It is understandable that the current economic bad weather should cast a long shadow over smaller companies and corporate bonds. Worst-case assumptions have left the sectors unloved. But I do not buy into the double-dip scenario. Therefore, even though both my portfolios have benefited from being overweight to smaller companies and corporate bonds relative to the benchmarks, now is a good moment to further increase that exposure, rather than reducing it.
The economic and political dimension
I have long suggested that economic growth in western economies will flatline for some years to come. No one is underestimating the challenge for policymakers. All previous recessions have been destocking recessions, when the problem was a shortage of demand. The answer was a good old-fashioned dose of Keynesian stimulus - if necessary using borrowed money.
By contrast, this is a deleveraging recession caused by excessive debt. Such recessions are not solved by adding more debt. Instead, governments and consumers need to pay down their overdrafts. Governments will help by adding to inflation, by printing money and keeping interest rates artificially low at both the short and long end of the yield curve. Post-war governments undertook a similar policy with some success. This will be regardless of the pain inflicted on savers.
But this will all take time - years, in fact. Furthermore, as politicians in recent months have shown, governments have other reasons to ensure economies do not slip back into recession. Recession would probably end some key political careers on both sides of the pond, while in Europe would probably fracture - if not end - the euro and with it the dream of political union. All this points to years of economic flatlining.
The challenge is to achieve the right balance between the deflationary forces of deleveraging and the use of the various stimuli packages at policymakers' disposal, so that inflation doesn't get out of control. The perception is that the chances of achieving this are no better than 50-50. Accordingly, sentiment and markets will oscillate between risk-on and risk-off trades, with volatility and perhaps investor disillusionment the consequence. This will present opportunities for investors, as smaller company trust discounts and expected corporate bond default rates illustrate.
| Growth | Income | |
|---|---|---|
| Portfolio Total Return [%] | 65.1 | 56.8 |
| APCIMS Total Return [%] | 40.6 | 36.1 |
| Relative Performance [%] | 24.5 | 20.7 |
Returns are Jan 2009-February 2012, benchmarks are Apcims growth and income model portfolios
The investment dimension
The long-term case for smaller companies is well established. If you'd invested £1,000 in 1955 in the Hoare Govett Smaller Companies index (which measures the bottom 10 per cent of stocks by their market value) you would have enjoyed a total return of £3.25m, against £620,000 for the same investment in the FTSE All-Share. The problem for investors is the volatility that comes with it; sector can dramatically underperform in bad economic years. In 2008, for example, the FTSE Small Cap index fell 43.9 per cent. Such volatility harms sentiment. Getting the economic big picture right is therefore important.
But, in a way, this is only part of the story. Today, smaller companies are far more international in their outlook than they used to be. Technology and globalisation has meant they have greatly extended their reach beyond their own borders to gain access to the growing markets of the world. Add in their sheer number and the fact that the sector generally is under-researched, and one can understand why the right trust managers are producing great returns. Such performance will be rewarded with narrower discounts over time, particularly as fear of a double-dip recession recedes.
I have therefore added to both portfolios' existing holding in BlackRock Smaller Companies trust (BRSC). Run by the well-respected Mike Prentis, it has a superb track record over both the short and long term. It is conservatively run and seeks good-quality companies with high barriers to entry and exposure to growing markets overseas. Yet BRSC stands on an 18 per cent discount.
This has been paid for by top-slicing Worldwide Healthcare trust (WWH) and the Leveraged Gold ETF (LBUL) in both portfolios and the Jupiter European Opportunities trust (JEO) in the growth portfolio, after strong relative runs since the beginning of the year. I remain positive on all three holdings, but it seldom harms taking a profit.
Likewise, I have increased both portfolios' smaller company exposure in Japan by moving out of the Baillie Gifford Japan trust (BGFD) and into the Baillie Gifford Shin Nippon trust (BGS). Similar discounts but a superior medium-term performance and better prospects justify the trade.
Finally, within the income portfolio, I have sold the iShares index-linked gilt ETF (INXG) and taken a small profit. In the short term, the main concern will be deflation. Although both portfolios have benefited from being overweight corporate bonds relative to benchmarks, I have used the proceeds to add to existing holdings of both corporate bond ETFs (ISXF and SLXX) and City Merchants High Yield trust (CHY). I have also added to the growth portfolio's holding of ISXF.
Despite a good start to the year, corporate bonds continue to look attractive relative to gilts. The market is factoring in an overly bearish default rate - unlikely if economies flatline. Again, such is our opportunity.
■ John Baron waives his fee for this item in lieu of donations by FT Group to charities of his choice. As these are live portfolios, he holds interests in all the securities mentioned.
