Liontrust UK Smaller Companies Fund January 2022 review | Insights

Past performance does not predict future returns. You may get back less than you originally invested. Reference to specific securities is not intended as a recommendation to purchase or sell any investment.

The Liontrust UK Smaller Companies Fund returned -9.5%* in January. The FTSE Small Cap (excluding investment trusts) Index comparator benchmark returned -3.4% and the average return of funds in the IA UK Smaller Companies sector, also a comparator benchmark, was -7.7%.

Concerns over inflationary pressures and the monetary policy response were a feature of 2021, but central banks were largely happy to take a wait-and-see approach. In January, statements from the US Federal Reserve delivered a strong message that quantitative easing would finish in March, with US interest rates also likely to be raised in the same month and continue to be hiked through 2022 at a faster rate than had been anticipated.

As well as driving up bond yields (US and UK two-year government bond yields both rose around 30bps to 1.1% and 1.0% respectively), the prospect of higher interest rates prompted a sharp equity market rotation away from ‘growth’ stocks – which suffer from higher discount rates applied to their future forecast earnings – and towards ‘value’ stocks, which, by contrast, are viewed as short-duration assets less affected by discount rates.

The rotation shows up dramatically in MSCI index data: the UK value series outperformed its growth equivalent by 12 percentage points in January alone.

The Economic Advantage investment process applied to this Fund is a bottom-up, stock-picking process. We do not set out to achieve any style bias outcomes within the Fund. But because the process seeks out dependable, consistent businesses with barriers to competition, high financial returns and strong balance sheets, there is an observable style footprint that emerges: a tilt towards ‘quality’ and away from value. The investment process doesn’t actively target companies with high forecast EPS (earnings per share) growth, but this often goes hand-in-hand with the characteristics it does seek, such as high cash flow return on capital; this is particularly true when the process is applied to smaller companies, as it is in this Fund.

In a stark risk-off environment, there was also a size bias to equity market returns; while the FTSE 100 index made a positive 1.1% return, the mid-cap FTSE 250 lost 6.5% and the FTSE Small Cap (excluding investment trusts) returned -3.4%. The FTSE AIM All Share Index fared even worse, losing 10%. Three-quarters of the Fund is invested in AIM stocks, leaving it exposed to the heavy sell-off.

Over the years, the Fund’s style profile has been a tailwind to performance but in January it represented a sizeable headwind as investor sentiment shifted away from high forecast growth and small caps.

Many of the share price falls were unconnected to company newsflow. For example, AIM-listed YouGov (-26%) shares lost a quarter of their value despite issuing a trading update which upgraded full-year financial guidance. Impax Asset Management (-26%) suffered a similar fall despite only reporting another quarter of solid growth in assets under management. Dotdigital Group (-25%) issued an in-line trading update.

Another group of detractors issued in-line results but included notes of caution within outlook statements which triggered disproportionate share price falls. Craneware (-22%) is a good example. A half-year trading update maintained guidance for the full year and noted that recurring revenues have grown ahead of expectations. But it also noted that one of its revenue lines has been affected by an elongation of the sales cycle and staff shortages due to Omicron, an effect it expects to prove temporary. In January’s market environment, the note of caution had a bigger impact on the share price than the confirmation of full-year forecasts.

Microlise Group (-28%) fell as it issued cautious outlook comments. Its 2021 trading update referred to revenue and earnings which were in line with market expectations but noted that supply chain challenges were likely to last longer into 2022 than many anticipate.

In our experience, January often sees an automatic reversal of the trends that worked well the previous year. On this occasion, it’s very hard to predict whether these headwinds will persist or ease. Our investment process explicitly excludes any form of macroeconomic forecasting in favour of pursuing the bottom-up approach that has served us so well over the years.

While the equity market narrative around rising inflation and interest rates currently centres on the value versus growth debate, it may well develop to incorporate more nuanced factors, such as which companies possess the pricing power to maintain margins within an inflationary environment. One of the fundamental characteristics we look for in companies we invest in is a durable competitive advantage which confers a high degree of pricing power. A company with true pricing power can pass on some or all cost inflation rather than having to absorb it through a reduction in profit margins.

The evidence so far is that our companies are coping well in the current environment. Overall, we’ve found that trading updates across the portfolio continue to be positive, with expectations being met or exceeded. We have seen some caution in outlook statements, as companies continue to draw attention to global political and economic uncertainties which are out of their control, such as supply chain problems.

While the Fund’s style footprint was unhelpful in January, it performed exactly as we would expect it to given the prevailing conditions. Over the long term, the consistent application of our investment process has yielded very good returns. Even if the market correction has further to go, we have high conviction in our stocks and every reason to believe they will continue to add value over the long run.

Three stocks exited the Fund in January. The first two were due to the completion of takeovers with both companies being swallowed up by larger competition: Charles Stanley by large US wealth business Raymond James, and video game production business Sumo Group by the Chinese tech giant Tencent. Finally, the managers exited the position in Plexus Holdings after several years of underperformance as the business struggles to adapt its business model to the reduction in new Oil & Gas exploration, despite still possessing some interesting intellectual property.

Positive contributors included:

Arbuthnot Banking Group (+13%), Concurrent Technologies (+13%), James Cropper (+8.8%), Keystone Law Group (+4.2%), Netcall (+3.6%).

Negative contributors included:

Microlise Group (-28%), Impax Asset Management (-26%), YouGov (-26%), Dotdigital Group (-25%) and Craneware (-22%).

Discrete years' performance** (%), to previous quarter-end:

	Dec-21	Dec-20	Dec-19	Dec-18	Dec-17
Liontrust UK Smaller Companies I Inc	24.7%	15.2%	31.0%	-6.0%	27.2%
FTSE Small Cap ex ITs	31.3%	1.7%	17.7%	-13.8%	15.6%
IA UK Smaller Companies	22.9%	6.5%	25.3%	-11.7%	27.2%
Quartile	2	1	2	1	3

*Source: Financial Express, as at 31.01.22, total return (net of fees and income reinvested), bid-to-bid, institutional class.

**Source: Financial Express, as at 31.12.21, total return (net of fees and income reinvested), bid-to-bid, primary class.

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Key Risks

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Some of the Funds managed by the Economic Advantage team invest primarily in smaller companies and companies traded on the Alternative Investment Market. These stocks may be less liquid and the price swings greater than those in, for example, larger companies.

Disclaimer

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