These are uncertain times. But markets climb walls of worry. And the uncertainty is creating some wonderful opportunities for investors - no better than in the UK smaller companies sector.
Long-term success
Logic suggests smaller companies should do well over the longer term. And the figures confirm this: £1,000 invested in 1955 in the bottom 10 per cent of UK stocks by market capitalisation would now be worth over £3m with dividends reinvested. Had the money been invested in the FTSE All-Share instead, then the figure drops to £600,000 - a significant difference.
This is a global phenomenon. A report issued earlier this year by the London Business School has produced some useful statistics for the period 2000-2011. Despite underperforming last year, smaller companies beat large caps in all but four of the 29 markets covered - representing over 98 per cent of global equity markets. And it wasn't a close race. The average outperformance was 5 per cent a year.
The facts suggest investors should overweight this sector over the longer term. However, the problem for investors has been volatility. For example, in 2008 the FTSE Small Cap index dropped 43.9 per cent. In 2009, it then bounced 54.3 per cent. Such volatility harms sentiment and turns investors away. This has proved a costly mistake over the long term, but is particularly the case now.
Short-term opportunity
The present low-growth environment will be characterised by governments and consumers paring back their excessive debts for some years to come. It is uncertain when they will emerge onto the sunny uplands but, despite much talk of austerity, the coalition government has still only managed to reduce the rate at which we are adding to our existing debt by a quarter. Markets know this is going to be a long, hard slog.
But smaller companies are better positioned than they've ever been. Because of technology and globalisation, they are far less tied to domestic fortunes and far more international in their targeting of faster-growing economies. Many investment trust portfolios derive more than half their earnings from overseas.
Furthermore, smaller company balance sheets are stronger, managements are better, and there are a lot of them - which means they tend to be under-researched. Good fund managers are having a field day! Meanwhile, perhaps the volatility that has plagued the sector will improve as economies flatline, and with it investor sentiment.
Herein lays the opportunity. The smaller company investment trust sector is awash with good performing trusts on large discounts - 20 per cent is not untypical. In my view, this remains an anomaly that will be corrected over time. One is spoilt for choice - the bargains are to be had. And the added attraction is that some trusts do not help themselves by their very nomenclature.
Both the Growth and Income portfolios have been overweight smaller companies since inception, and this has helped performance relative to their respective APCIMs benchmarks. However, I continue to add to exposure.
Portfolio changes
During September, I added Henderson Smaller Companies (HSL) to both portfolios. Run by the well-respected Neil Hermon, it has consistently outperformed its benchmark. HSL has around 75 per cent of the portfolio invested in the FTSE 250 - often holdings introduced as smaller companies - with the balance in small caps or the Alternative Investment Market.
I have also introduced Montanaro UK Smaller Companies (MTU) to the Growth portfolio. It also has an excellent track record, and is now run by David Lindley and supported by George Cooke. The previous manager, Charles Montanaro, will continue to provide guidance and strategic oversight – and retains a £2m stake.
Speaking with both Neil and David, they emphasised the importance of quality when it comes to stock selection - good growth prospects, sound finances and strong management. The ratings of both portfolios are therefore a little higher than the 11/12 times for the sector, but are considered undervalued given their growth potential. Both trusts were bought on a 20 per cent discount - and this remains the case.
To fund the purchases, I have sold Baillie Gifford Shin Nippon trust (BGS) in both portfolios at a reasonable profit. It has been a good performer but is difficult to justify holding when trading close to net asset value (NAV) - particularly as HSL and MTU possess better long-term track records both in absolute terms and relative to appropriate benchmarks. At the very least, the three trusts should be standing on similar discounts - particularly as doubts linger regarding Japan.
Within the Growth portfolio, I have taken a small profit by selling HICL Infrastructure (HICL) while on a 9 per cent premium to NAV (it remains in the Income portfolio because of its 5.6 per cent yield). I've also top-sliced Golden Prospect Precious Metals trust (GPM) as it has risen 40 per cent since its recent introduction in July, helped by a narrowing discount and strong portfolio performance. However, GPM remains as the outlook is extremely positive.
See John Baron's page for details of his updated investment trust portfolio.
