Montanaro UK Smaller Companies Investment Trust Plc

(Incorporated in England and Wales)

Company Number: 03004101                                                                                                                                 

ISIN: GB00BZ1H9L86       

LEI: 213800UDDXXTXIF29P85

('Montanaro UK Smaller Companies Investment Trust', or the 'Company')

20 June 2023

Montanaro Uk Smaller Companies Investment trust PLC

2023 ANNUAL RESULTS ANNOUNCEMENT

and

notice of annual general meeting

Montanaro UK Smaller Companies Investment Trust PLC announces its annual results for the year ended 31 March 2023 and the publication of its annual report and accounts for the same period, which includes the notice of its 2023 annual general meeting.

HIGHLIGHTS

For the year ended 31 March 2023

Performance

Sources:

* AIC

** NSCI

*** Composite sourced from NSCI and Bloomberg.

† Montanaro Asset Management

1 Details provided in Alternative Performance Measures on page 65.

All returns are shown with dividends reinvested.

The Benchmark is a composite index with the NSCI used since 1 April 2013.

1 Details provided in Alternative Performance Measures on page 65.

2 Details provided in the glossary on page 67.

CHAIRMAN'S STATEMENT

I am pleased to present the twenty-eighth annual report of MUSCIT for the year ended 31 March 2023.

Results

In the year to 31 March 2023, the total return on the Net Asset Value ("NAV") and share price of MUSCIT was minus 12%. In comparison, the Numis Smaller Companies (excluding investment companies) Index was minus 7.9%. Please refer to the Performance Review section of the Manager's Report on page 6 for further details.

Since inception in 1995, the Company has delivered a cumulative NAV total return of 801% and a cumulative share price total return of 836%, significantl  outperforming the composite benchmark which delivered a cumulative return of 501%.

Dividends

The Company's investment objective has always been to generate capital growth. This remains unchanged. A new dividend policy was introduced in July 2018. Dividends are now paid each quarter equivalent to 1% of the Company's NAV on the last business day of the preceding financial quarter, being the end of March, June, September and December.

During the Financial Year, the Company declared four quarterly dividends amounting to a total of 4.5p, equivalent to 3.8% of the share price at the start of the year and 4.5% of the share price at the end of the period. MUSCIT remains one of the highest yielding UK SmallCap investment trusts. The Company holds substantial reserves which are available for distribution in future.

Discount

Over the last financial year, the discount of MUSCIT's share price to NAV, as shown in the graph on page 3, widened slightly, from 7.8% to 8.3%. The Board and the Manager have worked hard to make MUSCIT attractive to private clients, including implementing a five-for-one share split in 2018; the new dividend policy; reducing costs and an increased focus on marketing. These initiatives continue to bear fruit as more and more retail investors appear on the share register. Hopefully this will help to reduce discount volatility in the shares of MUSCIT.

Share Buy Backs

The Board is responsible for the implementation of share buy-backs which are undertaken at arms' length from the Manager. No shares were bought back during the Financial Year.

Board

The Board consists exclusively of independent Non-Executive Directors with a good balance of skills, experience, diversity and knowledge of the Company and its business.

There were no changes to the Board during the Financial Year. James Robinson, a Director for nine years, has indicated that he intends to retire at the Company's forthcoming AGM. James will hand over the chair of the Audit Committee to Barbara Powley and the Board will look to appoint a new director later this year. On behalf of the Board, I would like to thank James for his significant contribution to the Company during his tenure. He will be missed.

Administrator and Company Secretary

The Company has appointed, with effect from 1 July 2023, Juniper Partners Limited as Company Secretary and Administrator, in place of Link Company Matters Limited and Link Alternative Fund Administrators Limited respectively. On behalf of the Board and the Manager, I would like to thank the entire team at Link for their service and commitment to our Trust over almost three decades.

ESG

The Board and Montanaro believe there is a strong correlation between how well a business fares on Environmental, Social and Corporate Governance grounds and the value it creates for its shareholders. This is why ESG considerations form an integral part of the Manager's assessment of a company's "Quality" and have been fully integrated into the investment process for many years.

