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Get the most out of UK smallers by picking the right trust

The secrets of getting your timing right with small-caps
November 16, 2018

The UK stock market has been beaten up this year. The FTSE 100 was down 4.1 per cent over the first 10 months of the year as Brexit uncertainty, fears over global trade and foreign investor concern about the UK economy weighed on the share prices of the country’s largest companies. Smaller companies, which are typically more reliant on the UK economy than FTSE 100 stocks, have been hit even harder. The FTSE Small Cap (ex IT) index was down more than 8 per cent over the first 10 months of the year, and the FTSE 250 down 6.3 per cent.

But while this may not sound good, if you take a contrarian stance, now is arguably a good time to buy into UK equities.

Over the long term, smaller company stocks have outperformed their larger peers as some of these are the nimble growth-type companies that in future grow into large-caps. This has been proved by academic studies and investor experience. For example, professors Paul Marsh and Elroy Dimson of London Business School found that UK small-caps have returned 15.4 per cent on an annualised basis since 1955. Over 10 years to 6 November 2018 the FTSE Small Cap ex IT index has risen 266 per cent versus 140 per cent for the FTSE 100. And over the 25 years to the start of 2018 small-cap stocks rose 686 per cent versus 552 per cent for large-caps

But these are long-term numbers, and in the past 20 years there have also been two periods when the FTSE Small Cap (ex IT) index has fallen by over 50 per cent, and three periods when it fell over 30 per cent. If you invest in these assets, having a long-term investment horizon is very important, as is knowing when to buy. Figuring out when to buy UK smaller companies is not easy, but these have tended to do well when economic growth is returning and companies are coming out of recession. Smaller companies do even better when this transforms into positive economic figures and sentiment, and serious risk-taking in markets. However, they will always be the first to suffer when investors start to apply the brake pedal. Generally, the closer you are to the beginning of an economic cycle, the better small-caps will perform.

At the moment, you could argue that the UK is not near the beginning of an economic cycle but heading towards the end, and so allocating to smaller companies is setting yourself up for a fall. The FTSE Small Cap (ex IT) index looks as though it may have already had its run in this cycle: between December 2011 and March 2014 it rose 111 per cent versus 34 per cent for the FTSE 100. And the Bank of England is expected to raise interest rates in 2019 as core and wage inflation become stable – another signal of a late-cycle economy.

But the vote to leave the European Union has had an impact. UK small-caps have been the worst-hit segment of UK equities since the vote in 2016 because they tend to be more focused on the UK domestic economy. The appetite for taking bets on smaller companies when so little is known about the future has not been great among domestic or foreign investors. This arguably leaves UK smaller companies at a discount to their true value.

Daniel Lockyer, co-head of fund management at Hawksmoor Investment Management, says: “The valuation of smaller companies varies hugely. There are pockets of expensive valuations, notably among certain Alternative Investment Market (Aim) stocks that have seen comparatively valuation-insensitive buying for inheritance tax reasons. However, overall, there are probably a disproportionate number of good opportunities among small-caps relative to large-caps, not least because [the vote for] Brexit has depressed the ratings of UK domestic stocks.”

Monica Tepes, investment companies research director at brokerage finnCap, adds. “Small-cap valuations have contracted significantly over the past year, and some would argue that UK companies will do well regardless of Brexit. They are the sweet spot for growth, flexibility and adaptability."

Simon Evan-Cook, senior multi-asset manager at Premier Asset Management, says there are some useful indicators in terms of when to invest in UK smaller companies. “There is always a good reason not to buy small-caps,” he says. “Elections, recessions or interest rate shifts are the most commonly cited. Waiting for clarity is also common.”

But there isn't often clarity, and he adds that with the current outlook most investors seem to be avoiding smaller companies – certainly as far as valuations suggest. “This indicates we should have some exposure to the asset class but maybe not fill our boots,” he says.

Low valuations and a bad outlook make UK smaller companies very much a contrarian play. Simon Elliott, head of research at Winterflood Securities, says there are pockets of expensive stocks and pockets of value. “UK all-cap fund managers are starved of the kind of mega-cap growth companies that have been powering markets in the US and Asia, so many are instead delving into the smaller end of the UK market to find growth stocks," he says. “Unsurprisingly, these growth stocks have performed extremely well, so this is the kind of thing we should avoid. As a result, we’re not holding UK small-cap growth funds, rather, we’re holding small-cap value funds as their style and chosen stocks are out of favour. There are times when you want to buy small caps and times when the attraction of doing this is less obvious – such as right now. But a lot of their risks are already priced in, which make them a compelling opportunity.”

