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The future is small

John Baron highlights additional reasons why UK smaller companies should continue to outperform
The future is small

The debate continues as to whether the rotation into ‘value’ during the final quarter of 2020 is signalling the start of something more sustainable. Given the disparity in valuations and likely nature of the economic recovery, I have been top-slicing some growth holdings given the extent of their outperformance and increasing exposure to more cyclical sectors and unfashionable markets, while remaining true to the portfolios' growth mandate.

However, it is no accident that the portfolios’ overweight positions in UK smaller companies have been retained. In addition to their intrinsic long-term advantages, there are short-term reasons to be positive, including attractive ratings, signs that investor confidence is picking up and likely government policies. But perhaps the current debate regarding value may provide the biggest catalyst of all for a rerating.


The long-term case

Over the years, investors have questioned the portfolios’ commitment to smaller companies. Yet such a bias is one of the more reliable investment strategies in generating higher returns over time, relative to the wider market. The important caveat is that, as with investments generally, investors need to be invested for the long term. The fact that smaller companies exhibit greater volatility can then be embraced as an opportunity.

Figures to 31 December 2020 suggest UK small companies outperformed the FTSE All-Share in 15 of the 21 years this century. The strongest bouts of performance (19 per cent in 2003 and 24 per cent in 2009) followed previous years of underperformance (-2 per cent and -10 per cent in 2002 and 2008). And despite the negative news last year, the sector again outperformed, this time by 6 per cent, in large part because news of the vaccines in the fourth quarter initiated large earnings upgrades.

The longer term is similarly impressive. A few years ago, professors Paul Marsh and Elroy Dimson at the London Business School focused on the Numis Smaller Companies Index (NSCI), which represents the bottom 10 per cent of the UK market, excluding investment trusts. Over the 64 years since 1955, the index had produced average annual returns of 9.7 per cent compared with 6.4 per cent for the FTSE All-Share. Small figures compound over time. While the FTSE 100 has made little progress since 2000, the NSCI has risen nearly three times.

There is an inherent logic to this. Elephants do not usually gallop. As mentioned in previous columns, many smaller companies operate in niche and growing markets, are nimble and exhibit faster growth because they are benefiting from the advance of technology. This is not just helping to reduce costs and open new markets but is better enabling them to embrace the disruptive practices needed to compete with larger companies.

In the recent environment of pedestrian growth, low interest rates and high debt, many larger companies were always going to struggle. A few genuine growth stories will continue to command lofty ratings. However, many have been slow to respond to this changing environment and have withered at a rate faster than first imagined, as organic growth has become ever more elusive.

The absence of genuine entrepreneurship and adherence to a financial system too focused on the short term have contributed. The column ‘Where are our pioneering giants?’ (IC, 8 February 2019) touches on this theme in more detail. Concomitant to this has been a recognition by investors of the need for greater diversification when seeking income, which has included smaller companies given the high-profile dividend cuts in recent years.


Short-term attractions

However, there are shorter-term reasons to be positive. Unfounded concerns about Brexit have cast a long shadow over the UK market. Over the six years to December 2020, the Nasdaq, S&P 500, Nikkei 225, MSCI Europe and FTSE All-Share indices have returned 206 per cent, 107 per cent, 95 per cent, 26 per cent and 1 per cent, respectively. The UK has reached almost pariah status – the forward price/earnings (PE) ratio of around 14.5 times being well below that of other markets.

Yet economic prospects remain encouraging with an EU trade deal secured, numerous trade deals signed since, and application made to join the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which offers tremendous potential. Meanwhile, the economy remains attractive to inward investment and its gradual but meaningful shift towards technology should not be underestimated.

These are all reasons why the portfolios’ UK exposure has been increased. But within the market, smaller companies look even better value. A trailing PE of 14.5 times does not look expensive relative to the historical average or prospects. The sector has seen significant net outflows over the past six years, particularly during the Brexit referendum and the tortuous wrangling in Parliament over a deal in 2018 and much of 2019.

