Investment trusts for small cap growth on the cheap

It’s been a choppy few months in the market. Nervousness has crept in about the waning effectiveness of the first wave of Covid vaccines and also about rising inflation. The discounts on many trusts that are vulnerable to these threats have widened, especially growth-focused, smaller-companies investment trusts. This could be an opportunity.

This month’s central theme is a focus on growth-orientated, small cap trusts, and especially those with a focus on the UK.  More broadly, though, it looks like there are two key factors at play this month which have helped shape the choice of ten trusts.

One of the factors is familiar from last month when the report highlighted a number of growth-focused trusts that had slipped to discounts (often very small ones) despite their strong long-term performance records.

The worries about future returns from “growth” are related to signs of rising inflation which brings the prospect of tighter monetary policy. Broadly speaking, tighter monetary policy means higher interest rates. This increases the cost of investment for businesses. 

Growth companies tend to invest a lot. They have good reasons to do so given their potential to grow. All things being equal, a higher cost of investment reduces the shareholder value that growth creates. 

The cost of investment also feeds directly into popular valuation models that attempt to put a present value on all of a company’s  future cash flows; so-called discounted cash flow (DCF) models. With interest rates currently exceedingly low, and valuations looking very high from a historical perspective, there are fears that it will not take very much monetary tightening to create a lot of pain for growth investors from falling valuations. 

This is the type of bet the Alpha screen likes to take the other side of when three-month momentum is still strong. Historically this has proved a profitable strategy on average, but not always.