Figure 1 – Long-run cumulative performance of US stocks in different size bands

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However, the Yearbook also shows that while the small cap premium persists, there are prolonged periods when it is substantially diminished. In figure 2 we show that over the last 25.5 years MSCI ACWI Small Cap has outperformed MSCI ACWI by 2.3% p.a. on a total return basis which is broadly consistent with the long-term data for the U.S. and UK markets. Figure 2 demonstrates is that is has been a game of two halves with small cap underperforming by -1.3% p.a. since 2011 and -3.3% p.a. since 2019. What has driven this outperformance, and will it continue?

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Figure 2 – The relative annual performance of MSCI ACWI Small Cap vs MSCI ACWI

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Regarding the first part of the question, over the five and a half years to 28 June 2024, MSCI ACWI has delivered a total return of 99.2% in USD. This has easily surpassed MSCI ACWI Small Cap’s 63.6%, by 35.6%. The top ten stocks in the ACWI (Apple, NVIDIA, Microsoft, Amazon.com, Meta Platforms, Alphabet, Eli Lilly, TSMC, Broadcom and Novo Nordisk) now account for 22.9%, up from an average of 12.5% over the last 12 years.

Figure 3 – Gross index return (%), weight in index (%)

In 2023, concentration in the MSCI ACWI Index reached its highest level since 1999.

Figure 3 shows the current level of concentration in the top ten has now surpassed the 21% reached at the height of the dot-com bubble in 2000. The subsequent period saw a diminished contribution from the top ten, and a decline in concentration. As seen in figure 2, this coincided with a 16-year period, 2000 to 2016, that saw relatively robust performance for MSCI ACWI Small Cap, a period over which small caps outperformed in 75% of the time.

What figure 3 also illustrates is that the top ten concentration is a result of exceptional performance. We estimate the top ten as of 28 June 2024 has returned a simple average of 706% and have accounted for 35.2% of ACWI’s total return, the vast majority of ACWI’s outperformance of ACWI Small Cap.

Turning to the second part of the question, will it continue? We anticipate many of these businesses will continue to develop in a favourable manner, innovating at scale, entrenching their market positions, while driving substantial growth. So much so, we invest in five of them in the Heriot Global Fund. However, price is what you pay, value is what you get, and fundamental progress is not always commensurate with shareholder returns. These ten companies now represent $18.5 trillion in total market capitalization as of 28 June 2024, a considerable proportion of global gross domestic product which the World Bank estimated at $97.5 trillion for 2021. If the returns of the past five and a half years are prologue and the top ten again return 706%, their total market cap would exceed $130 trillion, and global GDP. These businesses have changed the world, and they can continue to do so, but will the consume the world and their equity markets? While this is highly unlikely, their quality and fundamentals are not reminiscent of previous periods of high concentration such as the dot-com bubble. As such, it is perfectly possible they continue to outperform, just to a lesser extent.

Figure 4 shows the Price to Sales ratio of the MSCI World, MSCI World Small Cap and the ratio of the two from 29 December 2000 to 28 June 2024. I have used the Price to Sales ratio to control for earnings adjustments and margin volatility, but other ratios are just as valid. The Price to Sales ratio of the World index (in orange) has been on a steady upward trend while the World Small Cap index (in white) has barely moved since 2013. The result is that on this measure, the World index is at its most expensive relative to the World Small Cap index since 2003. The gold line in figure 4 shows the ratio of the two Price to Sales ratios and stands at 2.2x, around the same level as the previous high in index concentration shown in figure 3. Today, it is 38% higher than the 23-year average of 1.6x.

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Figure 4 – MSCI World P/S, MSCI World Small Cap P/S, Ratio of the two

If we are at or nearing the zenith of “top ten exceptionalism” what does this mean for investors? Again, turning to the Yearbook Dimson, Marsh and Staunton conclude their section on smaller companies by observing the variability but persistence of the premium and that “…we can see no case for underweighting smaller companies.” Stock selection is our forte not asset allocation. Offering MSCI’s definition of smaller companies as the bottom 15% of global market capitalization establishes the “neutral” allocation.

Closing of this valuation gap, a decline in index concentration and the relative outperformance of smaller companies would be consistent with history. There is a plethora of catalysts for this including an inflection in interest rates, earnings of the Magnificent Seven failing to meet high expectations, and the gradual reallocation of capital to relative value. To echo Dimson, Marsh and Staunton’s conclusion we can see no case for underweighting smaller companies and can see a compelling case to be overweight.

