Smithson (SSON) has published its letter to shareholders that is also its investment manger’s review for 2024. Simon Barnard, SSON’s investment manager, says that after a strong market sell-off in the last few days of the year, SSON’s final performance for 2024 can only be described as mediocre. He notes that it will also be marked down as the second time since the trust’s inception in 2018 that SSON has finished the year behind its reference index – SSON provided NAV and share price total returns of 2.1% and 4.9% respectively – both significantly behind the MSCI World SMID Index, which returned 11.5%.

Barnard says that, while rising interest rates played a part not everything can be blamed on this, adding that individual performance detractors were not particularly severe, with no single position detracting as much as SSON’s worst performer in 2023, a year in which the portfolio generated a double digit return and outperformed the reference index by four percentage points. Instead, he says there was a lack of outstanding winners getting the portfolio motoring, with the top performer this year which would have ranked only 5th on last year’s hit list. Of course, big winners were out there, even in the small and mid-cap sector, which again underperformed the large cap sector, this time by 11% over the year.

This has prompted the manager to look for potential improvements and as a result incremental changes have been made to its process. The primary change is to focus ever closer on the specific areas where it thinks the best long term returns will reside, with the exclusion of all distractions. Previously, SSON’s manager has been concentrating on companies between £500m and £15bn market capitalisation, but it now believes its attention should be placed into businesses in the lower half of this range, driven by the fact that many of its companies have grown quite large during SSON’s period of ownership.

Portfolio changes

The manager initiated a position in Monotaro, an online MRO (maintenance and repair organisation) based in Japan. Barnard says that it sells all the products that businesses need to run, except for raw materials. For example, safety clothing, tools, spare parts and office furniture. Monotaro is the largest online reseller in Japan, with around 15% market share, but currently only 20% of the Japanese domestic MRO market is online. This provides a good path to growth and SSON’s manager expects revenue to grow at around 15% a year as most of the marginal growth in the industry accrues to Monotaro as the largest player, supported by its broad product selection and strong online presence.

The manager also initiated a position in Medpace, a US company that provides outsourced research and development and drug trial services to small pharmaceutical and biotechnology companies. It says that this is an attractive market being the fastest growing part of the pharmaceutical industry, adding that these small companies typically opt for full service contracts given a lack of internal infrastructure, and such contracts often carry the highest margins, making Medpace one of the fastest growing, highest margin and highest return contract research organisations in the industry. The company has only grown organically to date (i.e. with no acquisitions), and continues to be run by the founder. It is also currently trading on a lower than average rating due to market concerns regarding the post-pandemic funding environment for biotechnology companies, although weak funding environments have proven to be short lived when they occurred in the past.

These new positions were funded by selling out of three existing holdings. TechnologyOne, a company which had increased in share price by five times during SSON’s period of ownership, had become the highest rated company in the portfolio and was trading at a valuation the manager could no longer justify. Similarly, Fortinet was sold. Its share price had increased by four times since it was purchased in 2020 and it had become very large at over $60bn in market capitalisation, making it an appropriate source of capital with which to acquire smaller companies. Finally, Cognex was sold as its exposure to deteriorating economic conditions in China and the global autos sector was causing the business to struggle, while it appears the market still had high hopes for the company, given it was trading on a lofty multiple.

Performance

The largest detractors were:

• Temenos – a Swiss banking software company. SSON’s manager now believes that this company will require more investment in the short and medium term to fix a badly managed transition to a Software as a Service (SaaS) business model, which will likely place pressure on both margins and returns over the coming years. The position was sold in the first half.
• Spirax Group, the industrial business based in the UK, has been a victim of slowing global industrial production growth over the last couple of years, which has continued falling, down from 1.5% in August to 0.9% now. All regions have slowed but there was particular weakness in China due to its struggling property market having knock-on effects across its economy. Further to this, Spirax’s peristaltic pumps business has a large exposure to the pharmaceutical sector which has been weak since the pandemic-stimulated boost faded away. However, the latest trading statement showed some acceleration in group revenue growth, with all business units now growing again, which SSON’s manager takes as a positive early sign of recovery.
• Domino’s Pizza Enterprises, the Australian Domino’s franchisor also performed poorly during the year. This is a company that had performed very well until 2021, after which mis-execution in several markets, including Japan and Germany, led to underperformance. Management has set out a plan to recover sales in these markets, but SSON’s manager thinks that the amount of time this turnaround might take means that its capital would be better deployed in other opportunities and the position was sold.
• Fevertree is the UK producer of premium tonics and mixers. While its margins have been recovering from the logistics and raw material cost squeeze it suffered in recent years, its overall demand environment has become weaker over the last 12 months due to declining alcohol consumption, particularly the gin market in the UK, its largest and most profitable market.
• Qualys is a US company providing cyber security software and its order growth has been held back recently by the macroeconomic uncertainty leading to reductions in corporate IT budgets. SSON’s manager expects this to be temporary and for orders to recover once corporate budgets start growing again. Its latest results showed that billings growth had rebounded to 14%, sending the share price up 16% at the time of the report. As it happens, there was also bid speculation reported on the same date, causing the shares to jump a further 10% by the end of the day.

The largest contributors were:

• Fortinet, the US cybersecurity company performed extremely well this year, up 55% in share price terms, after results in Q2 and Q3 positively surprised the market. In particular, the growth rate of bookings started reaccelerating in Q2 after a substantial slowdown over the last couple of years. This news sent the share price up 25% in a single day, which the manager says demonstrates that equity returns are anything but linear.
• Fisher & Paykel Healthcare, the medical device company based in New Zealand, had a much better year as its demand recovered from the post-Covid lull it had experienced over the last couple of years, propelling the share price to new highs.
• Addtech, the diversified Swedish industrial business, has only been in the portfolio for 3 years but over that time its share price has more than doubled. Earnings results over the last 12 months continued to be better than expected, primarily due to its strategy of frequently acquiring small, profitable companies at low multiples of earnings.
• TechnologyOne, the software company based in Australia, continued its strong share price performance as the business managed to maintain the mid-teens revenue growth it has achieved since 2022. This is a result of a successful transition to Software-as-a-Service (SaaS) for its Enterprise Resource Planning (ERP) software, which has proven popular with institutional clients such as universities and the UK government.
• Diploma is an industrial distribution business that has performed so well over the last few years that it has grown into SSON’s largest holding. This has been achieved by maintaining organic growth in the mid single digit range despite the slowing global industrial production, while also adding new companies to the group which have significantly outperformed management’s initial expectations, thus proving to be extremely good value acquisitions in SSON’s manager’s view.