The depth of Montanaro's commitment is perhaps best exemplified by the fact that they are one of the few UK asset managers to be a certified B Corporation - a certification Montanaro has held since 2019. Certified B Corporations are businesses that meet the highest standards of verified social and environmental performance, public transparency and legal accountability to balance profit and purpose.

An expanded report on ESG is provided in the Manager's Report on pages 5 to 6.

AGM

The Annual General Meeting will be held on 27 July 2023 at 12 noon at the office of Montanaro Asset Management, 53 Threadneedle Street, London EC2R 8AR. Shareholders are warmly invited to attend the Meeting where there will be an opportunity to meet and ask questions of the Board and the Manager.

Continuation Vote

At the AGM held on 12 August 2021, over 99% of shareholders voted in favour of the continuation of MUSCIT for a further five years. Unless brought forward, the next Continuation Vote will be held in 2027.

Outlook

As we move forward into the post-COVID era, there are two major factors that continue to influence and shape financial markets: the aftershocks of the pandemic and rising interest rates. Both these factors have significant implications for investors.

In addition to a global economic recession and unprecedented government interventions, the pandemic also brought about profound shifts in consumer behaviour, some permanent. These include, for example, the democratisation of remote working; a substantial increase in e-commerce and contactless payments; the growing demand for digital entertainment and streaming services; a renewed focus on wellness, health and leisure; and a desire by companies to make their supply chains more resilient. In turn, these trends are resulting in new demand for an array of products and services ranging from cyber-security and digital payments to healthcare products.

The second factor that investors are having to wrestle with is rising interest rates. Fearing that inflation could get out of hand, the Bank of England has raised interest rates by more than 4% since December 2021 in its fastest rate-hiking cycle in three decades. This is already having an impact on consumer spending and residential property markets across the UK. Companies with fragile balance sheets and high amounts of debt may struggle to renew their loans on reasonable terms. Some will simply not survive this new reality.

Stock pickers such as Montanaro are well placed to capitalise on this new reality. Their large team of analysts can help to navigate the risks and opportunities arising from new consumer behaviours. Meanwhile, their focus on quality businesses with sound balance sheets is reassuring. The past three years have been dominated by a significant outperformance of Value stocks, but a renewed focus on corporate balance sheets could put an end to this. The Board believes that the Manager is well placed to make the most of this new environment and looks to the future with confidence.

ARTHUR COPPLE

Chairman

19 June 2023

Manager's Report

The Attractions of Quoted UK Smaller Companies ('SmallCap')

The key attraction of investing in quoted smaller companies is their long-term record of delivering higher returns to investors than large companies. In the UK, over the last 68 years, this has amounted to an average of 3.1% per annum (the "SmallCap Effect"). £1 invested in UK large companies in 1955 would now be worth £1,255 whereas the same £1 invested in UK smaller companies would now be worth £8,326 - almost seven times more (see chart below).

The market for UK smaller companies is inefficient. While some large companies are analysed by more than 50 brokers, many smaller companies have little or no such coverage. Some have none at all. We believe that this makes it easier for those with a high level of internal resources to identify attractive, undervalued and overlooked investment opportunities. This in turn makes it possible to deliver long-term performance over and above that of the benchmark.

Montanaro

Montanaro was established in 1991 and we celebrated our 30th Anniversary last year. We have one of the largest and most experienced specialist teams in the UK dedicated exclusively to researching and investing in quoted smaller companies. Our team of thirty-eight includes ten nationalities, which gives us the breadth of resources and scope to conduct thorough in-house research.

At 31 March 2023, we were looking after around £4 billion of assets.

Investment Philosophy and Approach

We specialise in researching and investing in quoted smaller companies.

We have a disciplined, two-stage investment process. Firstly, we identify "good businesses" within our investable universe. In the second stage, we determine the intrinsic value of each company to ensure they will make a "good investment" (the two are not always the same).

