Five great trusts

Backing an investment trust involves backing the opinion of an individual fund manager or investment team. With this in mind, the funds we've chosen to highlight not only boast a strong track record from the last recovery but also have the same manager. We've spoken to each manager to give a flavour of what his fund offers and the opportunities that exist. Here's the lowdown.

1. Andy Crossley, manager of Invesco English & International

Invesco English & International came roaring out of the last bear market with its shares rising by 105 per cent in the first year of recovery. The trust does not have any debt facilities in place with which to gear up investments, but hopefully this will be rectified in time for any recovery. Prospects for recovery could also be held back this time by a discount control mechanism that involves the trust buying back shares once every quarter at a 4 per cent discount. That said, at the time of writing, the shares are trading on a 15 per cent discount.

The trust's well-respected manager, Andy Crossley, believes there are bargains to be had among profitable companies with strong balance sheets. But he thinks that investing in distressed stocks, such as housebuilders and heavily indebted pub groups, which some may regard as classic recovery plays, will end in tears. "Smaller companies are so out of favour at the moment that it feels like a once-in-a-generation chance to get exposure at valuations that can result in very high future returns," says Mr Crossley.

At the same time as being optimistic about the potential for valuation uplifts, Mr Crossley believes we've got some pain to experience first. "We're cautious on the outlook," he says. "The problem of the banks is pretty deep-seated and I'm not sure the government policy of encouraging people to borrow and spend is the right one, but we think there is real value in the equity market. The valuation support with the FTSE 100 at 3500 to 4000 is immense, so we don't think there's much disadvantage in being in too early now."

Mr Crossley believes takeovers could act as an early catalyst to unlocking value in the market. With this in mind he's keeping a close eye on events at life assurance group Just Retirement, which is one of his top 10 holdings and is in bid talks. Among Mr Crossley's top stock picks are Novae, a Lloyds insurer that is benefiting from rising premium rates following last year's barrage of natural disasters. He is also a fan of Healthcare Locums which is a recruitment firm placing locum doctors and is keen on newspaper and magazine distributor Smiths News.

2. Harry Nimmo, manager of Standard Life UK Smaller Companies

Despite the strong performance put in by the Standard Life UK Smaller Companies investment trust in the first year of the last bull market, its manager, Harry Nimmo, claims he's not much of a recovery investor. The trust's approach to investment is based on a sophisticated stock-screening tool known as the Matrix. One of the reasons Mr Nimmo thinks a recovery could temporarily wrong-foot him is that one of the key factors the Matrix looks for is momentum, whether it be in share price, earnings or broker forecasts. So Mr Nimmo thinks his stocks could be yesterday's news for a while when a recovery kicks in.

However, the experience last time around suggests any underperformance shouldn't continue for too long. What's more, the performance the trust has been producing in the meantime means a short spell of disappointment may well be more than compensated for by the peace of mind offered by Mr Nimmo's bear market record.

Mr Nimmo thinks that just being in smaller companies will be enough to make the recovery a time for bumper returns. "At the turning point we will underperform," he says, "but the good news is that we will all be very strong in smaller companies. And who actually knows when turning points are going to happen. I do think there are super-normal profits to be made over the next three to five years."

Mr Nimmo can already see the seeds of the next bout of market panic. "We're still in for a bit of a choppy ride in the next few months," he says, "Private equity-funded businesses will be a big issue in summer as they get into trouble."

The fund has benefited by the sell discipline embodied within the Matrix, which also looks at key-solvency indicators such as z-scores. Mr Nimmo says red flags from the Matrix led to him making timely exits from the real-estate sector as well as from buy-to-let lender Paragon and New Star Asset Management. In some cases he sold against his better judgement but his obedience to the screening system has paid dividends in many cases.

When an upturn in the market does come, the fund may benefit from a narrowing discount as it does not have a discount control mechanism in place. However, it does plan to introduce one next February, which would allow shareholders to sell their holdings at a 10 per cent discount to NAV once a quarter. This will happen after the trust is merged with another trust that was formerly run by Gartmore.

At the moment the trust's portfolio looks like a growth investor's last stand. Mr Nimmo is holding some of the few winners in this space, which means many of his top holdings have internet-based businesses. These include online clothing retailer ASOS and online antibody distributor Abcam. All in all, Mr Nimmo says about 20 per cent of the fund is exposed to online businesses.

