I mentioned, when I was looking at JP Morgan Claverhouse, that the performance of JP Morgan Mid Cap has not been all that great recently.The other two funds it competes with directly – Mercantile and Schroder UK Mid Cap – have, at least, both managed to beat the mid cap index over the past year in net asset value (NAV) terms.
In price terms, though, things are not quite so good as the discounts on all these funds have widened over the past year – most likely as investors’ perceptions of the outlook for the UK economy worsened. This has left these funds looking quite interesting but before you dive in it might be worth having a look at Henderson Smaller Companies.
The Henderson fund sits in the smaller companies sector but is benchmarked to the Numis Smaller Companies Index (the old Hoare Govett index) which has a higher average market capitalisation than the FTSE equivalent. By sticking to the top end of the market cap range for the index, the Henderson fund has ended up having over 70% invested in Mid 250 stocks.
It is interesting therefore that over the past 12 months it has managed to generate NAV performance of 28% – almost 7% ahead of Mercantile and Schroder Mid Cap over the same period. Its discount has also widened during the past 12 months so that it sits on over a 22% discount against 18% for the Schroder fund and 13.5% for Mercantile.
Henderson Smaller’s discount has been a perennial problem and it has been subject to frequent exhortations from me and others to tackle the issue. The board is aware of the problem but seems to have more or less given up trying to fix it. Token share repurchases in recent years have had no effect. I believe small cap trusts have a natural tendency to trade on discounts because of the illiquidity of their underlying portfolios (that is, in the event of a forced liquidation, you might expect some hit to the NAV).
Discount looks too wide
However, given the preponderance of larger, more liquid stocks in Henderson Smaller’s portfolio, it is perverse that it trades on a much wider discount than most of its peer group. Some might see this as an opportunity, especially given there is a continuation vote scheduled for the annual general meeting next year. However, unless there is much change to the share register in the meantime, I would expect it to sail through.
The bad feeling that the discount problem engenders in me is a shame given how good the performance has been while Neil Hermon has been running the portfolio (indeed Henderson Smaller Companies may be the archetypal example of good performance not necessarily translating into a narrower discount).
As the chairman points out in his latest statement, in NAV terms, Neil has outperformed the benchmark in eight of the nine years – a pretty good result, which means that over the past decade Henderson Smaller has overtaken the likes of Standard Life UK Smaller Companies to rank as the second-best performer, just behind BlackRock Smaller Companies. The dividend yield, while lower than that of Mercantile and Schroder Mid Cap, is growing as well.
One negative that the fund has been burdened with for some time is a £20 million 10.5% debenture. This does not mature until 2016 and it is probably still prohibitively expensive to repay it early. Offsetting this is a competitive management fee – just 0.35%, albeit on gross assets (which I dislike as it gives an incentive to over-leverage a fund), this makes its total expense ratio competitive with Mercantile.
Neil’s investment approach is long term – the average holding period is about five years. Like many other investment managers, he is aiming to identify undervalued companies with strong management and good growth prospects. These also tend to make good takeover targets and the fund has benefited from corporate activity, notably in recent months, the bid for design, engineering and management consultancy WSP Group, one of his top 10 holdings.
In common with most of the peer group, the portfolio is quite diversified, with more than 100 holdings. The nature of investing in this area of the market means it is still easy to miss out however – for example, Logica dropped into his universe and promptly got taken over during the year and Ophir Energy, an African exploration and production stock, which only listed in July 2011, rocketed up before he decided to acquire a stake in it.
The combination of Hermon’s long-term approach, good track record, the growing yield and the liquidity of the underlying portfolio make the wide discount look anomalous. If the board is determined not to shrink the fund, the emphasis ought to be on a marketing push from Henderson. This fund should be better rated than it is.
James Carthew is a director of Sapient Research