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On Dividends:

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In many respects the year has been significant. Through the lens of dividends, it will go down in history. We estimate that in the first calendar quarter of 2024 over US$5 trillion in market value and 5% of global market capitalisation (as measured by the total market capitalisation of MSCI ACWI) initiated dividends. The most significant are Alphabet, Meta Platforms, Salesforce and Booking Holdings. We believe these four fall into two categories 1) high quality growth businesses with incredible network power and 2) growth businesses with a poor record of recent capital allocation decisions. While we will leave you to judge into which category they fall, what we would suggest is they are trying to signal the same thing, which is the following:

• They are high quality growth businesses today

• Management will allocate capital with discipline in the future

These companies are initiating a dividend as a sign of confidence and, where required, reassurance. These strong market positions and good capital allocation are features of dividend growth companies; they tend to outperform in the long term. It is our conviction that where dividends grow, share prices follow.

For a portfolio to consistently deliver faster dividend growth than the market it must have premium qualities. The following table demonstrates that we own businesses of significantly higher quality than the market as shown by a Return on Equity almost 4x greater than the market, with a fraction of the leverage, and 1.6x the profitability as measured by the operating margin.  

While we have shown we own quality companies, without growth, substantial shareholder value is unlikely to be created. This growth is created by the ability to compound reinvest profits into high return on capital projects. The table below shows the breakdown of our dividend announcement record into those companies that have grown, held, or cut their dividend and where we have invested in the expectation of a dividend initiation.

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Dividend announcements are the most reliable signal with which to judge a business’ development and management’s conviction for its prospects. The reliability is underwritten by its honesty and its value. It is honest because it is a tangible cash distribution to shareholders that cannot be manipulated through creative accounting. It is valuable because the dividend growth signal is costly as it occurs over time, a precious commodity, and requires discipline, something that is difficult to achieve. Our portfolio businesses continue to communicate optimism in their prospects, despite high interest rates and fears of recession with an average growth rate of 9% calendar year to date, comparing favourably to the MSCI ACWI Small Cap average of 1.4%. Excluding the case of Trend Micro, our average rises further to 11%.

Trend Micro develops cybersecurity products for businesses, data centres, cloud environments, networks, and consumers. The business has been navigating an industry under significant change due to a dynamic competitive landscape, the move to a Software-as-a-Service (SaaS) business model, and evolution of cyber threats. Like many Japanese businesses, Trend Micro has a fixed pay-out ratio policy, returning a set proportion of profits to shareholders every year. Earnings fell through 2023 due to their continued transition to SaaS weighing on revenue in the short-term and rising development costs. While Trend Micro reduced their ordinary dividend by 63% to reflect the decline in earnings, they also announced a special dividend equivalent to 12x the ordinary dividend. Furthermore, Trend Micro announced a large share repurchase equivalent to 5x the ordinary dividend. Both decisions improve the capital efficiency of the business while indicating management’s confidence in growth and that shares are attractively valued. We are of the view that earnings and ordinary dividends will recover in short order and be once again accretive to the portfolio.

A notable positive contributor is MonotaRO, a Japanese industrial B2B e-commerce supplier of materials to factories, construction, and auto-maintenance related customers. MonotaRO stocks over 23 million items, over half a million of which are available for same day shipment. This convenience combined with their pricing strategy provides tremendous value to customers and as a result MonotaRO is rapidly gaining share within an industry plagued by poor price transparency and legacy distribution models. We believe MonotaRO is in the early innings of a decades long growth journey which can be extended through their expansion into new markets as demonstrated by their partnerships with IndiaMART InterMESH Ltd in India. MonotaRO announced a 19% increase in the dividend per share.

The portfolio is exceptionally well placed to continue to deliver a dividend growth premium to the benchmark of MSCI ACWI Small Cap. Consolidating our bottom-up estimates of the sustainable growth rate of dividends as well as top-down approach of multiplying the return on equity by the retention rate (the proportion of profits reinvested) suggests 13% p.a. for our portfolio. Using the same top-down method for the benchmark suggests 5% p.a. It is on this premium that we have attached our hopes for long term outperformance.

