Scottish Oriental: Watch the Discount

Scottish Oriental Smaller Companies Trust is a listed investment trust that invests in small-cap companies across the Asia-Pacific region. The fund has an impressive track record since its inception in 1995, significantly outperforming its benchmark index over the period. More recently, in the last 10 years, the trust’s share price has increased by ~252% versus an ~154% increase for the MSCI AC Asia ex-Japan Small Cap Index.

Despite this impressive long term performance and a lower fee structure versus its competitors, the trust currently trades at a ~15% discount to NAV. This discount to NAV has actually widened over the last few years as Asian equity markets have under-performed relative to other markets (the US, in particular). Further contributing to this issue have been the recent restructuring of the trust’s parent company and a series of changes to the management team.

In my view, the trust has a sound long term investment process in place and, given management’s commitment to actively cap the discount at around these levels, the shares have relatively limited downside from the current price (~890p). I am generally cautious in my outlook for equity markets, but think an entry point at a greater than 15% discount to cum-income NAV could work out well for medium to long term investors despite the management fees payable.

From 2000 through 2013, the trust was managed by Susie Rippinghall. Upon her retirement, Angus Tulloch was appointed interim lead manager covering for the appointed successor Wee-Li Hee, who was then on maternity leave. For readers unfamiliar with Angus Tulloch, there’s a detailed chapter about him in the book Asia’s Investment Prophets by Claire Barnes.

Wee-Li Hee returned to the trust in mid-2014 and, for a while, served as co-manager alongside Angus Tulloch. In July 2015, the First State Stewart team split into two smaller teams: one based in Edinburgh (Stewart Investors) and the other based in Hong Kong (FSS Asia). As per the company’s announcement, the goal of the restructuring was to allow “the two successor teams to develop as smaller, dynamic investment groups, recognising that this has been critical to their success over the last 20 years.” Following the reorganisation, FSS Asia assumed responsibility for the trust and Wee-Li Hee was joined by Martin Lau and Scott McNab. In turn, Angus Tulloch stepped down as co-manager.

More recently, in April 2016, Vinay Agarwal was appointed as interim lead manager in anticipation of a second period of maternity leave for Wee-Li Hee. He will continue to be supported by Martin Lau, Scott McNab and the broader FSS Asia team. Agarwal joined FSS Asia in 2011 and is the lead manager of the First State Indian Subcontinent Fund. Given the trust’s significant exposure to Indian companies, the board felt Agarwal was the best person to take up the lead manager role in the absence of Wee-Li.

This seemingly complicated sequence of events have led some investors to question the continuity of management. The reality, however, is that Wee-Li has been with the firm since 2002 and had worked closely with Angus Tulloch from 2005 up until his departure. Martin Lau and Scott McNab have also been with the firm for some time. Although Wee-Li is the lead manager, the three work closely together in making investment decisions and are aligned in terms of both investment philosophy and process.

Investment Philosophy
The trust aims to achieve long term capital growth by investing in small cap companies across Asia. Their definition for small cap is companies with a market capitalisation less than or equal to US$1.5 billion at the time of first investment. The investment team are bottom-up stock pickers, although macroeconomic influences do on occasion play a part in their decision making process. They are not, however, obliged to hold investments in any market, sector or country. As a result, the trust’s asset allocation on a sector and country level is purely a residual of their investment process.

The trust’s investment approach is also inherently conservative, focused as much on capital preservation as capital growth. They are absolute-return focused and will often hold cash in the absence of compelling investment opportunities (cash was ~10.6% of the portfolio as at June 30, 2016). Finally, they have the ability to employ leverage at their discretion, but rarely do so given their conservative disposition.  

Portfolio Composition
The trust classifies their investment holdings into four categories according to economic activity (see below):

Source: FSS Asia
Source: FSS Asia

The majority of the trust’s holdings are either directly or indirectly exposed to the Asian consumer. This is now a fairly common theme for Asian investors and I won’t cover it in detail here, but you can see my post relating to Overseas Asset Management if you’re interested to read more about it.

The largest sector weightings in the fund are consumer staples and consumer discretionary, but indirect plays on consumption include telecommunications and financial services companies.

Source: FSS Asia
Source: FSS Asia

By contrast, you can see the sector weightings of the benchmark index (the MSCI AC Asia ex-Japan). The index is heavily weighted towards the financial services and IT sectors, which illustrates Desmond Kinch’s point about how the Asian indices don’t accurately capture the region’s growth.

Geographically, the trust has significant exposure to India (~25%) and China (~17%), while Taiwan and Singapore also represent large weightings. As previously stated, allocation by geography is purely a residual of management’s bottom-up investment process, but it’s interesting to see where they are finding value.

Finally, for your further study, below are the trust’s top 10 holdings:

Source: FSS Asia
Source: FSS Asia

Market Outlook
Management are very cautious in their outlook for Asian equity markets, saying they are in “capital preservation mode” for the rest of 2016. They continue to have a heavy emphasis on well-managed consumer companies with strong franchises, which they believe are likely to do well over the long term. 

Here’s the last paragraph from their most recent investor update:

“Growth is scarce and where it exists valuations are full. Accordingly the Trust will remain conservatively positioned and endeavour to seek out sustainable franchises at reasonable valuations for the benefit of longer term returns. We would need Asian stock markets to fall to feel enthusiastic about the medium-term prospects for the Trust.”

Fees & Alignment
FSS Asia receives an annual management fee equal to 0.75% of total net assets. In addition, they receive a performance fee if the share price total return exceeds their benchmark by 10% over a rolling 3 year period. This fee is equal to 10% of the net excess return and is capped, for now, at 1.5% of total net assets. On an blended basis, total fees paid in 2015 were 1.05% of NAV.

The investment team at FSS Asia are also required to “eat their own cooking” via a profit sharing program which sees them invest into the group’s funds with a 3 year lock-in. Any money invested into group funds via this program over the last 3 years on their behalf is void if they decide to leave the firm.

Discount Policy
The board doesn’t have a formal policy in place to control the trust’s discount to NAV, but it tries to act in the interest of shareholders. It will buy back shares opportunistically – in 2015, for example, shares were repurchased at an average 14.2% discount to NAV. It can also issue new shares at a small premium to NAV when advantageous to existing shareholders.

Below is a comparables analysis presented by Edison Investment Research (the market data is as of March 2016, so it’s a little dated):

Source: Edison Investment Research
Source: Edison Investment Research

From above, Scottish Oriental is the best performing fund (as measured by NAV TR) over the past decade. It also has a below-average annual management fee, although a performance fee is payable. Finally, the trust’s discount to NAV is the widest of the group, comparable to the Aberdeen Asian Smaller Companies trust. In fact, the trust’s current discount to NAV (~15%) is now wider than its average over the last 1, 3, 5 and 10 year periods (the range goes from ~5% to ~12%).

In summary, investors have the opportunity (at recent prices) to buy into a well managed trust with a:

  • Conservative and long-term investment philosophy
  • Lower than average fee structure despite top tier returns
  • Discount to NAV near levels where management has historically bought back shares 
  • Recent period of under-performance that reflects the returns for Asian vs. global equity markets

I would recommend an entry price at a >15% discount to cum-income NAV.