When we consider that we have identified a good company, it must pass our stringent Quality and ESG Checklists and be approved by our Investment Committee before it can be added to our "Approved List". ESG has been integrated in our disciplined investment process for almost two decades. Only the most attractive companies make it on to the Approved List and it is from these that we construct your Portfolio.

We have an in-house team of fourteen Analysts who are sector specialists. This is one of the largest such specialist teams in the country. Utilising their industry knowledge and a range of proprietary screens, they are continually searching for new ideas. With around 1,800 companies quoted in the UK to choose from, we are spoiled for choice.

We look for high quality companies in markets that are growing. They must profitable; have good and experienced management; deliver sustainably high returns on capital employed; enjoy high and ideally growing profit margins reflecting pricing power and a strong market position; and provide goods services that are in demand and likely remain so. We prefer focused companies that can deliver self-funded organic growth and remain focused on their areas of expertise, rather than businesses that spend a lot of time on acquisitions.

Conversely, we avoid those with stretched balance sheets; poor free cash flow generation; incomprehensible or heavily adjusted accounts; unproven or unreliable management; or that face structurally challenged business models with stiff competition.

We believe that a deep understanding of a company's business model and the way it is managed are essential. In normal circumstances, we visit our investee companies on a regular basis, although this was not possible during pandemic. Thankfully, these visits have now resumed and the team is busy.

Management's past track record is examined in detail as we seek to understand their goals and aspirations. In smaller companies, the decisions of the entrepreneurial management can make or break a company (which is why meeting them is so important). We look closely at the board structure; the level of insider ownership; and carefully examine remuneration and corporate governance policies.

Once a company has been added to the Portfolio, our Analysts conduct ongoing reviews. We will sell a holding if we believe that the company's underlying quality is deteriorating or if there has been a fundamental change to the investment case or management. We will get some things wrong and make mistakes, but we try to learn from them.

In summary, we invest in well managed, focused, high quality, growing companies bought at sensible valuations. We are happy to pay more for a higher quality, more predictable company that can be valued with greater certainty. Finally, we align ourselves with our investors by investing meaningful amounts of our own money alongside yours. We are significant shareholders in MUSCIT.

Environmental, Social and Governance ("ESG")

Montanaro became a certified B Corporation in 2019, placing sustainability at its core. This was achieved by meeting verified standards of social and environmental performance, transparency and accountability. It is regarded as one of the toughest sustainability standards to achieve globally. Montanaro recertified for "B Corp" status in 2022 and achieved a score of 105.5, well above the 81.8 originally achieved in 2019 and an achievement of which we are proud.

In 2021, Montanaro was the only UK investment boutique to be invited to join the Glasgow Financial Alliance for Net Zero ("GFANZ") taskforce, chaired by former Bank of England Governor, Mark Carney. In March 2022, Montanaro won the Best Small & Mid-Cap Sustainable Investment Boutique award from Ethical Finance. This recognised Montanaro's continuing commitment to sustainable investing within its own business, across the investment industry and in our investment process.

Montanaro continued to achieve industry leading standards over the last year. In particular, we recently announced our commitment to becoming carbon negative and removing 100% of our historical emissions by 2030. In March 2023, we entered into a partnership with Klimate, a Danish carbon removal specialist. Together, we are building an innovative portfolio of carbon removal projects to achieve our targets. This will include projects such as direct air capture; deep storage bio-oil; ocean kelp; and restorative tree-planting. All will be verified independently to ensure their integrity. We believe that we are the first asset manager in the world to have publicly stated such ambitious goals.

These industry standards and our participation in collaborative initiatives allow us to stay abreast of an area of the investment world that is rapidly changing and ensure that our investment process evolves accordingly. We aim to be pioneers and to lead by example.

Montanaro has a long track record of sustainable investing, which has always been represented in the way the Portfolio has been managed. Ethical restrictions mean that we do not invest in companies that generate a significant proportion of sales from products with negative  societal impact such as tobacco, gambling, armaments, alcohol, highinterest- rate lending and fossil fuels. Similarly, we do not invest in companies that conduct animal testing, unless it is required by law for healthcare or regulatory purposes.

