UK small-caps: 2017 wildcard or Brexit casualty?

"The received wisdom is that large-caps have the advantage because they tend to derive a large proportion of their revenues from overseas - over 70 per cent of FTSE 100 earnings are earned outside the UK - so they should benefit from those foreign earnings [due to the weaker pound]," explains Jason Hollands, managing director of Tilney Bestinvest. "There is also a very common expectation that the outlook for dividends in large-caps will climb 10 per cent next year because of the currency and a slightly better outlook for oil companies, so smaller companies have fallen off the radar."

But smaller companies funds could prove to be a wildcard next year as there is the possibility that the sector has been oversold. "The rotation into large-caps may have substantially played out as large-caps have become a consensus trade," says Mr Hollands. "It's also the case that the negativity around the UK economy has been overdone and small-cap valuations look appealing."

Furthermore, because smaller companies tend to be less well-researched than larger ones, it is often easier for active managers to come across hidden gems. "As an ignored part of the market which is under-brokered by analysts and barely touched by index funds, this is a fertile hunting ground for active managers," Mr Hollands explains. "Attractive areas in my view include small businesses that operate internationally but have much of their cost base in the UK. For example, Fevertree Drinks (FEVR) which produces tonic water, Abcam (ABC), which makes protein testing kits for life scientists, and defence technology company Ultra Electronics (ULE)."

Smaller companies have also demonstrated strong performance over the long term, with the IA UK Smaller Companies sector delivering returns of 109.7 per cent over the past 10 years against 68.1 per cent for the IA UK All Companies sector.

Darius McDermott, managing director of research company FundCalibre, says he understands why investors might be swayed by the argument that larger, more global companies represent a better bet than UK smaller companies. But this view does not take account of the range of companies in the small-cap space.

"With Brexit yet to happen and be felt, some think that smaller UK companies might struggle," says McDermott. "At an index level that's a fair argument, but at a stock level good active fund managers are thinking about these things all the time. They will be looking for companies that are strong, have a niche product or some overseas earnings, so will not be as affected by Brexit or a slowdown. Yes, there is some trouble ahead, but the breadth of choice in smaller companies and the growth they can achieve means they should very much continue to have a place in investors' portfolios."

Richard Bullas, manager of Franklin UK Smaller Companies Fund (GB00B7FFF708), argues that small-cap valuations look cheap, with UK smaller companies typically trading on a 15 to 20 per cent valuation discount to their larger peers.

"The valuation gap can be explained by a number of factors, the most obvious of which are the liquidity premium for larger companies and the greater domestic content in small-cap earnings at a time of heightened uncertainty regarding the UK economy," he says.

But he points out that UK growth is still expected to be between 1 and 1.5 per cent in 2017, so it will be a case of slow growth rather than no growth.

He adds: "One of the prime attractions of the small-cap asset class is the sheer breadth of opportunity from an investable universe of more than 1,000 stocks. Many of these will flourish whatever the macro backdrop. The asset class will, however, be much more interesting and potentially more profitable for investors if business leaders are still making decisions, buying and selling businesses, and moving forward with investment plans. This will only happen if confidence holds up."

Neil Hermon, manager of IC Top 100 Fund Henderson Smaller Companies Investment Trust (HSL), is focusing on finding companies able to produce self-generated growth irrespective of the wider economic backdrop. This trust is overweight in areas such as healthcare, through holdings such as ethical drug supply and speciality pharmaceuticals distributor Clinigen (CLIN), drug delivery device supplier Consort Medical (CSRT), and veterinary drugs firm Dechra (DPH). Mr Hermon has also been adding stocks he thinks have undervalued structural growth potential, such as litigation finance company Burford Capital (BUR), Smart Metering Systems (SMS) and Accesso Technology (LOQ), which provides technology to the theme park industry.

Peter Walls, manager of IC Top 100 Fund Unicorn Mastertrust (GB0031218018), takes a contrarian approach to managing his portfolio of investment trusts. He thinks the wide discounts to net asset value (NAV) at which many UK smaller companies investment trusts trade make them an interesting opportunity.

He says: "The rationale for those wider discounts is easy to explain - Brexit continues to weigh on sentiment. Discounts have widened quite appreciably over the past 12 months, in some cases reaching double-digit levels, so I think there's some value there for long-term investors."

The relatively cheap valuations of small-cap stocks may also herald a period of increased merger and acquisition (M&A) activity.

"It's probably time to look at some of the value-type trusts where M&A might be expected to have an impact on their portfolios," says Mr Walls. "Aberforth Smaller Companies Trust (ASL) had a holding called e2v technologies (E2V) which was bid for at a 48 per cent premium [by US conglomerate Teledyne Technologies (TDY:NYQ) on 12 December] so there may be more of that sort of activity taking place next year."

Brexit, volatility and liquidity risks

Investing in smaller companies is considered to be generally more risky than investing in larger, more established companies, as smaller companies tend to be less resilient to economic shocks. And the market for dealing in smaller companies is smaller than that for larger stocks, making them a lot less liquid to trade.

You should also expect higher volatility as well as the potential for above-average losses with smaller companies.

And there are a number of other risks at the current time for UK small-cap investors to be aware of, according to Mr Hermon. The UK economy may falter due to uncertainty over the triggering of Article 50 and negotiations on the UK's exit from the EU. And rising inflation could lead to a squeeze on consumers' disposable income, so Mr Hermon is particularly nervous about the outlook for the UK consumer in 2017 and underweight the travel, leisure and retail sectors.

Mr McDermott agrees that the uncertainty surrounding the UK economy could lead to a sustained period of small-cap underperformance.

