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Investment trust portfolio: Elephants still don’t gallop

John Baron explains why now may be a particularly good time to be overweight UK smaller companies
Investment trust portfolio: Elephants still don’t gallop

Although we still have a couple of weeks of the year to go, it appears smaller companies have once again outperformed their larger brethren – albeit at perhaps a more modest pace than last year. There exists an inherent long-term reasoning as to why this is the case but, shorter term, there are also other reasons to be positive about the outlook – particularly as we enter the New Year. So while the debate about the nature of the economic recovery and investment styles remains relevant, the small cap sector in general should continue to outperform.


The inherent logic

Although there have been periods of underperformance, an overweight position in smaller companies has proved to be one of the more reliable investment strategies in generating higher returns relative to the wider market. It is no accident the nine (soon to be 10) real investment trust portfolios managed on the website in real time, including the two covered in this column, have long benefited from being overweight the sector.

The fundamental reason is that elephants don’t gallop. Smaller companies tend to be more ‘nimble’ in seeing opportunities and responding to market changes. There is less baggage and bureaucracy to handle. They tend to be more entrepreneurial. Indeed, by comparison, the lack of entrepreneurship in our larger companies, and adherence to a financial system too focused on the short term, has plagued their performance. The column ‘Where are our pioneering giants?’ (IC, 8 February 2019) highlights this theme in more detail.

If anything, the advance of technology is quickening the pace of smaller companies. By helping to reduce costs and find new markets both at home and abroad, it is better enabling them to embrace the disruptive practices needed to better compete regardless of size. Little wonder the Numis Smaller Companies Index (NSCI), which represents the bottom 10 per cent of the market excluding investment trusts, has risen three-fold over the period since 1999 when the FTSE 100 has struggled to make gains.


Further positives

But there are further reasons to be positive at this point. Despite their increasing international reach, many smaller company fortunes remain largely tied to the domestic economy. The ‘project fear’ message regarding Brexit has proved erroneous, but this did not stop these undue concerns casting a long shadow over the UK market. This is now lifting. More large investment houses are overweighting the market – including those who helped lead the pessimistic chorus, such as JPMorgan.

Recent forecasts suggest the UK economy will be one of the fastest growing next year. Numerous trade deals have been signed and talks instigated as to the UK joining the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which promises huge potential. Inward investment continues (with some high-profile positive news in recent months) because the UK remains an attractive place to do business for a host of reasons. Unemployment remains comparatively low by international standards.

Such factors suggest optimism and this is partially reflected in a currency which is slowly strengthening. And yet, despite the long shadow receding somewhat, the market remains attractively rated by international standards – as evidenced by the extent of M&A activity, often instigated by overseas buyers. This all provides a useful tailwind for UK smaller companies given the sector is broadly rated in line with the FTSE All-Share and yet continues to offer superior returns over time.

Sentiment towards the sector is already improving. After six consecutive quarters of outperformance to 30 September, net inflows into UK small company funds are on the rise. 2019 and 2020 saw outflows but recent figures from Montanaro Asset Management for 2021 suggest this has more than reversed. And the scale of this reversal is impressive. Indeed, the sector has seen nearly £2.2bn of outflows over the last 15 years, yet 2021 (to 31 July) has so far seen around £750m of inflows. This is indicative.

The current debate about the nature of the economic recovery cannot be ignored. As a result of the very high levels of government debt, policy-makers are robustly pursuing monetary and fiscal stimulus in an effort to generate a strong economic recovery, in order to help pay down the debt. And while accepting that the global economic backdrop has become more challenging in recent months as countries continue to grapple with Covid and its variants, if successful it should bode well for smaller companies in general.

Meanwhile, the high debt level is further encouraging governments to keep interest rates artificially low for fear of startling the bond markets. Policy makers are relaxed in part because borrowing costs are low – low gilt yields largely reflect substantial purchases by governments using printed money. Governments are prepared to tolerate higher inflation as a consequence in part because it helps erode the debt over time, while believing it can be tamed when needed. The policy has the added benefit of concealing the true agenda in plain sight.

Yet other factors suggest inflation will not be transitory. Courtesy of the pandemic, business supply chains will be shortened which will adversely impact profitability unless prices rise. Further long-term structural shifts in the inflation equation include globalisation ‘stalling’, the new balance between capital and labour, an ageing population, and the continuing standoff between the US and China. In combination, rising inflation is now part of the investment landscape almost whatever the economic backdrop.

