I have long advocated the case for smaller companies. Yet logic suggests that, with the global economic outlook remaining uncertain, now might not be the right time. This would be a mistake.
Now more than ever, long term investors should overweight the sector as it is at a seminal turning point in its history – the volatility traditionally associated with the sector is in decline. This will help to improve sentiment over time. And investment trust opportunities still abound.
Small is big
The long-term case for smaller companies is well established. Money invested in 1955 in the bottom 10 per cent of the UK market, with dividends reinvested, would now be worth over five times that had the money had been invested in the broader FTSE All-Share. This is a significant difference.
The problem for investors is that the sector can be volatile given it has tended to be a geared play on the economy. The figures have sometimes been stark. In 2008 the FTSE Small Cap index dropped 43.9 per cent. In 2009, it then bounced 54.3 per cent. The extent of this volatility has harmed sentiment and turned investors away – despite the long term evidence suggesting they should stick with the sector.
However, I suggest the sector is at a major turning point because its volatility is declining for a variety of reasons. Because of globalisation and the harnessing of technology, smaller companies are less tied to the swings of the domestic economy as they search for better growth opportunities abroad – particularly in the emerging economies.
Meanwhile, at home, the quality of their management has improved, their balance sheets are stronger and they are more likely to be operating in fast growing parts of the economy. This will also help them to better withstand economic downturns.
But when talking about a sector, we need to address the relative as well as the absolute. Technology has helped smaller companies both to reduce costs and embrace disruptive practices, and so level the playing field somewhat with their larger brethren.
Indeed, I would go further. The consensus view is that, in this world of slow growth, large blue-chips are the place to be. Yet in such an environment, these companies are going to struggle by past standards as increased competition erodes margins - note the increase in recent years in share buy-backs relative to longer term investment.
A select few genuine growth stories and those with wide moats will thrive and command lofty ratings because of their liquidity and scarcity value. However, many will be slow to respond to this changing environment. And some will wither on the vine at a rate faster than first imagined.
By contrast, smaller companies tend to be lean, nimble and adaptable when meeting the challenges of the market place. This is where the productivity gains of the future will be anchored. It is where innovation and enterprise will thrive.
The market will gradually recognise their growing resilience and enterprise value relative to the economy and their larger brethren. The resulting lower volatility will help to improve sentiment. This process will not be smooth but it will be inexorable.
Today, the small company sector still stands at a modest discount to the FTSE All-Share index despite its greater potential. This presents the investor with opportunities.
Gone are the days when many good quality trusts were standing on 20 per cent discounts, as highlighted in previous columns (‘Drawn to small company discounts’, 5 October 2012). But value can still be found. There remain good quality investment trusts on attractive discounts, and producing a decent level of income.
Aberforth Geared Income Trust
Step forward Aberforth Geared Income Trust (AGIT), which I have introduced to the Growth portfolio during July. The trust is run in a collegiate manner by Aberforth Partners, which is owned by six partners who are all investment managers specialising in smaller companies. I suggest such a corporate structure is well-suited for the task in hand.
AGIT is the ordinary share of a split capital investment trust whose benchmark is the Numis Smaller Companies Index (excluding investment trusts) – this focuses on the bottom 10 per cent of the UK market by capitalisation. The largest constituents are companies valued at around £1.5bn.
Aberforth are value investors who focus particularly on balance sheet strength and dividend cover. As a result, the rating of AGIT’s portfolio usually stands at a discount to the wider benchmark - the figures being 13.3x and 15.2x respectively, according to the latest annual Report & Accounts. This search for value also means AGIT is overweight the smaller index constituents.
Such an approach has resulted in an excellent track record. As at the end of June, over the last three years AGIT had produced annualised returns of around 36 per cent compared to the benchmark’s 20 per cent and the FTSE All-Share’s 11 per cent. The five year figures are similarly impressive.
Investors should be aware that, courtesy of the zeros, AGIT is around 40 per cent geared. Given my long term view of smaller companies, I consider this a positive as gearing enhances performance when portfolios are rising in value. However, analysis suggests the majority of the outperformance has been achieved through good stock selection – which is reassuring.
Its progressive dividend policy is also an attraction. The current yield is 3.7 per cent, which rises to 4.3 per cent if one includes the latest special dividend of 1.2p. Revenue reserves of six months support the policy going forward.
In short, AGIT has an excellent track record, currently sits on a 14 per cent discount – nearly twice its recent average - and offers a healthy and growing dividend. Meanwhile, the managers have ‘skin in the game’. This is an attractive combination. Furthermore, there is a planned winding-up date of 30 June 2017.
Other portfolio changes
To fund this purchase, I have sold the Growth portfolio’s holding of Strategic Equity Capital (SEC), after a near 50 per cent profit over a 15 month period, as it was looking expensive on a premium of 10 per cent. This is despite the high quality of its management. Longer term, it remains a good investment and one day I may revisit – my website’s Thematic portfolio retaining a reduced holding.
Otherwise, there were no changes to the Income portfolio during July.
Finally, because I am away on holiday and was unable to update the figures at the beginning of August, the Growth portfolio’s breakdown has been updated as at 18 July to reflect the changes just described, but both the Income portfolio’s breakdown and both portfolios’ performance figures remain as at 1 July. All figures will be updated as usual in my next column. Meanwhile, I wish all readers a good summer break.