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Performance

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The strength in underlying fundamentals has gone unrewarded on an absolute and relative basis through the reporting period. The Heriot Global Smaller Companies Fund returned 3.06% relative to a benchmark return of 15.6% as measured by the MSCI ACWI Small Cap Index. We operate at the intersection of four disciplines; growth, quality, dividends, and valuation while the market does not. For example, U.S. small caps account for roughly half the index and over the reporting period MSCI U.S. small cap growth returned 17.5% and MSCI U.S. small cap value returned 15.9% in GBP. On 31 May 2024, U.S. small cap growth traded on 56.7x price to earnings with a dividend yield of 0.48%. Due to our disciplines, we underweight this part of the market with a 22.5% allocation. It has thus far been wrong to do so.

A few companies have made notable positive contributions. Disco Corp returned 161.6% in GBP, contributing 1.25%. Disco has a 70% market share of the discing and grinding machine tools market for semiconductor applications. The recovery in memory markets, as well as anticipated demand growth due to AI’s High Bandwidth Memory requirements, has supported the share price. New portfolio addition Biotage returned 38.1%, contributing 0.94%, more on that later. Finally, we added to our position in GB Group which returned 18.3% and contributed 0.74%. This addition was underwritten by our work on peers and near peers like MediTek, Experian, Equifax and Transunion that suggests we are nearing a fundamental reacceleration in the business.

On the notable negative contributors, Paradox Interactive stands out falling 42.8% in GBP contributing -1.18%. This video game publisher and developer focuses on complex strategy games for the PC market. Their niche games have fiercely loyal fans and when launched generate annuity like revenue streams for years. The highly anticipated sequel to Cities: Skylines had a difficult launch and one of their new games ‘The Lamplighters League’ underperformed sufficiently to require a write down and a parting of ways with the partner studio. These are concerning developments for a company whose core competency should be the successful development and launch of these titles. While we are heartened that management elected to increase the dividend by 50%, we continue to monitor Paradox Interactive closely and note the valuation has fallen to its lowest level of just 11x price to cash flow. An improvement in growth and execution is essential.

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Portfolio changes

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As long-term, buy and hold investors, who seek to allocate capital for holding periods measured in decades, the level of portfolio activity has been high. The source of this portfolio turnover has been threefold. The first, is the meaningful number of our businesses that have been acquired or that are under offer. The second, is that a few of our management teams have been determined to snatch defeat from the jaws of victory through high risk, strategic M&A. We are determined not to be casualties of this misadventure. Finally, a theme linked to the first, we have found many excellent businesses are now attractively valued.

Four of our portfolio businesses were acquired for a simple average premium of 50% to the pre-offer price. These were National Instruments, Dechra Pharmaceuticals, ABCAM and Spirent Communications. In three of these deals, excluding Dechra Pharmaceuticals, the acquirers are high quality corporate capital allocators such as Emerson Electric and Danaher. We find this heartening as a confirmatory sign that, as the prior owners, we are on the right track. At the time of writing a further two companies are under offer. Keywords Studios and Alpha Financial Markets Consulting. While the current offer price for the latter has yet to be disclosed, the current offer price for Keywords represented a 75% premium to the pre-offer price. If these deals close, it will mark the seventh portfolio business to be acquired, six of which have been listed in the UK. Why is this happening? As either owners or prior owners we are biased. We believe they have a plethora of attractive qualities such as the ability to sustain relatively high returns on capital, while reinvesting profits to capture the structural growth of their end markets. At least two further reasons come to mind. The British pound averaged just US$1.25, one of the lowest exchange rates against the dollar, in a non-crisis period over the last forty years. Priced in U.S. dollar, UK PLC could be considered “on sale”. And third, growing assets under management of private equity, with significant unspent capital has put many small and medium sized businesses in play. While we do not invest to sell a business, we would rather more potential buyers than fewer as it bodes well for valuations, which we see as increasingly well supported across our portfolio.

Our highly cash generative portfolio businesses do M&A as a course of business. Small deals to acquire technology, customers or entry into adjacent markets can be considered lower risk and when financed with internally generated funds can turbo-charge the compounding engine. Large deals that represent a significant proportion of market cap, require external financing through share issuance or leverage, and will preoccupy management for years to come have, in our experience, a poor record of sustainable shareholder value creation. To this end we divested from GN Store Nord, Globus Medical, Tenable and John Bean Technologies.