But things often get worse before they get better, and UK smaller companies are very risky – they are small and some will fail. The market is heavily affected by sentiment and the economic cycle, so if you invest in these your holding period should be long, and an allocation to UK smaller companies should be a small part of a balanced portfolio.

 

Buying at a discount

One way for private investors to buy into UK smaller companies is through investment trusts. There are also many open-ended funds that invest in smaller companies, but investment trusts have advantages when it comes to liquidity. Their managers can invest in stocks without having to worry about selling them to meet redemptions if investors sell out of the trust. This is because when you dispose of your shares in an investment trust you have to sell them to another buyer on the secondary market – the company that manages the trust won't buy your holding back as it does with open-ended funds. 

But investment trusts' share prices can suffer due to poor investor sentiment, even if their underlying assets are performing well. For example, if a sector such as UK smaller companies is out of favour, the share prices of the investments trusts focused on this sector might not keep up with their net asset values (NAV), opening up discounts to NAV. UK smaller companies investment trusts are arguably going through such a period right now, so if you believe there are good times ahead for the assets they invest in, they could represent a bargain, as you are buying into a basket of assets for less than their value. If sentiment changes, the discounts could tighten giving investors a significant boost.

However, there is no guarantee that their share prices will catch up with their NAVs and their discounts will tighten. UK smaller companies investment trusts tend to trade at discounts to NAV most of the time, and these discounts can widen significantly if UK smaller companies are not in favour.

8 per cent is the amount the FTSE Small Cap (ex IT) index was down over the first 10 months of the year

To benefit from the possibility of discount tightening you should look to trusts trading at discounts wider than their long-term average or their sector average, as this could be an attractive entry point. A sector and a trust’s discount compared with their long-term averages also show whether UK smaller companies are in favour.

Charts 1 and 2 show the Association of Investment Companies (AIC) UK Smaller Companies sector average basic discount and weighted discount over the past five years. The basic average discount is the sum of the discounts divided by the number of trusts. The weighted average discount also takes into account the size of the trusts so, for example, a small fund on a large discount and large fund on a small discount do not skew the figures.

 

The charts show that on both metrics the AIC UK Smaller Companies sector’s average discount is currently above the average over the past five years. The discount is volatile and follows a sharp pattern of ups and downs, tightening to -6 per cent in 2015 at the peak of the small cap bull run, but widening to -16 per cent shortly after. Currently, the weighted average discount for the sector is -8.61 per cent versus the five-year average of -11.08 per cent. This suggests that now is not the best time to buy into the sector as there’s a strong likelihood that discounts will widen further.

But this is just the sector average and each trust is different. Chart 3 shows the difference between the current discounts and the five-year average discounts for the 14 trusts in the sector with five-year track records.

Only three trusts currently offer a discount wider than the five-year average, so as a whole the sector does not seem to offer good value. James Calder, research director at City Asset Management, would not buy a UK smaller companies trust unless it was close to a double-digit discount.

“Otherwise the risk is always on the downside," he explains. "On a five-year basis, I suppose it’s always a good buying opportunity, but there might be a better one around the corner.”

Mr Elliott says some investors compare UK smaller companies' discounts to the wider investment trust sector, and think the discounts provide a good entry point. However, as chart 3 shows, the current level is quite tight for the sector. But there are historic reasons for this that could change in the future.

“They invariably trade at a wider discount to other investment trusts,” says Mr Calder. “This is because, historically, there has been an oversupply of UK smaller companies investment trusts, but over the past 15 years we have seen a rationalisation. What is left is best in class and most now have very good long-term track records and capable investment teams. This is an area of the market where active management can really make a difference and a diversified portfolio can be very beneficial. The classic way to invest in smaller companies is as a contrarian investor. You wait until the trusts that offer exposure to them get beaten up, buy them on a mid-teen discount, and then enjoy the double whammy of capital appreciation and the discount tightening.”

But Ms Tepes argues: “From the perspective of current discounts versus the long-term average, they are not a bargain. But given NAVs on average are down by single digits over the past year I would say this is not a bad entry point.”

Smaller companies are an asset class to hold for the long term, and if your investment period is long enough – say over 10 years – the rating on which you bought the trust is unlikely to have a significant impact on your ultimate final return. But if you want to get the best return possible it can make sense to wait for the discount of the investment trust you want to buy to widen.