"The risk is that Brexit might be the catalyst for a long period where small-cap funds are out of favour," he says. "As small-cap funds are also less liquid, you could see some underperformance because if for whatever reason a stock does get hit, you tend to see sharp movements in share prices because of the liquidity."

David Liddell, chief executive of online investment service IpsoFacto Investor, suggests caution when investing in UK smaller companies because the outlook has worsened since the vote to leave the EU.

"The big question is what is going to be the effect of Brexit and other things in the world economy on the UK economy? If you're going small-cap, by definition you're going more UK focused and arguably the risks are a lot higher than they were a year or so ago," he says. "You might say companies that are completely focused on the UK economy will do OK because they don't have the risk of exports to Europe being disrupted [by Brexit], but if the whole UK economy goes into recession then that's not going to help very much."

He recommends having less exposure to UK small-caps at the moment, but advocates choosing a larger investment trust if you do want to invest in small-caps, because larger-sized investment trusts will generally be better at maintaining liquidity.

He explains: "What is important is the liquidity in the trust and the spread on it. It obviously tends to be the case that larger trusts have a smaller spread and are more liquid."

Mr Hollands also thinks there is a case for choosing a closed-end fund when investing in small-caps, but he adds that ultimately investors should give most weight to a strong performance record.

"In any asset class or part of the market where you end up in positions that are quite illiquid from a trading perspective, there's an advantage in having a closed-end structure," he says. "If you get a half-year like we have had where we've seen lots of investment outflows, a manager running an open-ended fund is going to have to sell holdings in an unfavourable market just to return cash to unit holders. That can be quite disruptive and it may mean that the more liquid names they hold are the ones they have to sell, because those are the ones that they can liquidate in a tidy manner."

But unlike Mr Liddell, he argues that there are risks to choosing a small-cap fund that is too large.

"The reality is, if you're running a couple of billion pounds in UK smaller companies, for liquidity reasons you're not going to be able to look below a certain threshold," explains Mr Hollands. "Therefore it limits the scope of the business you're looking at and creates potential liquidity issues for your ability to deal in the fund. So we like funds that are not too large."

Smaller companies funds

Mr McDermott suggests Liontrust UK Smaller Companies Fund (GB00B8HWPP49), which is run by Anthony Cross and Julian Fosh, who also manage IC Top 100 Fund Liontrust Special Situations (GB00B57H4F11).

Liontrust UK Smaller Companies employs the same investment strategy as Liontrust Special Situations, but with a small-cap bias. Its managers look for companies with durable economic advantages, which include ownership of intellectual capital, distribution channels or repeat business revenues. They believe these intangible assets are difficult to replicate and give companies that possess them a competitive advantage, pricing power and sustained profitability. The companies the fund invests in must have a minimum 3 per cent of directors' equity ownership as Mr Cross and Mr Fosh believe this motivates a company's key employees to maintain its competitive edge. Liontrust UK Smaller Companies has an ongoing charge of 1.37 per cent.

Mr McDermott also favours Wood Street Microcap Investment Fund (GB00BV9FYS80), which focuses on companies with a market capitalisation of £250m or below. It has a concentrated portfolio of small and micro-cap companies listed on the Alternative Investment Market (Aim) as well as on the main market. It has an ongoing charge of 1.01 per cent.

Marlborough Special Situations (GB00B907GH23) aims for capital growth by following a speculative policy of investing in smaller companies, new issues and companies going through a difficult period with good recovery prospects. It has an ongoing charge of 0.80 per cent.

Mr Walls likes Henderson Smaller Companies Investment Trust, which as of 19 December was trading on a 14.7 per cent discount and has an ongoing charge of 0.44 per cent. The trust is one of three smaller companies investment trusts Mr Walls holds in his portfolio, alongside BlackRock Throgmorton Trust (THRG) and Strategic Equity Capital (SEC).

Despite its name, Henderson Smaller Companies typically invests a significant portion of its assets in the FTSE 250. Its manager, Neil Hermon, favours mid-caps for liquidity reasons, and because he thinks they are typically higher quality than smaller companies due to their superior performance, which is driven by earnings growth.

Mr Hollands adds: "Neil Hermon also manages an open-ended fund, Henderson UK Smaller Companies (GB0007447625), so if I can buy the investment trust at a 14 to 15 per cent discount to NAV I will have that over his open-ended fund because you're getting similar assets at a quite a good discount."

This trust has also performed well and is a reasonable size, with assets of about £620m, and is quite well diversified so is not taking big sectoral bets.

Mr Liddell also highlights BlackRock Throgmorton Trust, which invests in small and mid-cap companies, and uses derivatives such as contracts for difference to try to profit from shares that go down - as well as those that go up.

Mr Liddell thinks the 3.4 per cent yield on Aberdeen Smaller Cos Income (ASCI) makes it attractive, although cautions that with a market capitalisation of £45m the trust is quite small.

Another way to access smaller-companies is via UK equity income funds that have a high weighting in small-caps, such as Unicorn UK Income (GB00B00Z1R87) and AXA Framlington UK Select Opportunities (GB00B7FD4C20). AXA Framlington UK Select Opportunities has 20 per cent of its assets in small and micro-cap companies, and Unicorn UK Income has 60 per cent in this area.

"Unicorn UK Income sits in the UK Equity Income sector, but in practice is a smaller companies fund," says Mr Hollands. "The portfolio is almost entirely invested in smaller companies, which is a key competency of Unicorn asset management, the boutique that manages it. It's a good fund because it looks for companies that can kick off a good, sustainable dividend and has a focus on quality businesses as opposed to more speculative names. In its top 10 holding it's got stocks such as Cineworld (CINE) and BBA Aviation (BBA)."

Performance

Source: Morningstar as at 16/12/16