The analysis of ESG factors has long formed part of our definition of a company's "Quality". The analysis of such information allows us to better understand the risks - and opportunities - that our companies may be exposed to.

An important research and engagement project conducted during the year focussed on biodiversity. The purpose of this Deep Dive Report was to gain a greater understanding of how companies are coping with the biodiversity crisis. One of the companies we were able to talk to about their ecological footprint and how they measure their impact on nature was M.P. Evans, a company that owns, manages and develops sustainable palm oil estates in Indonesia.  We spoke to the CEO about the company's approach to sustainability and nature preservation to find out more about the importance of biodiversity to the business and how they plan to protect it whilst managing their plantations in Indonesia.

We have engaged with several companies to discuss good governance practices. The Chairman of the Diploma Remuneration committee contacted us regarding proposals for their new Remuneration Policy. The company wished to increase executive salaries and the limits on variable pay. We discussed how pay had been considered in the context of the wider workforce. We were pleased with the increased focus on Earnings Per Share ("EPS") over Total Shareholder Returns ("TSR") as an indicator and expressed our preference for simple pay structures. We also heard about some of the ESG work being undertaken as part of the company's 'Delivering Value Responsibly' campaign. As a result, we opted to support management at the AGM and voted in favour of their proposals.

We continue to participate in collaborative engagements. We joined the Farm Animal Investment Risk and Return ("FAIRR") initiative engagement with Cranswick to discuss labour rights. Through discussion with the CFO, we established that the majority of its workforce is directly employed and labour metrics are reported to the Board on a monthly basis, with followup reports on actions taken to mitigate problems. We will continue to monitor labour practices at the company but are satisfied with the policies, approach and transparency.

We also joined FAIRR as part of an $18 trillion investor coalition urging The Food and Agricultural Organization of the United Nations (the "FAO") to set a roadmap to 1.5°C for the global food sector. A letter was presented to the FAO ahead of a council meeting in June 2022. In response, in November 2022 at COP27, FAO Deputy Director, Zitouni Ould-Dada, confirmed work is underway to produce a roadmap for the Agriculture, Forestry and Other Land Use (AFOLU) sector to align with 1.5°C by 2050 and they are aiming for publication by COP28.

We are pleased that MUSCIT was awarded a 'AA' rating - the second best rating out of a possible seven - for its ESG credentials by MSCI.

With almost every asset manager dedicating more time and resource to ESG and sustainability, we believe that we remain ahead of the curve. This is due to our experience; the high level of in-house resources that we have at our disposal; and our belief that embedding ESG factors into an investment process leads to better investment outcomes. We look forward to sharing further developments with you in the coming years.

How to invest

We have dedicated a great deal of time to make MUSCIT readily available to all investors. We have continued to grow our presence across the UK's investment platforms and are delighted to see a steady increase, year after year, in MUSCIT's retail following.

Together with the Board, we have appointed Marten & Co to provide sponsored research. The latest report published in July 2022 is available here: https://montanaro.co.uk/montanaro-uk-smaller-companies-selloff-provides-opportunities/.

For further details about how to invest, please refer to the website: https://montanaro.co.uk/trust/montanaro-uk-smaller-companies-investment-trust/

The Portfolio

At 31 March 2023, the Portfolio consisted of 40, high conviction investments of which the top ten holdings represented 42%. MUSCIT held 14 companies traded on AIM, representing 30% of the Portfolio by value.

Sector distribution within the Portfolio is driven by stock selection. Although weightings relative to the market are monitored, overweight and underweight positions are held based on where the greatest value and upside are perceived to be. 

Gearing

The Alternative Investment Fund Manager ("AIFM"), in consultation with the Board, is responsible for determining the net gearing level of the Company. At 31 March 2023, gearing stood at 4.8%.

