A cheap small-cap trust for the (eventual) recovery

For the patient investor, the case for small caps looks attractive. Historically, US small caps have tended to outperform large caps in the year after a recession, according to analysis by index provider MSCI. On a 10-year investment horizon, developed small caps outperformed developed large caps 81 per cent of the time. The figure was 80 per cent for emerging markets and rose to 90 per cent over 15 years.

Last year was equally bad for large and small listed companies, with both the blue-chip and small-cap versions of MSCI’s All Country World indices down 8 per cent in sterling terms. Since the start of 2023, recovery has been weighted towards larger companies, with the MSCI ACWI up by 7.5 per cent against 2.3 per cent from its small-cap equivalent.

Whether or not the UK and the US will tip into a recession remains uncertain. Some economists believe the US might manage a so-called ‘soft landing’, whereby inflation is tamed without smothering growth. Meanwhile, the IMF expects comparatively weak levels of global growth of 3 per cent in both 2023 and 2024.

Either way, when the recovery takes hold and investor sentiment changes, small caps should be well-positioned. The chief reason: fundamentals look solid. MSCI analysts found that as of May 2023, small caps were trading at historically cheap valuations, while profitability was close to a historical high compared with the past 15 years.

Truly global 

UK-focused investors have ample choice of investment trusts dedicated to domestic small companies, but for those hoping to hedge their bets with a wider geographical exposure, the selection is more limited. The main trusts in this area are Baillie Gifford’s high-octane Edinburgh Worldwide (EWI), the Herald Investment Trust (HRI), which focuses on technology and media companies, the Smithson Investment Trust (SSON) and the GSCT.

Stifel analysts recently labelled GSCT a “well-diversified one-stop shop” for exposure to global small and mid-sized companies. “The portfolio is relatively balanced in terms of its weighting in growth versus value stocks, certainly compared to other trusts which have become growth-focused,” noted its analysts. 

The managers aim to invest in quality companies that are attractively priced. They look for companies with competitive advantages, pricing power and positive cash flows, while generally avoiding “conceptual and speculative companies without a track record of profitability”.

Unlike Smithson, GSCT looks beyond developed markets, and has a particular focus on Asia. While potentially risky, small emerging market companies have advantages, including the index’s lower levels of concentration and more balanced country composition, and lower exposure to China. This distinction has been especially important of late. In the year to date, the MSCI Emerging Markets Small Cap index is up 7.8 per cent, compared with a 1.9 per cent decline in the MSCI Emerging Markets index.

To do this, GSCT takes stakes in funds and investment trusts focused on Japan, emerging markets, and Asia, while investing in single companies in the UK, Europe and North America.

Investment trust aficionados will recognise two of its key holdings in the region, namely Scottish Oriental Smaller Companies (SST) and Utilico Emerging Markets (UEM), which as of 31 July accounted for 3.3 per cent and 2.5 per cent of the portfolio, respectively. The first invests in Asian smaller companies, while the second focuses on infrastructure and utilities in emerging markets; both have had a solid year to date, with share price total returns in the region of 7 per cent.

Despite this double layer of fund fees, the trust’s ongoing charges are among the cheapest in the sector at 0.79 per cent. It also slightly reduced its management fees in May, although the use of external managers does make it harder for investors to get the full picture of the underlying holdings.

Portfolio

While the remit is global, around a quarter of the portfolio is concentrated in UK small caps, slightly above a benchmark split one to four between domestic and international stocks. This ratio used to be 30 to 70 per cent, until it was reduced earlier this year to reflect the shrinking weight of the UK in global markets. As a result of this domestic focus, the trust has lower exposure to the US than the MSCI ACWI Small Cap index. Together with a greater balance between growth and value, this comes with a risk of underperformance if US growth stocks are hot.

The trust has recently struggled to keep up with its mixed index benchmark. In the year to 30 April, its net asset value (NAV) dipped 2.9 per cent against the benchmark’s 2.1 per cent fall. The UK and European portfolio underperformed, while North America, Japan and emerging markets were ahead. 

The trust’s top single holdings include LKQ (US:LKQ), an American distributor of automotive parts, and Kirby (US:KEX), an owner and operator of tank barges, whose shares – buoyed by re-shoring trends – are up by almost 30 per cent so far this year. Within the UK, one of the trust’s largest holdings is buy-to-let lender OSB Group (OSB), whose shares slipped in July after the company announced a write-down in expected income from its mortgage book.

Like many investment trusts, GSCT is looking cheap, trading at a discount to NAV of 13.2 per cent as of 24 August. Smithson, by contrast, sits at a 10.3 per cent discount. A buyback programme is ongoing, although chair Anja Balfour has noted that share repurchases are unlikely to reverse sentiment on their own. Still, she has argued they are in shareholders’ interest, “providing liquidity for those in need of an exit along with NAV accretion to remaining holders”.

Unlike the rest of the AIC’s Global Smaller Companies sector, GSCT pays a small dividend, equivalent to a 1.6 per cent yield, and makes the AIC’s ‘dividend hero’ list with 53 years of consecutive dividend increases. In the year to 30 April, the dividend was raised by 25 per cent on the prior year, comfortably beating inflation.

High interest rates, considerable inflation and economic uncertainty do not make the most fertile environment for small caps, and trying to time a recovery is usually a fruitless endeavour. But for investors who want to be ready when better times come, GSCT should make a solid, straightforward way to gain exposure to this sometimes-overlooked corner of the market.