Royal London UK Smaller Companies: March 2022 Fund Update

• Henry Lowson has built a strong track record in investing in UK smaller companies and we rate him highly
• He’s supported by a nimble team including co-manager Henry Burrell
• The fund focuses on quality growth companies at attractive valuations
• The fund was recently added to the Wealth Shortlist of funds chosen by our analysts for their long-term performance potential

How it fits in a portfolio

Royal London UK Smaller Companies aims for long-term growth by investing in some of the smallest companies in the UK stock market. Smaller companies typically have more room for growth than larger ones, though they’re more volatile and higher risk.

Growth is the overarching style of the fund, which means the managers focus on companies with long-term earnings growth potential. They also consider valuation meaning a company’s share price should be lower than its future earnings suggest it should be. This investment approach is ‘GAAP’ – growth at an attractive price. This fund could add diversification to the UK portion of a more adventurous portfolio, or one focused on larger, more established businesses. Its growth focus could also complement other investments in out-of-favour value companies.

Manager

Henry Lowson has spent his investing career focused on UK small and medium-sized companies. After graduating from the University of Edinburgh with a master’s degree in Economics and Geography, he joined AXA Framlington in 2005 where he was mentored under veteran UK investor, Nigel Thomas. He joined Royal London in September 2016 and became lead manager of the Royal London UK Smaller Companies fund.

Henry Burrell has served as deputy manager since January 2020 after joining Royal London in 2017 to focus on UK small and medium-sized companies. He joined the investment industry in 2011 on the Smith & Williamson graduate scheme and has covered UK companies of all sizes throughout this time. We believe he’s become very aligned with Lowson’s investment approach with a focus on generating returns that are aligned with an appropriate level of risk.

Alongside this fund, the duo also manages a Mid Cap fund which targets slightly bigger companies using a near identical process. Given the overlap in approach we believe the managers can comfortably handle these responsibilities. They also work closely with the broader UK equities team at Royal London, which also provides opportunity for debate and challenge.

Our Research team has spoken to Lowson several times and our conviction in him has continued to grow. We believe he’s a passionate, considered and highly experienced smaller companies investor, with the potential to deliver attractive returns over the long term. Burrell has also impressed – he is driven and has worked closely with Lowson since joining the team. That said, our conviction mainly lays with Lowson who is the more experienced of the two.

Process

The managers believe in the potential for superior growth from small and medium-size companies. With far less research available in this part of the market, the managers aim to use their experience to uncover hidden gems.

Share prices can rise and fall based on short-term news or market sentiment, but over the long run they tend to be driven by the quality of the company in question. That’s why the managers undertake detailed company analysis to ensure the companies they invest in possess the traits that will enable them to grow more sustainably than most. They only buy companies whose share prices look attractive compared with their growth prospects. This leads them to favour quality companies that possess the financial resilience and leadership skills to thrive or survive when times get tough.

The managers take a long-term view and assess companies using the acronym ‘SIMBA’: scalability, innovation, management, barriers to entry and unique assets. Companies require at least four of these characteristics to be considered for the fund. Emphasis is placed on company management which is why they conduct over 400 company management meetings each year. This helps them gain a deeper understanding of their character, alignment with investors, and strategy.

This analysis whittles their investment universe down to around 65-80 companies. New investments make up between 1-1.5% of the fund and this can go up to 3% as the managers’ conviction grows. This limit helps to keep the fund diversified.

The managers currently find plenty of opportunity in industrials and consumer discretionary companies. They also invest more in technology and healthcare than the benchmark. In contrast, they tend to steer clear of companies that are loss making, highly indebted and capital intensive such as real estate. They also avoid those that are highly sensitive to the health of the wider economy or commodity prices.

The managers also invest in some initial public offerings (IPOs), which are companies newly listed on the stock market. For example, in November 2021 they invested in the IPO of Stelrad, a leading radiator manufacturer. With pricing power, scale advantages and a well aligned management team, they are optimistic about the growth prospects. They’ve also recently added to investments in companies that have seen their share prices fall, but where the managers think they could bounce back. This included online auctioneer Auction Technology Group and software company GB Group.

Culture

Royal London Asset Management was established in 1988 and is a subsidiary of Royal London, the UK's largest mutual life and pensions company. It’s well known for managing fixed income funds, but it’s also making headway in equity funds. The UK team has a flat structure and appears to be a tight-knit community which encourages challenge and debate.

Although this is not an ESG (Environmental, Social and Governance) fund, corporate governance factors form a crucial part of their analysis. Lowson believes that companies with poor ESG credentials can become bad investments. That said, companies with good ESG credentials are not guaranteed to be prosperous. While the managers can invest in any sector, they avoid companies with material ESG risks like betting shops.

As long-term investors they actively engage with boards on ESG issues such as director remuneration to help align the interests of all parties. Lowson and Burrell are also well aligned with investors in this fund as they both have significant personal investments in the fund.

Cost

The fund has an annual ongoing charge of 0.77% which makes it one of the lowest in the sector. We think this is great value for access to a talented management duo. The HL platform fee of up to 0.45% per year also applies.

Performance

Lowson has delivered impressive returns over the course of his management career. Since managing UK smaller companies funds for retail investors, his track record has performed better than both the FTSE Small Cap (excluding Investment Trust) index and the average fund in the IA UK Smaller Companies sector. This includes his time running the AXA Framlington UK Smaller Companies fund between May 2012 and May 2016, followed by the Royal London UK Smaller Companies fund from September 2016.

Our analysis suggests that Lowson’s performance throughout his career has been primarily driven through his stock picking ability and being invested in the right sectors. His funds have also tended to experience less volatility than the average UK smaller companies fund. As always past performance is not a guide to future returns.

His focus on higher-quality companies means we expect the fund to hold up better than the average when markets are falling. We saw this during the Covid setback in March 2020. We broadly expect the fund to keep pace with rising markets, but not when markets are driven by lower-quality, more value-orientated companies.

More recently over the past 12 months, the fund returned 3.42% vs 1.80%* for the IA peer group. However, both underperformed the index return of 12.02%. The fund didn’t own some of the strongest performing companies in the index over this time, but these businesses don’t tend to meet the managers’ quality criteria for long-term investment.

Elsewhere, Alpha Financial Markets was one of the top performers following robust growth and the successful acquisition of a company in the US. Asset manager Sanne Group also helped returns after they were acquired by Apex Group. Other notable performers include Serica Energy and digital transformation company Kin & Carta.

Past performance is not a guide to the future. Source: *Lipper IM to 28/02/2022.

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