How will smaller companies perform in such an environment? Policy makers’ logic of keeping interest rates artificially low only holds as long as the bond markets hold. But Treasury yields have been edging higher. Unless a forced buyer or in search of robust diversification, gilts are not the investment of choice. Looking back to the introduction of the NSCI in 1955, it is interesting to note how the sector has performed relative to larger companies during periods when bond yields were rising and falling.

In broad terms, during the bond bear market up to the early 1980s when yields rose from 2 per cent to 15 per cent, UK smaller companies outperformed by 5.6 per cent a year on average. Afterwards, during the bull market, they outperformed by nearly 2 per cent a year. A closer examination of relative performance since 1962 suggests they outperformed in most environments, whether deflationary or inflationary, except very high inflation (over 12 per cent). It would appear the sector’s inherent strengths can more than compensate for various inflation scenarios.

And further data analysis suggests now is a good time to ensure an overweight position. Looking at the NSCI index since 1962, and at the average returns of each of the first four months of each year, smaller companies have produced an average return of 8.6 per cent which compares with just 2.2 per cent over the remaining eight months. This perhaps reflects optimism as each year starts, which then gets tempered (‘sell in May’, etc). There are always exceptions which prove the rule, but this pattern is sufficiently pronounced for it not to be ignored.


Portfolio holdings

We should also remember that small company investment trusts possess a disproportionate number of good managers. Their closed-ended structure allows managers to take the long view, not worried about the short-term money flows which can bedevil unit trust managers. This is important when investing in the more illiquid assets such as smaller companies. Returns have also been enhanced over time by managers being able to borrow and so ‘gear’ the portfolio – which is particularly helpful in rising markets.

As for trust selection within the website’s portfolios, generally, more of a balance has been sought recently between the growth and value investment styles. The portfolios have long been overweight growth regarding equities generally – which has been of benefit. But this overweighting has been reduced somewhat in favour of value given the economic scenario – so too with smaller companies. Otherwise, all holdings mentioned below have performed well relative to their respective benchmarks under their respected managers.

Holdings such as BlackRock Throgmorton Trust (THRG), Montanaro UK Smaller Companies (MTU) and Aberdeen UK Smaller Companies (AUSC) tend to seek quality-growth companies which possess a high return on capital, high operating margins and a differentiated product line – niche businesses in growth markets. THRG use derivatives so it can sell investments it does not own and generate leveraged exposure when positive. Meanwhile, AUSC and MTU apply tailor-made screening processes when seeking opportunities.

In contrast, Aberforth Split Level Income (ASIT) is managed by an avowed value team which has more than held its own over the years given growth has been the dominant investment style. More ‘agnostic’ holdings tend to include Invesco Perpetual UK Smaller Companies (IPU), JPMorgan UK Smaller Companies (JMI) and River & Mercantile UK Micro Cap (RMMC) – the latter focusing on the many opportunities at the very small end of the scale, while prudently ensuring its size reflects the investment mandate.

The portfolios have also long benefited from holding specialist trusts. Herald Investment Trust (HRI) and Augmentum Fintech (AUGM) pursue their particular technology remits which continue to offer exciting returns. Oryx International Growth Fund (OIG), North Atlantic Smaller Companies (NAS) and UIL Ltd (UTL) tend to focus on undervalued investments on both sides of the private/public divide. The managers help these businesses improve their operational performance as supportive and long-term investors.

As a final word, for those seeking income, it is worth highlighting the two highest-yielding trusts in the sector – Montanaro UK Smaller Companies (MTU) followed by Invesco Perpetual UK Smaller Companies (IPU). The former pays a quarterly dividend equating to 4 per cent of NAV, calculated as 1 per cent of each quarter-end value. The latter pays a quarterly dividend equating to 4 per cent of its share price as at the financial year end – the final being the larger. Both are valued as they offer the best of both worlds – outperformance and yield.

With that in mind, I wish all readers a merry and peaceful Christmas, and a happy New Year.


Portfolio performance
1 Jan 2009 – 30 Nov 2021 
Portfolio (%)438.9293.3
Benchmark (%)*222.6162.6
YTD (to 30 Nov 2021) 
Portfolio (%)9.36.8
Benchmark (%)*13.69.1
Yield (%)2.73.5
*The MSCI PIMFA Growth and Income benchmarks are cited (total return)