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Time to buy UK small-caps

Following a 33 per cent total return over the past 12 months, the overlooked and outperforming investment trust screen is looking to unloved UK small-caps for the year ahead
October 10, 2017

The diversity of investment opportunities offered by the investment trust sector means it is hard to draw comparisons across the full spread of funds on offer. My outperforming and overlooked screen attempts to square this particular circle by focusing on two broad factors that many students of the market regard as having the most significant influence on future returns: value and momentum.

My 10-year back-testing of this straightforward screening strategy suggested it had promise (see table). So far this has also been reflected in the cumulative performance from the screen in the three years I’ve run it in this column. The portfolios of trusts selected over that time have produced a cumulative total return of 49.2 per cent, or 42.5 per cent if an annual 1.5 per cent charge is included to account for notional dealing costs. This compares with 30.6 per cent from the FTSE All-Share and 29.7 per cent from the S&P Global index.

 

 

Back-test results

Total returnOverlooked and outperforming ScreenScreen with annual costs at 1.5%FTSE All-ShareMSCI WorldFTSE/MSCI blend
10 years to mid-2014305%247%133%95%114%
10 years to end-2013253%201%132%94%

113%

Source: Winterflood Securities, Thomson Datastream

 

The past 12 months have seen the screen on particularly good form, with its 10 2016 trust picks delivering a total return of 33 per cent compared with the FTSE All-Share’s 14.4 per cent and 20.2 per cent from S&P Global.

 

2016 performance

NameTIDMTotal return (27 Sep 2016 - 2 Oct 2017)
TR European GrowthTRG61%
Allianz TechnologyATT45%
Pacific HorizonPHI36%
Edinburgh WorldwideEWI36%
Templeton Emerging MarketsTEM34%
Baillie Gifford JapanBGFD32%
JP Morgan AsianJAI31%
Scottish Investment TrustSCIN23%
Invesco AsiaIAT21%
JP Morgan IndianJII12%
S&P Global 1200-20%
FTSE All Share-14%
Overlooked and Outperforming-33%

Source: Thomson Datastream

 

Value

To hunt for value, this screen looks at the discount investment trusts tend to trade at compared with the net asset value (NAV) of the underlying portfolio. However, as discounts tend to vary widely depending on the type of assets a trust invests in and its track record, the screen doesn't set store by the absolute level of an individual trust’s discount, but rather it looks at a valuation measure called the Z-score. The Z-score (not to be confused with the Altman Z-score, which can be used to assess the financial health of individual companies) offers investors an insight into valuation that can be used to compare all trusts on equal terms. The metric does this by producing a standardised score based on where a trust's share price discount or premium to NAV stands compared with its range over a given period (one year in the case of my screen). A negative Z-score suggests a trust is, by its own standards, on the cheap side (the larger the negative score the cheaper). A positive score suggests a trust is expensive. Because each trust is having the current valuation of its shares to NAV assessed in comparison with its own history rather than other trusts, the Z-score measure can then be used to make comparisons between trusts with very disparate valuation characteristics.

 

Momentum

The other factor the screen looks at is share price performance. Specifically, the screen wants to see strong share price performance over three months. The fact that it looks at price and not NAV performance means it gives some credence to the wider market view of a trust’s prospects. For example, if sentiment has been improving towards a trust, thereby narrowing its discount over the three months, this means stronger momentum and a more favourable ranking from the screen. Scepticism implied by a widening discount will be taken into account because it will hold back overall price performance, which will be viewed less favourably by the screen. That said, the overall objective when combining momentum with value is to find promising performance trends that the market has not yet fully priced in.

 

Bringing it all together

To assess both factors together, the screen uses the ranking method employed by hedge fund manager Joel Greenblatt in his two-factor 'magic formula' (the magic formula uses different inputs). The method simply ranks both factors and then adds the rankings together to find the 10 trusts with the most attractive combined ranking. I also apply a set of rules to the screen results aimed at avoiding excessive focus on a single theme or on trusts that are likely to prove highly illiquid.

 

The 10 top ranking trusts are listed in the table below. I’ve taken a look at the two themes evident in the top 10 trusts and given a quick precis of the trusts that do not fit into either of these two broad categories.