Performance Review

The total return on NAV was minus 12% over the period, the benchmark total return was minus 7.9%. As the discount only slightly widened compared to a year ago, the share price also declined by 12%. The negative performance of UK SmallCap as an asset class can be attributed to the combined effect of rising interest rates coupled with investor concerns over a possible recession in the UK. According to the Investment Association, investors redeemed a record £1.3 billion from open-ended UK SmallCap funds in the 12 months to 31 March 2023. In addition to this, MUSCIT suffered from its exclusive focus on Quality and Growth companies, which as a whole underperformed, as detailed in the Review & Outlook section. In other words, the underperformance cannot be explained by a small number of large detractors. Pleasingly,MUSCIT posted the second strongest NAV and share price return of the peer group of eight investment trusts.

Since its launch in March 1995, MUSCIT has delivered an annualised NAV total return of 8.2%, which represents an outperformance of 1.6% p.a. compared to the benchmark.

Performance Attribution

The largest positive contributors over the period were:

4imprint, the supplier of promotional merchandise, saw its share price rise by more than 70% during the year as it benefited from a reopening of the US economy after the pandemic.

AIM-traded Ideagen, which develops compliance and risk software, received a bid from private equity firm Hg Pooled Management at 350p, valuing the business at £1.1 billion. The shares climbed by 46% on the day of the announcement. We were sorry to say farewell to a management team we like and admire.

Games Workshop, the designer of the hobby miniature creature behind Warhammer, reported strong earnings and announced a possible collaboration with Amazon to produce a movie.

There will always be some investments that do not go as expected. The largest negative contributors over the period were:

Marshalls, the UK's leading hard landscaping manufacturer, fell on concerns about the outlook for the residential property market following a rapid increase in mortgage rates.  The company has reduced its profit guidance three times since August 2022. Nonetheless, we regard the management team highly.

Treatt, the specialist in citrus oils and flavourings, declined as it suffered from the impact of lower US consumer demand on its range of tea products (and iced tea in particular).

NCC Group, a leading cyber security consultant, issued a profit warning, largely as a result of its tech-heavy US customer base reducing its business activity in a weak macroeconomic environment.

Review & Outlook

The IMF is forecasting that interest rates will return to "rock bottom" due to chronic low growth in the developed world, linked to low productivity and ageing populations. Such forecasts are interesting insofar as they highlight just how unusual 2022 was. Interest rates soared as a result of the economic dislocation of COVID and the war in Ukraine, rather than underlying structural trends.

Unusually, the Quality and Growth styles significantly lagged the market last year. As Quality Growth, SmallCap investors, it will always be challenging when Quality, Growth and SmallCap all underperform - especially at such extreme levels. UK SmallCap posted its worst performance relative to LargeCap (21%) in 2022. It was MUSCIT's third worst year ever in terms of NAV performance, in a calendar year (see chart below):

However, it is unwise to become too down-hearted by one year. We have long argued that UK SmallCap is an attractive asset for long-term investors. It is important to give companies time to grow over time and different cycles. Taking a longer perspective, since January 1955, UK SmallCap has outperformed in 78% of the 70 ten-year rolling periods since then and in 99% of the 30-year rolling periods (see chart below):

As time ticks by, the impact of the black swan events described above appears to be fading. Global inflation has largely stabilised and investors are now pricing in the first interest rate cut as early as September 2023 in the US and March 2024 in the UK. The headwinds of the past 18 months might soon turn into tailwinds. However, we claim no expertise in forecasting macro-economic developments and waste little time in trying to do so.

Instead, we talk to our companies. We continue to be reassured by their performance. Many (not all) have posted good numbers in the latest reporting season, giving us the confidence that in our quest for good companies with outstanding management, we have identified those that are not only growing, but are doing so from a position of strength. History has shown us that it pays to invest in and back high quality companies with good pricing power, strong competitive positions in markets with high barriers to entry, robust balance sheets and highly motivated, entrepreneurial management with exemplary standards of corporate governance.

