The European Smaller Companies Trust (LSE:ESCT) beat its benchmark in the year to June and has moved to a higher distribution policy, with shares trading about 7% below net asset value in November.

The European Smaller Companies Trust (LSE:ESCT) ended its most recent financial year ahead of its benchmark, and manager Ollie Beckett has said that the sell-off in businesses perceived as being threatened by artificial intelligence opened up attractive opportunities.

In the year to 30 June, the net asset value total return was 16.8% and the share price total return 15.3%, against a benchmark return of 12.4%.

Net Assets rose sharply over the year, from £510.7m to £863.0m.

About the company

The European Smaller Companies Trust is a closed-ended Investment trust listed on the London Stock Exchange and part of the FTSE 250 index. Its mandate is to deliver Capital growth by investing in a diversified portfolio of smaller companies across continental Europe, with the United Kingdom excluded. The trust holds shares in businesses that are typically too small to attract wide attention from large institutions, which is where the manager believes mispriced opportunities are most likely to arise.

As an investment trust, it does not sell products or services of its own. Instead, it earns returns through the capital growth and dividends of the companies it owns, and shareholders participate through the trust's net asset value and the Market Price of its shares. The portfolio is built from the bottom up, so sector and country weightings are largely the outcome of individual stock decisions rather than top-down allocation. The trust can also use borrowing, which can magnify gains and losses.

The financial year to 30 June showed how that approach translated into numbers. Net asset value total return of 16.8% and share price total return of 15.3% both exceeded the benchmark return of 12.4%, while net assets climbed from £510.7m to £863.0m. The board has also changed its income approach, adopting a policy of distributing 5% of the previous year-end net asset value per share, after paying 8.43p a share for the latest year.

A larger income commitment

The income proposition has also changed. The trust (LSE:ESCT) paid 8.43p a share for the year to June and has adopted a policy of distributing 5% of the previous year-end net asset value per share, which equates to a prospective 12.64p for the year ending June 2027.

Policies of this kind have become increasingly common among investment trusts, reflecting boards' efforts to attract income-focused buyers and to narrow discounts, though they may require distributions from capital when natural income falls short.

Technology and financials led

Information technology was the largest contributor to returns, with Mr Beckett's portfolio benefiting from SUSS MicroTec, Smartoptics Group, PVA TePla and ams OSRAM. Financials also contributed, including Banco Comercial Português, Alpha Bank, CrediaBank, Optima, flatexDEGIRO and Van Lanschot Kempen.

Detractors were concentrated in the businesses that the market judged to be vulnerable to AI, including Karnov, IONOS, adesso and HBX. Jungheinrich also held back returns, and an underweight position in energy was a modest headwind.

Mr Beckett noted that the portfolio added to IONOS and MTG during the AI-related sell-off and that these purchases later produced significant gains. He also drew attention to Sweden, where valuations were, he said, very attractive for the first time in many years. New holdings included Asmodee, RaySearch Laboratories, XVIVO and Thule, several of which are Swedish companies.

Several holdings left the portfolio following takeovers or other corporate events, including Grupo Catalana Occidente, Dalata Hotel Group, Hellenic Exchanges and Dermapharm. Takeover activity of this kind has long been a feature of the European small-cap market and it can provide a useful route to realisations for specialist managers.

How a smaller companies trust makes its case

European smaller companies cover a very wide universe, spanning industrial suppliers, software firms, banks and specialist manufacturers across many countries and currencies. Many are family-influenced or founder-led and receive limited coverage, so prices can diverge from underlying Business performance for long stretches. A manager with local knowledge can attempt to exploit that gap, although the same illiquidity can make positions harder to build or exit.

Because the Asset Class tends to be more sensitive to economic conditions and to investor sentiment than larger company indices, returns can be volatile. The trust's structure helps in one respect: a closed-ended vehicle does not have to sell holdings to meet redemptions, so the manager can hold positions through periods when sentiment is weak. The trade-off is that the share price can move away from net asset value, producing a discount or premium.

What to watch next

The first point of interest is how the new distribution policy behaves over time. A payout linked to net asset value rises and falls with portfolio performance, and where natural income from holdings does not cover it, the shortfall is met from capital. That can support Demand for the shares, but it also means total return, rather than Yield alone, remains the more useful measure of progress.

The second is the discount. Shares trading about 7% below net asset value leave room for the board to use Buybacks or other measures if it wishes to narrow the gap. Investors may also follow how the portfolio responds to continued uncertainty about artificial intelligence, European growth and geopolitical risk, as well as the pace of takeover activity among smaller companies, which has repeatedly delivered realisations for the trust.

An uncertain backdrop

The manager said he continued to see opportunities across European smaller companies, despite concerns about the economy and the Middle East, and that valuations in parts of the market look attractive.

For the FTSE 250 constituent, the coming year will test whether the higher payout can sustain demand for its shares while stock selection continues to add value.