Royal London UK Smaller Companies: February 2023 Fund Update

• Henry Lowson has built a strong track record 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 trading at attractive valuations
• The fund features on our 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 to grow an investment over the long-term 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.

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. 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 has over a decade of experience in the investment industry, having started out on the Smith & Williamson graduate scheme. We believe he’s well 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 manage a Mid Cap fund which targets slightly bigger companies using a similar 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 provides opportunity for debate and challenge.

Process

The managers believe small and medium-size companies harness significant growth potential. With less research of 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 should enable them to grow more sustainably than most.

The managers take a long-term view and assess companies using the acronym ‘SIMBA’: scalability, innovation, management, barriers to entry and unique assets. They require companies to possess at least four of these characteristics to be considered for investment. They place significant emphasis on the capabilities and track record of 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 for future success.

The managers look to only buy companies when their share prices look attractive when 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.

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 have made some changes to the portfolio over the last year. In the final quarter of 2022, they invested in two new positions, the global market leader in secure data Blancco Technology and media group Wilmington. Lowson feels that the former has a dominant market share in the data erasure market and enjoys barriers to entry as a result. He also feels the business is likely to benefit from a growing addressable market as current and potential customers prioritise managing their data security. On Wilmington, he’s confident the company’s prospects are underpinned by multi-year subscription revenues. Power supply specialist XP Power was sold from the portfolio over the same period. The managers grew concerned about the company's balance sheet after it received an unexpectedly large fine and saw a deterioration in cashflow.

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. Lowson and Burrell invest a significant amount of their own money into the funds they run. This helps to align their interests with those of investors.

ESG Integration

All Royal London fund managers have access to ESG ratings and analysis produced by the firm’s central Responsible Investment team. The firm asks that all managers incorporate this into their investment decision making processes, but our meetings with Royal London fund managers suggest the quality of ESG integration from fund to fund is mixed. The firm’s sustainability branded funds fully integrate ESG, with the support of the Responsible Investment team.

The Responsible Investment team coordinates company engagement and the case studies can be found in the firm’s annual Stewardship and Responsible Investment report. The firm also publishes a summary of voting activity on its website, and an interface allows visitors to search for all voting activity relating to a specific company, or any time period, including a rationale in cases where the team voted against a proposal or abstained.

Cost

The fund has an annual ongoing charge of 0.77%. The HL platform fee of up to 0.45% per year also applies.

Performance

Lowson has delivered impressive returns over the course of his career. Since managing UK smaller companies funds for retail investors, he’s 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. Past performance isn’t a guide to future returns.

Over the last year, the fund has delivered a return of -22.54%* to investors, lagging behind the -10.00% return for the FTSE Small Cap ex IT index, and the IA UK Smaller Companies peer group average return of -16.71%. The fund has faced multiple headwinds over this period including a broader style rotation away from growth and rising interest rates compressing smaller company valuations.

Among the most significant detractors from performance over this period were the fund’s investments in financial services business Mortgage Advice Bureau, and chemicals company Treatt. Some of the fund’s investments did make money over the year though. Its investments in software business Cerillion and oil and gas producer Serica Energy were among the stronger performers.

We remain confident the managers continue to employ their well-established process and are well placed to pick out smaller companies with strong growth potential, although there are no guarantees.

Past performance is not a guide to the future. Source: *Lipper IM to 31/01/2023.

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