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Turn to defensive small-caps to protect against a slowdown

Mike Prentis, manager of BlackRock Smaller Companies, picks out some of the companies he's banking on
December 8, 2016

UK smaller companies investment trusts have derated due to fears over the UK domestic market, but that means now is a good time to buy into them, argues Mike Prentis, manager of IC Top 100 Fund BlackRock Smaller Companies Trust (BRSC).

The trust has recently hit its widest discount in four years, with its shares at times trading at a discount to net asset value (NAV) in excess of 19 per cent, as investors worry that uncertainty over the UK's exit from the European Union and slowing economic growth could take its toll on smaller, domestic-facing companies.

But 50 per cent of the earnings in BlackRock Smaller Companies' portfolio are derived from overseas. Mr Prentis is targeting a mixture of UK-listed stocks likely to benefit from the election of Donald Trump as US president, as well as smaller companies he thinks will be able to perform even if UK consumers stop spending.

"We like anything with exposure to the US at the moment," he says. "It is an interesting market and Trump is determined to make the economy stronger."

One company set to benefit from US growth is 4Imprint (FOUR), a promotional gift company listed in the UK with all its operations in the US, and which derives 96 per cent of revenues from that country. "4Imprint is growing at 15 per cent per year organically and the shares have done well over the past few months because its profits and costs are dollar denominated," says Mr Prentis.

The company also has just a 5 per cent share of its market in the US, which gives it further room to grow.

But BlackRock Smaller Companies invests in many domestically-facing UK companies too, and there are concerns over the UK economy and UK consumers. "The things we worry about are consumer confidence deteriorating because of a more uncertain outlook related to Brexit negotiations and signs of job losses, if we get those," says Mr Prentis. He expects "slower UK growth next year" and says the key risk for many UK smaller companies will be "demand-related risk connected to the UK consumer". That means downsizing retail allocation and increasing exposure to what he calls defensive UK stocks, which can continue to profit even if the wider economy slows.

Stocks he believes would be insulated from that kind of cyclical risk include Accesso Technology (ACSO), an online ticketing company based in Berkshire, which designs and integrates virtual queue systems for theme parks. He admits that on 61.2 times 12-month earnings "it is not a cheap stock", however believes that a deeply embedded technology, major upcoming contracts with big parks and growing business from Asia make it a good buy.

Another defensive stock he likes is CVS (CVSG), the "UK's largest vet surgery business", which has more than 300 veterinary practices around the UK. "It is a vertically integrated company with the potential to expand into more specialist operations, too," says Mr Prentis. "Whatever happens to the economy in the UK people will still need to look after their pets."

He is wary of UK retailers, though, which could suffer both from the currency impact of importing goods from overseas and selling in weak sterling, as well as any slowdown in UK growth. He has been reducing his exposure to these, however JD Sports (JD) remains one of the trust's top 10 holdings.

"There are definitely UK businesses sourcing products from overseas - this is the case with many retailers and car manufacturers in particular," he explains. "For example, many cars are made on the continent and shipped to the UK, so their costs are denominated in euros. This means there's a question as to whether the deals available to new car buyers will be as favourable going forward."

BlackRock Smaller Companies generates its returns from a mixture of dividends and capital growth. Smaller companies have had a stellar run: over the five years to 6 December the trust returned 126.7 per cent, against a return of 75.7 per cent for its benchmark, Numis Smaller Companies + AIM index, and 53.7 per cent for the FTSE All-Share. Over 10 years the trust has returned 211.5 per cent compared with 68.6 per cent for its benchmark.

Mr Prentis says he anticipates a larger proportion of future returns coming from dividends as the pace of capital growth slows. The trust yields 2 per cent and has reserves worth 1.5 years of its last full-year dividend payment, which it could tap into if necessary to increase dividend payments year on year - something it has done for the past 13 consecutive years.

He says a key benefit of his trust's income is that the payouts are more evenly spread than those from a fund invested in income-paying large-cap stocks. BlackRock Smaller Companies has 170 holdings and Mr Prentis is able to invest in companies with a market cap of up to £2bn. However, over 45 per cent was invested in companies with a market cap of between £100m and £400m as at August 2016.

"[This year] has been a year of uncertainty and discounts in this sector are wide because people think UK smaller companies means domestic risk," he says. "But that is not the case and history shows that often the best time to invest in this space is in a period of uncertainty."

For example, in 2010, two years after the financial crisis, BlackRock Smaller Companies made a share price return of nearly 80 per cent compared with just 14.5 per cent for the FTSE All-Share and returns also spiked in 2013, when the trust made a share price return of more than 70 per cent against 20.8 per cent for the FTSE All-Share.

BLACKROCK SMALLER COMPANIES (BRSC)
Price910pGearing exposure9%
AIC SectorUK Smaller CompaniesNAV1,093.55
Fund TypeInvestment Trust Discount to NAV17.71%
Market Cap£432.117mYield1.94%
No of Holdings170Ongoing Charge0.69%
Set up date02-May-06More detailshttps://www.blackrock.com/uk/individual/products/investment-trusts/our-range/blackrock-smaller-companies-investment-trust/trust-information
Manager start date01/09/2002  

Source: Morningstar, as at 06.12.16

Performance

1 year share price return3 year cumulative share price return5 year cumulative share price return10 year cumulative share price return
BlackRock Investment Management (UK) Ltd BlackRock Smaller Companies IT TR in GB-3.4814.20126.69208.49
FTSE All Share 11.3417.1153.7467.35
Numis Smaller Companies + AIM Excluding Investment Companies7.8215.0075.7368.61

Source: FE Analytics, as at 6.12.16

Top ten holdings% of assets
4Imprint Group2.5
CVS Group2.2
Dechra Pharmaceuticals1.9
Avon Rubber1.8
JD Sports1.6
Advanced Medical Solutions 1.6
Hill & Smith 1.5
Headlam Group 1.4
Accesso Technology 1.3
Restore 1.3

Source: Company fact sheet, as at 31.10.16

Sector exposure % of assets
Industrials 29.1
Consumer services 20.4
Financials13.5
Basic materials 10.5
Technology 8.2
Consumer goods8.0
Healthcare7.4
Oil & Gas2.7
Utilities 0.2

Source: Company fact sheet, as at 31.10.16