Although SmallCap remains out of favour as we write these lines, we cannot help but feel increasingly positive about what it holds in store for the coming years. At 31 March 2023, the Numis Smaller Companies (ex-IC) index was trading on 9.8x 12 months-forward earnings, 22% below its long-term average (see chart below):

To put things into perspective, since 2006 the index has only traded on a P/E of below 10x in 23 of the 198 months, i.e. 11% of the  time. Every single time this has happened, it was followed by a year where SmallCap outperformed significantly (averaging a remarkable 23%).

More importantly, as someone brought  up to recognise that you cannot eat relative performance, when UK SmallCap has fallen then the following three years have seen strong absolute returns. Last year saw the sixth worst year of absolute returns as the chart below shows (we will have to wait to add the figures for the next three years).

It is hard to recall such indifference to the asset class. As someone with more grey hair than most who has lived through seven Bear markets, it is hard not to be excited about investment opportunities especially for long-term investors. To borrow the words of Andrew Jones, the highly regarded Chief Executive of LondonMetric Property PLC: "when you invest in quality, time will help you to create wealth".

Since UK SmallCap appears to be cheap, you would expect take-over activity to pick up. Already there are signs that M&A activity is indeed rearing its head again (two of our holdings - Ideagen and Dechra - received bids in the past year).

As investors in Dechra since their float in January 2000, we consider the Chief Executive Ian Page to be one of the very best managers we have had the good fortune to meet. We hope that we do not have to part company. So, Private Equity seems to share our view that the pickings are as attractive as they have been for several years.

I am sorry, as a fellow shareholder, that MUSCIT has just suffered not only the worst three-year underperformance since launch in 1995 but also a decline in value. This is unprecedented. However, for those willing to close their ears to the noise and to ignore the doomsters at the Bank of England, opportunities abound.

CHARLES MONTANARO

19 June 2023

Top 20 Holdings

Twenty Largest Holdings as at 31 March 2023

1.        4imprint

a supplier of promotional merchandise.

2.        Games Workshop

the largest hobby miniatures company in the world and the owner of the Warhammer brand.

3.        Greggs

the bakery chain.

4.        Diploma

a supplier of specialized consumables in industrial seals, control systems and healthcare mainly in Europe and North America.

5.        Clarkson

a leading shipping brokerage business.

6.        discoverIE

a designer and manufacturer of components for electronic applications.

7.        Kainos

a software developer headquarterd in Belfast that specializes in digital transformation.

8.        Big Yellow

a real estate investment trust focused on self-storage market.

9.        Marshalls

the UK's leading provider of hard landscaping products.

10.     Tracsis

a provider of software and consulting services to UK rail and transportation markets.

11.     Ergomed

a global full-service contract research organisation (CRO) with a core focus on the US and EU.

12.     Watches of Switzerland

a British retailer of Swiss watches, with 16 stores in the United Kingdom.

13.     Porvair

a specialist in industrial filtration and environmental technology.

14.     Judges Scientific

a specialist in the acquisition and development of a portfolio of scientific instrument businesses. 

15.     Boku

a mobile payments company.

16.     Liontrust Asset Management

A specialist asset manager launched in 1995.

17.     Dechra Pharmaceuticals

an animal health specialist.

18.     Cranswick

the leading UK supplier of fresh pork meat products.

19.     Cerillion

a provider of billing, charging and customer management systems.

20.     Yougov

an Internet-based market research and data analytics company.

FURTHER INFORMATION

Montanaro UK Smaller Companies Investment Trust PLC's annual report and accounts for the year ended 31 March 2023 (which includes the notice of meeting for the Company's AGM) will be available today on https://montanaro.co.uk/trust/montanaro-uk-smaller-companies-investment-trust/

It has also been submitted in full unedited text to the Financial Conduct Authority's National Storage Mechanism and is available for inspection at data.fca.org.uk/#/nsm/nationalstoragemechanism in accordance with DTR 6.3.5(1A) of the Financial Conduct Authority's Disclosure Guidance and Transparency Rules.