Consider John Bean Technologies which is a U.S. industrial automation company focused on the food produce industry. Their equipment is essential to efficiently feeding the planet, ensuring productivity and profitability of their customers while their large installed base provides a lucrative stream of maintenance revenue. Their target is Marel, an Icelandic near peer that received a 38% interest in the consolidated entity and €950m in cash. Marel has generated negligible organic growth over the last five years and has suffered a decline in profitability. Marel’s share price peaked in September 2021 at €6.44, before falling to a low of €2.16 in November 2023. While management make a compelling case, we believe their commitment to maintain facilities, employment and stock listing in Iceland will make it extremely difficult to extract cost synergies, not least because Marel accounted for 20% of MSCI Iceland as of 31 May 2024. While turnarounds are intellectually gratifying, they are frequently emotionally exhausting due to the wide range of potential outcomes, many of which are negative. As such we chose not to invest in them and would ask that our management teams do the same.  

Capital raised from the takeover targets and sales has been successfully redeployed to portfolio accretive companies. For the sales, the three-year average revenue growth, EBITDA margin, and Return on Equity was 6% p.a., 18%, and 17% respectively. For the buys, the three-year average revenue growth, EBITDA margin, and Return on Equity is 14% p.a., 35% and 24% respectively.

Biotage is a new addition to our portfolio that demonstrates our process in action. Biotage is a Swedish health care technology business focused on the essential separations part of their customer workflow. Their customers are generally contract manufacturers, biotechs, pharmaceuticals and laboratories operating in highly regulated industries. 72% of their revenue is recurring through consumables and services, they are very profitable with a three-year average gross margin of 56% and EBITDA margin of 26%. Growth has been driven by their merger with Astrea Bioseparations which should accelerate the organic growth profile as well as the continual rise in global health care and related R&D spending. These factors have supported a 10-year dividend growth rate in excess of 12% p.a. We reviewed Biotage in September 2021, deeming it too expensive on 57x Price to Cash Flow and set a price trigger to review the company if the valuation became more attractive. A combination of higher interest rates, and a short-term decline in growth due to the waning of the pandemic saw the valuation fall. We were able to make our investment on 25x Price to Cash Flow, 56% lower than two years prior. This attractive entry point, a dividend yield of 1.5% and our estimate of sustainable dividend growth of 14% p.a. provides an excellent basis for double digit total returns. Process, planning and opportunity can be a powerful combination.

As noted earlier, many high-quality UK companies have indiscriminately de-rated, offering compelling opportunities for patient capital. In this context we would highlight another new addition in Rightmove, the UK real estate platform. The business has incredible network power with 78% of UK estate agents using the platform and an 85% market share of consumer activity as measured by website visits. It is an essential tool for estate agents for selling property and increasingly for those in the letting market. Rightmove is raising switching costs through the launch of additional functionality targeting agent’s workflows as well as monetising their platform through their fastest launch programme of paid advertising products. The quality, and innovation appears unrewarded with the shares trading on 21x prospective profits, down from a peak of over 35x in 2020. With a dividend yield of 1.8%, a total distribution yield nearing 5% including share repurchases, combined with our estimate of sustainable dividend growth around 11% p.a., Rightmove appears highly attractive. To underline the point, we were able to make investments in a further four UK companies due to a similar trend in multiple compression and robust fundamentals. These are AJ Bell, Auto Trader Group, Halma, and Spirax Group.

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Sustainability update & summary

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In 2023, the Financial Conduct Authority (FCA) issued new standards governing the use of sustainability vocabulary in the promotion and description of fund and asset management services. Funds may adopt one of four FCA labels describing their approach, or they may opt not to have a label. Dundas has decided for the present to operate without a label for the Heriot Global Smaller Companies Fund.

Dundas makes investment decisions in large part based upon audited annual reports which in recent years have expanded to address wider sustainability matters. Disclosure on CO₂ emissions and sustainability has improved but remains incomplete, inconsistent, and heavily reliant on estimation. In response, new IFRS Sustainability accounting standards were issued in 2023 effective 1 January 2024. Dundas welcomes the new standards. They are thorough, stringent and, when fully adopted, will raise and level the playing field for corporate sustainability reporting. Dundas is already engaged with the companies in which it invests about the new standards. We will re-evaluate the appropriateness of adopting a label once our analysis of improved sustainability reporting is complete.  

The modest return during the reporting period combined with strong fundamentals, as measured by dividend growth, means we have seen valuations continue to fall. This has been noted by acquirers who purchased four of our portfolio businesses for an average premium of 50%. These data points combined with our ongoing portfolio monitoring processes, and our contemporary mosaic view of the world indicates the portfolio is well positioned. It is our conviction in the long term where dividends grow, share prices follow, that patient shareholders will be rewarded, and as co-investors we remain aligned.

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