Just thought I would write up these two which reported last week as they are run by well regarded managers and had some interesting nuggets in their statements.
The first one is the Aberforth Geared Income Trust which is a split capital investment trust managed by the well regarded value managers Aberforth Partners. As a split they are probably not to every ones taste but I like it as a way of getting a geared exposure to a decent value small cap manager. This also boosts the yield they offer on the ordinary shares (AGIT) to over 4% and this has just been increased by 6.9% at the interim stage. The ordinary shares trade on an 11% or so discount to NAV but this reflects to a degree the risks from the prior ranking ZDP's and debt. The effect of this is that they need to grow the assets by around 3% pa to 2017 to return the current NAV. So I wouldn't put you off buying them, but you should do your own research and make sure you are comfortable with the structure and the risk from the gearing before you do. The Association of Investment Companies (AIC) has a good site for this.
The interesting points from the statement related to their thoughts and findings on current valuations available in the small and mid cap areas of the market and what they call "value stretch" as follows:
"Small companies were sharply re-rated in 2013. Share prices climbed, but profits across the asset class fell slightly over the year. This disappointing profit performance reflects sluggish macro economic demand conditions in the earlier part of the year and the particular difficulties faced by many of the resources companies in the index. The historic PE of the NSCI (XIC) moved from 12.8x to 16.8x, crossing the 13.3x average over Aberforth's 23 year history. Therefore, the valuation credentials of small companies, which made them such an attractive asset class in the wake of the global financial crisis, are no longer so compelling. However, there are mitigating factors.
• The stockmarket is forward-looking and, with macro economic demand picking-up and cost bases still lean, the prospects for profit growth in 2014 are good: consensus estimates suggest a 10% increase in profits across the small company universe. Moreover, the weakness of 2013 makes comparisons somewhat easier.
• AGIT is actively managed and is not condemned to track the NSCI (XIC), which recent years demonstrate, both on the upside and the downside. Your Managers strive to keep the portfolio different from the index. A statistical measure of this is Active Money, which has been the focus of much academic research in recent years. Active Money is the sum of the differences between the portfolio weight and the index weight for each stock held in the portfolio. Your Managers aim to keep the ratio above 70%. Given this definition of Active Money, it is impossible to reach 100% without holding companies that are not part of the NSCI (XIC). This is a practice that AGIT has not pursued: it invests in companies that are either members of the index or are likely to become members on future rebalancing.
• "Value stretch" is an important concept in a value investment philosophy and may be thought of as the degree to which growth companies are more highly rated than value companies. If the value stretch is wide, then value investors should be presented with an abundance of investment opportunities. As the stockmarket valuations of these opportunities move to reflect more fairly the underlying worth of the companies, the value investor should enjoy good performance, other things being equal. Your Managers believe that although the value style was helpful in 2013, the value stretch remains at attractive levels. This may be demonstrated in two ways. First, from a historical perspective, the average portfolio PE of 13.8x sits 18% lower than the NSCI (XIC)'s 16.8x. Over Aberforth's history, the average discount has been 10%, which suggests that many attractively valued companies remain within the investment universe. 2014 EV/EBITA ratio 34 growth companies, 257 other companies, Tracked Universe and AGIT's portfolio are 14.8x 10.8x 11.3x & 9.5x Second, forward valuations also demonstrate a significant gap between the valuation of the portfolio and that of small companies as a whole. In comparing the valuations of businesses, your Managers favour the ratio of enterprise value to earnings before interest, tax and amortisation (EV/EBITA), since it is unaffected by balance sheet structure and is also the metric commonly used in M &A situations. The table above shows the 2014 EV/EBITA ratio for four categories of company. The Tracked Universe represents 98% of the NSCI (XIC) by value and comprises the 291 companies that are followed closely by your Managers. These are subdivided into 34 "growth companies" and 257 "other companies". The average EV/EBITA of the former group, which tended to perform well in the aftermath of the global financial crisis, is 37% higher than that of the latter group. The premium of the growth stocks to AGIT's portfolio is higher, at 56%. "
Interesting that they use EV/EBITA as it takes account of debt and that is what bidders and VC's would use.
The second one is the Diverse Income Trust which has the great EPIC code of DIVI. It is an investment trust quoted on the London Stock Exchange with a total investment portfolio valued at £254m as at 30 November 2013. It managers include Gervais Williams who was a highly regarded Small Cap manager at Gartmore for a number of years before turning up here at Miton Group in a more broad ranging role which now includes more mid cap. stocks. It aimed to deliver a 4% yield from launch from a diverse list of stocks - hence the name. It is currently in 131 names with around 1/3 by value in FTSE 350 Stocks and the rest in small cap and AIM stocks. I do not hold this one personally as I pretty much do this myself in a more focussed way. However, if you are looking for that type of exposure with a 3% or so yield now (given the performance since launch) then I wouldn't put you off, although like many income growth trusts it is currently trading at a premium to NAV so not such good value. You can read the whole announcement here. But the following extract from the report was I thought interesting:
"The key advantage of smaller companies is their potential to deliver growth somewhat independently of the general economic trends. During the credit boom, growth was plentiful, both in large and smaller companies, and in developed and developing economies. More recently, world growth has become more limited, so investors are beginning to renew their interest in smaller stocks. If sustained, this is a promising trend for the future. The criteria used for selecting portfolio stocks.
There are five criteria that the managers use to determine the scope for the business to deliver good and growing dividends.
The prospect of turnover growth - If a business is to sustain and grow its dividend, then the portfolio needs to invest in companies that will generate more cash in the coming years. Without decent turnover growth, this is near-impossible to achieve over time.
Sustained or improving margins - A business needs to deliver significant value to its customer base if it is to sustain decent margins. Unexpected cost increases cannot be charged on to customers if they are anything less than delighted with their suppliers. Turnover growth will not lead to improved cash generation if declining margins offset it.
A forward-looking management team - Businesses often need to make commercial decisions on incomplete information. A thoughtful and forward-looking team has a better chance of making better decisions.
Robust balance sheet - There are disproportionate advantages to having the independence of a strong balance sheet in a period of elevated economic and political risks. Conversely, corporates with imprudent borrowings can risk the total loss of shareholders' capital.
Low expectation valuation - Many of the most exciting stocks enjoy higher stock market valuations but almost none can consistently beat the high expectations baked in to their share prices. Those with low expectations tend to be less vulnerable to disappointment, but conversely can enjoy excellent share price rises if they surprise on the upside. Companies that best meet these criteria on a prospective basis are believed to be best positioned to deliver attractive returns to shareholders, as well as offering moderated risk. These criteria, used in reverse, can also be useful in determining the timing of portfolio stocks that should be considered for divestment. So a business in danger of suffering a period of turnover declines, for example, would naturally be expected to generate less cash flow in future years and thereby struggle to sustain their current dividend over time, let alone grow it."
So some good common sense stuff there on valuation plus a focus on the growth prospects, financials and financing. A useful check list for investor - which is another subject I intend to write on in the near future - so stay tuned.