As well as the complication of trying to decide when to buy into a UK smaller companies investment trust, you also need to bear in mind that they can gear – borrow money to buy more exposure to the market. This can boost returns in rising markets but compound losses when they fall.

Mr Calder says the discount concerns outweigh the liquidity benefits of investment trusts, so he prefers to use open-ended funds to invest in UK smaller companies.

But Ms Tepes says: “The main driver of returns is always going to be the underlying portfolio, and the closed-end format affords the managers more flexibility in terms of picking the stocks, as they do not have the constraints of managing liquidity like an open-ended fund. While this is not a guarantee of superior performance, most investors would like fund managers to be able to implement ideas with as few technical constraints as possible.”

 

Trust suggestions

The AIC UK Smaller Companies sector includes trusts that invest via growth and value styles, and ones focused on micro-caps.

For high-growth small companies exposure, options include BlackRock Smaller Companies Trust (BRSC) run by longstanding manager Mike Prentis. This trust is diversified, with 131 holdings, and has beaten Numis Smaller Companies plus Aim (ex IT) index and AIC UK Smaller Companies sector average over one, three and five years.

BlackRock Throgmorton Trust (THRG) has been run by Dan Whitestone since 2015 and also has 131 holdings. It has beaten the FTSE Small Cap (ex IT) and Numis Smaller Companies plus Aim (ex IT) indices, and the AIC UK Smaller Companies sector average over three and five years.

Over one year Standard Life UK Smaller Companies Trust's (SLS) share price has fallen following its merger with Dunedin Smaller Companies Investment Trust, but its NAV performance is in line with that of its peers. The trust has been run by Harry Nimmo since 1997 who selects companies according to their individual merits, but also uses macro analysis to help identify which companies might do well. He takes a more concentrated approach than the BlackRock trusts so Standard Life UK Smaller Companies Trust only has 49 holdings.

It has beaten the FTSE Small Cap (ex IT) and Numis Smaller Companies plus Aim (ex IT) indices over three and five years. 

Growth investing has been in style for many years and was a major reason for the UK small companies bull market earlier this decade. But many analysts expect value to come back into favour, so if you want exposure to this investment style Aberforth Smaller Companies Trust (ASL) is run via a deep-value strategy. It is managed by a team of five two of whom – Richard Newbery and Alistair Whyte – have been in place since 1990.

Because value style investing hasn't been in favour, Aberforth Smaller Companies Trust has not performed well relative to its sector peers but has beaten Numis Smaller Companies (ex IT) index over one and five years. And over 20 years it has returned 1,080 per cent versus 630 per cent for this index and 899 per cent for the AIC UK Smaller Companies sector average. The trust does not invest in Aim stocks due to the lower governance standards for an Aim listing.

Strategic Equity Capital (SEC) provides more of a blend between growth and value stocks via concentrated positions in 18 companies. Its managers invest in a similar way to private equity funds, working with businesses to achieve positive changes - what they call constructive corporate engagement. 

Over 10 years the trust’s share price total return is 559 per cent versus the AIC UK Smaller Companies sector average of 383 per cent and FTSE Small Cap (ex IT) index's return of 268 per cent. However, much of this record is attributable to its previous manager, Stuart Widowson, who left GVQ – the company that runs the trust – in February 2017. Strategic Equity Capital also has a performance fee if it beats FTSE Small Cap (ex Investment Companies) Index so its ongoing charge could rise. 

 

Fund performance

Fund/benchmark1-year share price total return (%)3-year cumulative share price return (%)5-year cumulative share price return (%)Ongoing charge plus any performance fee (%)*Current discount to NAV (%)Five-year average discount to NAV (%)**
BlackRock Smaller Companies IT3.7248.0674.110.93

6.96

11.47
BlackRock Throgmorton Trust6.2658.7883.212.1610.2814.38
Standard Life UK Smaller Companies Trust-8.8339.2158.321.055.015.37
Aberforth Smaller Companies Trust-4.120.8342.540.7610.8911.08
Strategic Equity Capital-11.26-3.8452.781.1414.517.88
AIC UK Smaller Companies sector-0.4634.8563.06 8.6111.08
FTSE Small Cap (ex IT) index6.6821.3936.38 --
Numis Smaller Companies (ex IT) index-7.0822.4837.5 --
Numis Smaller Companies plus Aim (ex IT) index-7.2725.8234.61 --

Source: FE Analytics as at 07/11/2018, *AIC, **Morningstar/AIC.

 

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