But this now looks to be turning a corner. The net inflows during the final months of last year being two of only nine months of inflows during the past 28. A lot of bad news is baked into prices. And yet the sector’s cautious rating, its increasingly dynamic composition, the UK’s success in achieving an EU deal and others since, and signs that investors are becoming more optimistic about prospects, all bode well for the sector, as well as the wider market.

But there is another reason to be optimistic. The arguments for value continuing to outperform are varied. This year will see an economic recovery of sorts because significant swathes of the economy will no longer be in lockdown. Although unemployment is sadly rising due to lockdown, many more have continued to work and have been saving during the pandemic. The recovery will therefore be further supported as pent-up spending fuels demand for consumer goods and services, as restrictions ease.

But recoveries can be short-lived. For value to continue to outperform, longer-term tailwinds need to be in place. A sustained period of decent economic growth is one prerequisite. To this end, there can be no doubting the extent of the monetary and fiscal stimulus being pursued by governments – particularly in the UK. And given the extent of debt and the need to encourage economic growth, interest rates are set to remain low for some time to come. Policy leaders will tolerate higher inflation being the consequence.

If the rotation into value is sustained for these reasons, smaller companies will do well because of the economic backdrop – particularly during the early phase of the inflationary pick-up. If growth resumes its leadership role, then the sector should outperform as sentiment continues to catch up with fundamentals. And in being positive about markets, particularly in the UK, we should perhaps remember that since 1955 the NSCI has on average outperformed the wider market by 7 per cent a year in bull markets.


Portfolio holdings

There are also industry-specific reasons for investors to be positive. We should also remember that investment trusts are blessed in having a disproportionate number of good managers. Furthermore, their closed-ended structure allows fund managers to gear and to take the long view, not worried about the short-term money flows which can bedevil unit trust managers.

Meanwhile, smaller companies can be ignored by the large institutional fund managers because of liquidity and size – the sector is under-researched and provides many opportunities for good fund managers. Indeed, research a few years ago suggested that, on average, investment trusts have outperformed the NSCI by 14 per cent over the previous five years and traded on a discount of around 10 per cent.

The portfolios’ holdings are all worth buying for the long term. A few offer attractive yields, some still trade on decent discounts, many pursue a growth mandate, most have longstanding and respected managers at the helm, and all have performed well over time. But it is wise to understand the individual characteristics. For example, BlackRock Throgmorton Trust (THRG) uses derivatives, which allows it to sell investments it does not own and to generate leveraged exposure when positive, which can raise its risk profile.

Some companies, such as Standard Life UK Smaller Companies (SLS) and Montanaro UK Smaller Companies (MTU), apply tailor-made screening processes when focusing on quality growth opportunities which have been tried and tested through the economic cycles. In an environment of uncertainty and volatility, such businesses should provide resilience and will be sought-after.

Technology specialists Herald Investment Trust (HRI) and Augmentum Fintech (AUGM) pursue their particular remits, which continue to offer exciting potential and attract investor attention. Oryx International Growth Fund (OIG) focuses on undervalued investments on both sides of the private/public divide, while helping managements improve operational performance if needed as a long-term investor.

Mercantile Trust (MRC) and Henderson Smaller Companies (HSL) have a higher weighting in medium-sized companies and pursue wider remits in their search for attractive returns. In addition to MTU, the income portfolio holds Invesco Perpetual UK Smaller Companies (IPU) and Acorn Income Fund (AIF) for their dividends. Otherwise, other companies held in the nine real portfolios managed on the website include River & Mercantile UK Micro Cap (RMMC), given the rating of the very small companies.


Portfolio performance
                                                        Growth    Income
1 Jan 2009 – 31 Jan 2021  
Portfolio (per cent)                                         387.6263.1
Benchmark (per cent)*                                   182139
Year to 31 Jan 2021  
Portfolio (per cent)                                              -1.1-1.4
Benchmark (per cent)*                                      -0.8-0.7
Yield (per cent)                                                     2.63.1
*The MSCI PIMFA Growth and Income benchmarks are cited (total return)