Look past the noise, it’s the stocks that count

Investors could spend months mulling over geopolitical events or gloomy economic forecasts and what they might mean for their portfolios and their stock picking process. The ‘macro’ is undoubtedly important – unexpected events such as the pandemic, can shake markets vigorously – so it’s understandable that they’re given close attention. Yet, very few long-term investors attribute their investing success to how they navigate the range of complex scenarios that may play out in markets, but rather a disciplined approach to stock picking that remains consistent.

The past decade is a case in point. Though, by some measures, it was a blinding success for some equity investors, many describe the period as the ‘most hated rally in history’. Fresh from a searing financial crisis and a prior decade that proved a flop for equities, gains were built on a hesitant economic recovery, sceptical investor optimism, and underpinned by doses of emergency stimulus. With newspaper tabloids pedalling potential catalysts for the next financial downturn, there seemed plenty to worry about for European and UK investors.

At Henderson Smaller Companies Investment Trust, we looked past this macro noise, and instead focused on finding high quality, high growth businesses within the small and mid-cap (smid-cap) market. As long-term investors, we believe that these sorts of companies will weather the storms and thrive in years beyond them. The Trust aims to maximise shareholders’ total returns by investing in smaller companies that are quoted in the UK. And through a disciplined and consistent investment approach and philosophy, the Trust has beaten its benchmark in 16 of the 18 years, in which I have been the manager.

A decade of curveballs

There is a reason why some call it the most hated bull market in history, and this resonates particularly strongly with European and UK investors. Still recovering from the financial crisis, the 2011 sovereign debt crisis dealt a fresh blow to Europe’s recovery. Political churn uncovered financial mismanagement by a range of governments, starting with Greece. Ratings downgrades and rising yields ensued, and snappy headlines containing the now infamous ‘[country]-exit’ portmanteau – in this case ‘Grexit’ – led to fears of contagion across the bloc and abroad.

To thwart the dissolution of the union, politicians argued and debated, and rounds of bailouts eventually followed. Meanwhile, central banks dosed markets with quantitative easing (QE) to sooth concerns and keep borrowing costs low amid the uncertainty. Yet still, the crisis dragged on for years, and European equities remained broadly out of favour.

Some would say the difficulties in finding a political solution in Europe laid the groundwork for Brexit, with groups taking aim at the perceived sluggishness of multilateral organisations such as the European Union and the International Monetary Fund amid a backdrop of rising nationalism. After the shock UK referendum result in 2016, four years of political spats between Britain and its incensed neighbour followed, and it was UK equities’ turn to feel the cold from investors.

Protracted Brexit uncertainty segued neatly into pandemic chaos, which sparked a global bear market. The impact was sharp and dramatic, although relatively short-lived thanks to the rapid injection of fiscal and monetary stimulus. Though Brexit uncertainty has abated, and we slowly put the pandemic to bed – the threat of inflation, rising transportation costs and concerns that central banks will begin removing stimulus and raise interest rates have emerged to hang over markets. It seems the anxiety never ends.

Remaining clear-eyed

Though the decade reads rather nightmarishly, the returns have been quite the opposite and particularly strong for smid-cap stocks as illustrated below¹:

Returns over the last decade
FTSE 100	+93%
Euro Stoxx-600	+178%
FTSE 250	+198%
Numis Smaller Companies Index	+211%
Henderson Smaller Companies Investment Trust	+521%

Source: Bloomberg, 31/08/2011 to 31/08/2021

Warren Buffett once remarked that he doesn’t concern himself with the “macro stuff” because, although important, it is ultimately “not knowable”. Instead, he mused, it is much better to focus on “what is important and knowable”. For us, the Henderson Smaller Companies Investment Trust team – bottom-up stock pickers – what is important and knowable are the companies we invest in.

First, smaller companies tend to outperform broader markets over time. This is because by their very nature, they are more innovative, faster-growing, and have more entrepreneurial management at the helm. In addition, the ability to leverage their operations makes easier for them to turn a pound of earnings into two when compared to larger firms.

Second, we believe that strong, high-quality growth companies are not only positioned to survive the crisis of the day but should continue on a trajectory of solid growth as idiosyncratic macro events fade into the history books. However, small, and mid-cap stocks can be more volatile compared to their large counterparts.

We constantly follow the tried and tested process I have been using ever since taking over management of the Trust in 2003. The primary ingredient we look for in a company is solid fundamentals – all the essential bits of a business that contribute to its success. By understanding these fully and ensuring they’re robust, we gain detailed insight into the potential of the company.

