Framlington investors must decide

A choice faces shareholders of Framlington Innovative Growth this week as the board pursues a proposal for the trust to be restructured as a small-cap equity income vehicle for its manager.

Shareholders of Framlington Innovative Growth face an interesting choice this week, as they decide the future of the £90m investment trust.

Investors who choose to accept the board’s tender offer – which ends on Friday – and leave the trust will incur a 5% exit charge. Those who elect to stay can vote on a proposed restructuring. If the restructuring is approved, the trust will be converted into a small-cap equity income vehicle for its manager, George Luckraft.

The trust, which was run by Brian Watson from its launch in 1992 until the end of 2009, invests mostly in stocks with market capitalisations lower than that of the median company in the FTSE Small Cap (ex-investment companies) index. According to a circular published this month, the strategy has proved successful over the long term, enabling the trust to outperform the index in 14 of the past 17 years. (article continues below)

However, 2009 in particular proved tough going for Watson, Luckraft says, as a rebalancing of the index in the second quarter worked against the trust. “A lot of fallen angels with high debt – like Johnston Press, Yell, Punch Taverns – fell into the index just for one quarter,” says Luckraft. “These all came in at the top [of the index] so were outside mandate, but [they were] exceptionally high-risk/high-reward.”

As fears of a global depression receded after March 2009 and risk appetite returned, investors rapidly drove the prices of these relatively cheap, poorer-quality stocks higher in a so-called “dash for trash”. As a result, highly indebted companies accounted for over half of the Small Cap index’s 18% rise last April, says Luckraft – boosting the benchmark but hurting the fund’s performance in relative terms.

Because of this, the trust seemed doomed to miss its ­performance target as it approached its three-yearly review this June – a failure that would have triggered a continuation vote. Under Luckraft’s management, however, the trust staged a sharp recovery in the first six months of 2010, moving from eight percentage points behind the benchmark in February to about two percentage points ahead in June.

Dan Harlow, the former manager of Montanaro UK Smaller Companies, joined Axa Investment Managers in February and works alongside Luckraft. He says modelling has shown that a yield of 4.7% is achievable. “We’re not compromising on balance sheet strength in that process,” Harlow adds. “There is a lot of income around in small cap names. It remains an underinvested and relatively neglected corner of the market.”

With the trust’s discount at 15% last week, the yield would be above 5%, Luckraft says – a figure likely to appeal to investors in the low interest rate environment. Stephen Peters, an analyst who specialises in investment trusts at Charles Stanley, says 5% compares favourably with other yield-targeting small-cap trusts such as Dunedin Smaller Companies (4%) and Aberforth Smaller Companies (3.5%).

Peters praises Axa’s recruitment of Harlow, whom he invested with via the Montanaro trust. However, he says it is unlikely he would buy into a restructured Framlington fund, because of its small size. “[Small cap trusts] can be a bit like Hotel California – you can get in but you can’t get out,” Peters says. “Aberforth Smaller Companies has a £500m market cap but people still have problems buying and selling that trust.”

Luckraft, meanwhile, says the restructuring proposals have so far met a positive response from potential and current investors.

“Some investors who are already holders have indicated that, because of [the proposals], they will probably tender less than they were going to,” he says.

Whether or not investors stick to their word will soon become apparent – the trust is due to report on the tender offer next week.