Retaining trust in smaller companies

Long-term case

We at Equi are sometimes asked why our nine real investment trust portfolios tend to retain an overweight position to smaller companies, even though this sector has been underperforming of late. The answer is simple – the asset class has outperformed over the long term, for good reason, and we believe it will continue to do so, and our portfolios are invested for the long term. The fact that smaller companies exhibit greater volatility should therefore be seen as an opportunity.

Recent research confirms the extent of the outperformance. Professors Paul Marsh and Elroy Dimson of the London Business School have 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 has produced on average an annual return of 9.7 per cent, compared with 6.4 per cent for the All-Share index.

This may sound a small figure, but such small figures become big ones over time. The NSCI index has now risen by a multiple of eight over this period relative to the wider market. While the FTSE 100 has hardly made any progress since the start of the century, the NSCI has risen four times. Such outperformance is in fact replicated by smaller companies worldwide – and to a slightly larger extent.

This is set to continue for a variety of reasons. For one thing, it is easier to grow when small. Many smaller companies operate in niche and growing markets, are more nimble and offer faster growth in part because they are particularly benefiting from the advance of technology. Indeed, the technology that is disproportionately helping these smaller companies to reduce costs and find new markets is also helping them to embrace disruptive practices and therefore better compete with their larger brethren.

Such considerations are set to become increasingly relevant to investors, and may actually help to account for increased outperformance over the long-term. In an economic environment of low growth and high debt, the larger companies are going to struggle to consistently produce the returns of the past courtesy of increased competition eroding their margins. A few genuine growth stories, particularly in the technology sector, will continue to command lofty ratings.

However, many will be slow to respond to this changing environment. Some will wither at a rate faster than first imagined, as organic growth becomes ever more elusive as technology continues to favour the small. The assumption that ‘big’ is ‘strong’ will come to be increasingly tested across large swathes of the stock market. The column ‘Where are our pioneering giants?’ (8 February 2019) touches on this theme in more detail.

A smaller company bias will therefore certainly continue to be one of the more reliable investment strategies in generating higher returns over the long-term, relative to the wider market. This will also be helped by the fact that many are also becoming more important to those investors seeking income, given the number of high-profile dividend cuts seen in recent years.

Short-term opportunity

However, sentiment recently has been impacted by misguided concerns about Brexit. As highlighted in previous columns, the consensus is so cautious about the UK market that it is now the most unpopular in the developed world – more so than even Japan. Various reports and studies from the likes of BlackRock, Merrill Lynch, Morgan Stanley, Morningstar and various other commentaries have set in context the extent of this unpopularity.

Within this broad de-rating of the market, small companies have been impacted even further. As can be seen from the first of three tables, courtesy of Montanaro, the asset class has underperformed the All-Share index in three of the past four years, including 2019 to 30 September. This run of underperformance since the referendum result is unusual given the sector’s long-term record of having outperformed the index in 42 out of the past 64 years.

In part, this recent underperformance has been because of investors’ preference for larger companies with significant overseas sales both as a hedge against a weaker currency and a poor performing economy courtesy of concern regarding Brexit. Table two illustrates the extent of this trade.

It compares the performance of a FTSE UK Local index, consisting of all UK-listed companies with more than 70 per cent of their sales in the UK (‘UK domestics’), to that of the broader All-Share index (‘UK exporters’). Rebased to March 2009 for context, it shows that by the time of the referendum in June 2016 there was nothing between the two – with both producing a return just exceeding 70 per cent. Indeed, the gap between the two never exceeded more than 15 per cent at any one point during this period.

However, following the referendum result, performance has increasingly diverged, with UK domestics now having underperformed by 28 per cent up to September. It is difficult not to conclude that misgivings about Brexit, particularly concern regarding a possible ‘no-deal’, have been a – if not the – cause. I believe this to be misguided.

The evidence shows economic investment is about relative advantage. Lower corporation taxes, greater labour market flexibility, our language and financial expertise, top universities and skilled workforce are, in aggregate, more important drivers of investment than World Trade Organisation (WTO) tariffs averaging 3-5 per cent should the UK leave on no-deal terms. Witness the present strength of the UK economy in the full knowledge that no deal is a possibility – the unemployment rate being nearly half that of the EU average.

In all likelihood, the prime minister’s deal makes no deal far less likely. By confounding his critics and opening up the Withdrawal Agreement, Boris Johnson has removed the so-called backstop. This alone could have seen the UK indefinitely placed in a structure of the EU’s making if trade talks had failed leading up to December 2020. With the backstop removed, there is now an onus on both parties to negotiate a deal.

