered a total return of 161% compared with 118% for the benchmark Numis Smaller Companies excluding Investment Trusts and 137% for the IA UK Smaller Companies Sector.
Over 3 years to 18/10/2019 the fund is up 32%, significantly ahead of the benchmark’s 18%. Despite the challenges of the past year the fund has still managed a modest gain of 3% compared with 2% for the benchmark (source:FE analytics).
We consider the current OCF (ongoing charges figure) of 0.83% reasonable for a smaller companies fund.
Bullas and his colleagues regard the UK small-cap market as one of the most diverse and dynamic hunting grounds in the world. It provides access to emerging companies which are growing rapidly from a low base. In effect, it is easier to double turnover from £10m than £10bn!
Smaller companies are less well researched which means the market is inefficient and companies may not be valued correctly. This allows managers who are willing to ‘get under the bonnet’ to uncover mispriced opportunities and take advantage of the upside potential.
Based on estimated forward Price/Earnings (PE) ratios* the team believes overall small cap valuations are attractive relative to larger UK companies, and this is particularly the case in certain sectors.
Continued depreciation in the value of the pound, due to rising expectations of a harder Brexit and/or a general election, negatively impacted smaller companies. Any change of direction should be helpful although a global slowdown could put earnings under further pressure.
We like the collegiate approach adopted by the UK team at Franklin which shares ideas and research. The universe contains over 1,250 stocks to choose from and the managers’ different areas of expertise provides valuable input.
This fund is not tied to a growth or value philosophy, unlike some of its competitors, and is diversified across sectors and size bands. However, investors should be aware that a concentrated portfolio can deviate significantly from the benchmark which has a large number of constituents.
All smaller companies can carry higher risks and, although this fund does not invest in very early stage companies, exposure to the more lightly regulated AIM exchange is high. We believe the latter is validated by the thorough research undertaken although returns may be volatile over the short-term. Morningstar awards it a bronze rating.
* The Forward Price/Earnings ratio on FTSE Small Cap (ex. loss-makers) relative to FTSE 100, stood at a 25% discount at 30/09/2019. Source: Peel Hunt LLP.
Important information: Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Nothing in this article is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment.
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