3. Gervais Williams, manager of Gartmore Growth Opportunities...

Two of the top-performing smaller company investment trusts from the 2003 recovery were, and still are, run by the same man: Gervais Williams. Mr Williams is fairly optimistic about the chances of a recovery and has geared up both of his trusts to take advantage of rising asset values. The Opportunities fund is about 20 per cent geared while Fledgling has gearing of around 10 per cent. "We've had a period when people have anticipated a slowdown and discounted it aggressively," says Mr Williams. "But I think the data flow will start to improve quite soon."

Mr Williams believes small caps could become one of the few investments that provide investors with a decent and growing income stream. This view is based on anticipated cuts to dividends by blue-chips. Mr Williams cites the futures market which indicates that the market is expecting dividend falls of between 50 and 60 per cent. "None of us has seen anything like that in our lifetime," he says. "A large part of this is coming from large caps which have been over distributing in the past and are now over-geared. So, from that point of view, where will you get good dividends and growth? The only area that is under-distributing is small caps and especially Aim."

Should the switch from large- to small-cap really occur, Mr Williams thinks it could go on for a long time because so many large institutional investors are underweight in this part of the market having shunned it for decades. And it’s not just the potential for small caps to boost dividend payments that is attracting Mr Williams to them. "It's not just that they're cheap," he says. "It's almost embarrassing buying these stocks off those people that are being forced to sell them."

Mr Williams also believes it has never been easier to separate the wheat from the chaff. He says it's quite simply a case of looking for a strong balance sheet matched with a strong market position and management. "The difference between the winners and losers is a chasm," he says.

Gartmore Growth Opportunities is more the conventional of the two. It buys shares at the smaller end of the small-cap universe where Mr Williams believes he can find better value. He has also been targeting companies with stronger balance sheets. The trust has benefited in the recent downturn by purchasing put warrants to hedge against market falls as the bear market set in.

...and Gartmore Fledging (4.)

Gartmore Fledgling investment trust is the out-and-out recovery play. About two-thirds of the fund is allocated according to the constituents of the Fledgling index while around one-third is invested on a discretionary basis in the index to ensure the fund does not hold the real dross. The principle behind the investment trust is that by the time stocks fall into the FTSE Fledgling index they are so unloved and in such a dire state that there is often considerable value on offer.

According to Mr Williams, strong recoveries frequently come about by way of the business being forced to take radical action through management restructuring. There are also a lot of takeovers in this part of the market. The trust is one of the few that we've looked at with no formal discount control policy, but it is active in buying back its own shares. This means it may benefit more than most funds from discount narrowing when recovery takes hold.

5. Neil Hermon, manager of Henderson Smaller Companies

Neil Hermon, manager of the Henderson Smaller Companies investment trust, took over just as the market began to recover in 2003. A new manager can be a lot bolder in his actions than an incumbent one, which means it is possible that the trust handles the recovery differently this time around. But then the recovery itself is likely to have a different flavour. "This time around it's a fully fledged recession we're dealing with," says Mr Hermon. "But, on the other hand, valuations are very supportive."

Mr Hermon believes the market may be close to bottoming out, and thinks 3500 to 3600 for the FTSE 100 level could prove to be the floor. "The market has discounted a lot of bad news with the falls so far," he says. "There's a degree of undervaluation in equities, I think there's an understanding that there's a lot of value in small caps. I don't think we're far from finding a bottom. Valuations indicate that we're quite close."

Mr Hermon is not expecting markets to shoot straight back up and says analysts' earnings expectations are still too optimistic. But he has taken on 15 per cent gearing in order to benefit from any upturn.

Many of the investment themes recently backed by the trust have a classic recovery feel to them. For example, Mr Hermon has been buying into housebuilders and is enthused by recent data which suggests some thawing in the housing market. Support services and media are also areas he's been looking at that could provide major uplift in a recovery.

How UK Smaller Companies investment trusts performed

99-03 bear market = 28 Dec 1999-11 Mar 2003

Recovery year = 11 Mar 2003-11 Mar 2004

Bull market = 12 Mar 2004 - 15 June 2007

Bear market = 15 Jun 2007 to end-March 2009