And this should not be difficult given both start from a common position on tariffs and regulations after 47 years of integration, and it is in both parties’ interests to obtain a good trade deal. And when the penny drops, the market will start playing catch-up. It may even start climbing the wall of worry regarding the general election.

While not believing the more optimistic forecasts, I believe the Conservatives will be returned with an overall majority as long as it maintains possession of the narrative that, in trying to honour the referendum result, it has been up against a remain parliament. The last election was an enigma to many – there can be no doubting this time. A positive campaign and One Nation intent (ie a stronger economy to better help the less fortunate) will help.

Timing and style

The stage is set. But when will the expected outperformance start? It could be shortly. No one can doubt the negative sentiment. Figures showing net money flows regarding UK small company funds highlight that outflows have accelerated in 2019 – the highest in 10 years. Up to 30 September, the figure is £619m – the total being £2,918m since 2007. It is no surprise therefore that the trailing dividend yield on the Numis index was at a 10-year high – standing at 3.3 per cent.

Yet recent research suggests UK small companies offer handsome returns over the medium term. Total return estimates have been calculated for a number of asset classes based on four components reverting to mean – sales growth, dividend yield, profit margin and price/earnings (PE) ratio rerating. The estimates suggest the Numis (ex IC) index is set to produce annual returns of 9.5 per cent – helped by the trailing PE ratio currently not looking expensive. This compares with 5.9 per cent for the All-Share, 4.0 per cent for MSCI Europe and -0.2 per cent for the S&P 500.

Such analysis is of course subject to nuances, but it does capture a number of key metrics, which give a sense of perspective as to the extent the Numis index looks attractive. As for the present, history suggests the current and first quarters are usually very positive for the index. Since 2000, the fourth quarter has produced a positive return 68 per cent of the time and the first 75 per cent – this compares with just 50 per cent for the second and third quarters.

But which type of small company should an investor be looking to? After all, different investment trusts pursue different styles. Once again, history offers an insight. Chart 3 compares small and large companies globally since 1989 both by way of high and low quality – ‘quality’ being defined by way of various components grouped into the four categories of profitability, growth, safety and payout, while the size differential is defined as the 80th percentile by country. The results are expressed as the excess return over Treasury Bills.

They show ‘Small High Quality’ having significantly outperformed the rest – producing a return of 8.5 per cent a year. The next best performing category was ‘Large High Quality’, which produced 6.2 per cent. Various factors account for this, but perhaps the most relevant is that smaller companies have less of a safety margin when things go wrong, and yet can produce spectacular results when they get it right courtesy of their size. In addition, sentiment usually favours ‘growth’ companies in general during periods of slow economic growth.

The advantages of investment trusts?

While I believe UK small companies are due a period of outperformance, helped by the domestic market rerating once perceptions about Brexit improve, I have even more confidence in the ability of smaller company investment trusts to continue to deliver good relative returns. This is in large part on account of their closed-end structure, which allows fund managers to gear and to take the long-term view.

Smaller companies also tend to be ignored by the large institutional fund managers because of liquidity – the sector is therefore under-researched and provides a host of opportunities for good fund managers. Indeed, research earlier in the year suggested that, on average, investment trusts have outperformed the NSCI by 14 per cent over five years and traded on a discount of around 10 per cent.

This compared with trusts in the ‘UK equity income’ sector, which broadly matched the All-Share index and yet traded on a discount of less than 5 per cent. The average performance figure for trusts in the ‘UK all companies’ sector was somewhat worse still while the discount was around 7 per cent. The message is clear.

The trusts held across our nine real investment trust portfolios managed on the website www.johnbaronportfolios.co.uk include BlackRock Throgmorton Trust (THRG), Henderson Smaller Companies (HSL), Herald Investment Trust (HRI), Montanaro UK Smaller Companies (MTU), Standard Life UK Smaller Companies (SLS), Invesco Perpetual UK Smaller Companies (IPU), Oryx International Growth Fund (OIG), Aberdeen Smaller Companies Income (ASCI) and JPMorgan Smaller Companies (JMI).

All have performed well, a few offer yields of 4 per cent and more courtesy of dividend payments from capital based on 4 per cent of the price (IPU) or NAV (MTU), and some trade on discounts well into double figures. While portfolio balance must always be maintained relative to remit, investors should increasingly look to such trusts, particularly at this point in time. The future is indeed small – and portfolios need to be positioned accordingly.

John’s book explores the merits of investment trusts, the stepping stones to successful investing, and how to run and monitor a trust portfolio. Available from Amazon and other bookshops. A further edition is now being prepared.

John Baron waives his fee for this column in lieu of donations by Investors Chronicle to charities of his choice. As these are live portfolios, he has interests in all of the investments mentioned.