A process built to last

Alongside the insights and expertise of the small and mid-cap team at Janus Henderson Investors, we evaluate companies through our ‘4Ms’ process. We analyse the quality of the business ‘model’ and its ‘management’, the ways in which it makes and uses its ‘money’, and the ‘momentum’ of its earnings reported to investors. This enables us to gain a clear understanding of the business and its markets. This also includes a strong valuation discipline encompassing a wide range of valuation techniques to ensure that the growth stocks we are purchasing are bought at an attractive price. It’s neatly summed-up as GARP – growth-at-a-reasonable-price.

The buy and sell criteria surrounding the 4M’s model is outlined in the chart below²:

What is more, we aim to hold on to stocks and ‘run our winners’ as we believe long-term investing is consistent with wealth creation. This is evidenced in our portfolio holdings: 19 stocks have been held for longer than 10 years and have weathered the storms of the last decade, while helping deliver exceptional performance. Prime examples of stocks that fit this bill can be seen in the table below³:

Stock	Tenure	Return (share price total return)
Bellway	+15 years	+707%
RWS	+15 years	+883%
Howden	+10 years	+1008%

Source: Bloomberg, share price total return, 31/08/2011 to 31/08/2021

This consistency of approach has also delivered at the portfolio level. The Trust has returned +521% over the last decade (ending August 2021) compared to the benchmark (Numis Smaller Companies Index) return of +211%. This is significantly higher than its large-cap counterparts which have returned +93% (as measured by the FTSE 100) over the same period. More recently, the Trust outperformed its benchmark over its last financial year ending May 2021 – meaning it has outperformed its benchmark in 16 of the last 18 years. It also marks the 18^th consecutive year the Trust has increased its total dividends. This consistency in outperformance not only reflects the quality of the team, but also highlights the importance of staying disciplined and sticking with a tried and tested investment process, in spite of the macro noise that has characterised the decade.

The next leg

On the whole, the outlook for markets looks much brighter than it has been for years. Companies are performing strongly, profits are growing buoyed by the release of pent-up consumer demand, and UK valuations remain cheap compared to developed markets. However, inflation poses a risk, QE will soon be withdrawn, and who knows what might cause the next financial downturn. What is clear, however, is this is a stock pickers market and the ability to tune out the noise and focus on the fundamentals will be key to generating solid returns. As such, we at Henderson Smaller Companies Investment Trust, will continue to focus on what is “important and knowable”.

Bear market Expand

A financial market in which the prices of securities are falling. A generally accepted definition is a fall of 20% or more in an index over at least a two-month period.

Bottom-up Expand

Bottom-up fund managers build portfolios by focusing on the analysis of individual securities, in order to identify the best opportunities in their industry or country/region.

Fiscal policy Expand

Government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is typically set by a central bank. Fiscal austerity refers to raising taxes and/or cutting spending in an attempt to reduce government debt. Fiscal expansion (or ‘stimulus’) refers to an increase in government spending and/or a reduction in taxes.

Fundamentals Expand

Fundamentals include the basic qualitative and quantitative information that contributes to the financial or economic well-being of a company, security, or currency, and their subsequent financial valuation.

Inflation Expand

The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures.

Leverage Expand

The use of borrowing to increase exposure to an asset/market. This can be done by borrowing cash and using it to buy an asset, or by using financial instruments such as derivatives to simulate the effect of borrowing for further investment in assets.

Monetary policy Expand

The policies of a central bank aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.

Quantitative Easing Expand

An unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system.

Valuation Expand

Metrics used to gauge a company’s performance, financial health, and expectations for future earnings eg, price to earnings (P/E) ratio and return on equity (ROE).

Yield Expand

The level of income on a security, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, this is calculated as the coupon payment divided by the current bond price.

¹ Source: Bloomberg, 31/08/2011 to 31/08/2021

² Source: Henderson Smaller Companies Investment Trust: A decade of outperformance, as at August 2021

³ Source: Bloomberg, share price total return, 31/08/2011 to 31/08/2021

Discrete year performance % change (updated quarterly)	Share Price		Nav
30/09/2020 to 30/09/2021	66.1	56.6
30/09/2019 to 30/09/2020	-10.6	-4.0
28/09/2018 to 30/09/2019	-2.9	-5.2
29/09/2017 to 28/09/2018	18.4	10.6
30/09/2016 to 29/09/2017	23.6	26.2
All performance, cumulative growth and annual growth data is sourced from Morningstar

References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe, or purchase the security. Janus Henderson Investors, one of its affiliated advisors, or its employees, may have a position mentioned in the securities mentioned in the report.