 

NameTIDMPriceMkt CapDiscount to NAV  Z ScoreDYGearingNAV Performance    Price Performance    
----NowAvgLowHigh---1m3m6m1y3y5y1m3m6m1y3y5y
BlackRock Throgmorton TrustTHRG447p£327m-26%-17%-13%-26%-5.01.8%127%14%22%29%50%102%180%0.4%5.3%19%34%74%157%
Scottish MortgageSMT426p£5,948m-0.5%1.3%4.4%-1.6%-1.80.7%109%-0.1%10%18%31%92%189%-2.3%6.1%16%29%91%220%
Polar Capital Global Financials*PCFT138p£279m-16%-5.4%2.8%-16%-3.82.7%107%15%16%19%43%72%-2.8%4.8%5.2%36%53%-
BlackRock Latin American*BRLA484p£190m-13%-13%-7.8%-16%-0.52.3%105%2.1%18%9.1%24%26%20%1.3%18%10%22%23%14%
Biotech Growth TrustBIOG841p£470m-7.1%-6.3%1.3%-10%-0.5-111%-1.3%8.9%14%18%49%197%-0.4%8.9%12%18%49%180%
Dunedin Smaller CosDNDL247p£118m-19%-18%-13%-23%-0.52.5%104%2.5%9.1%15%25%53%110%2.7%6.5%13%21%49%81%
BlackRock Smaller Cos*BRSC1,251p£599m-16%-14%-10%-20%-0.81.7%110%3.9%11%18%37%80%163%0.4%4.7%19%36%74%161%
JPM Smaller CosJMI985p£168m-19%-19%-16%-22%-0.11.9%113%0.7%11%12%24%46%105%1.8%9.1%13%23%42%109%
Polar Capital TechnologyPCT1,054p£1,400m-0.8%-0.8%3.0%-7.0%0.0-103%0.5%8.4%12%28%99%169%0.5%9.3%14%30%109%166%
Henderson High IncomeHHI191p£358m-0.6%1.4%4.3%-1.7%-1.84.9%123%0.7%2.2%3.1%10%36%87%-1.2%2.3%-0.7%6.0%30%80%

Source: Winterflood Securities. *The author holds shares in these investment trusts

 

A big bet on UK smaller companies

One clear theme that has emerged from this year’s screen is a focus on UK smaller companies trusts. Smaller companies tend to be more domestically focused than large-caps, which means they have been subject to Brexit-related economic fears. This seems to be reflected in the discounts on smaller companies trusts. But while there is plenty of angst about the outlook for the UK economy, the actual experience to date has not proved anything like as bad as many had expected.

What’s more, the FTSE Small Cap index has delivered a 14.7 per cent total return in the year to date and the Aim All-Share is 21.5 per cent ahead. That compares with 8.0 per cent from the very international FTSE 100. The risk for investors in UK smaller companies, as reflected in the wider-than-usual discounts of many trusts in the space, is that the pain may have simply been slower than expected to materialise as opposed to overstated. But perhaps the biggest issue that UK-focused investors face at the moment is simply uncertainty, and as the UK and EU flesh out terms of a deal we could see anxieties reduce and discounts tighten.

Of the trusts highlighted above, Blackrock Throgmorton (THRG) looks particularly interesting. Not only is its performance record strong, but the trust is relatively highly geared (a structure that exaggerates investment returns, both good and bad). The gearing relates to the fact that the trust runs a long-short contracts for difference (CFD) portfolio equivalent to a maximum of 30 per cent of its assets. This portfolio has been making positive returns recently.

Despite the trust’s whizzy features, or perhaps because of them, the discount is wide. The trust’s board has recently sort to make the trust more attractive by cutting its base fee to one of the lowest in the sector, while increasing its performance fee. The discount has actually moved out since the fee change despite the fact the trust has been shooting the lights out. Given the lacklustre response to recent tinkering, the trust’s board may find itself under pressure to come up with a discount-narrowing proposal that tackles the issue of valuation directly.

 

Technology plays on

The other mini-theme to emerge from this year’s screen, which also proved a profitable punt for the screen last year, is technology funds. While it is only the Polar Capital Technology (PCT) fund that has the “tech” name on the tin, the blue-chip Scottish Mortgage (SMT) trust is also firmly focused on the companies of the future. In fact, given the reticence of some of the most exciting tech companies of recent years to float shares on the market, Scottish Mortgage recently increased the proportion of its portfolio that it can allocate to private equity to 25 per cent.

There are many very vocal sceptics on the subject of tech stock valuations. But nevertheless the prices of technology companies keep rising and the promise of many such companies is hard to deny. That said, tech has underperformed other sectors in recent months, which, coupled with valuation angst, has been enough to move both Polar Capital Technology and Scottish Mortgage off premiums and onto narrow discounts.

 

Polar Capital Global Financials

Ten years on from the global financial crisis and there is an increasing feeling that big banks are once again 'investable'. The Trump administration’s desire to roll back financial regulation has also helped sentiment. More significantly, though, rising US interest rates – especially rising long-term bond yields – are fuelling hopes of increasing profitability in the sector. Expectations for further rises have recently been piqued by comments by the Federal Reserve and the reheating of talk about tax reform – something that could potentially result in fiscal stimulus that would further encourage rate rises. All the same, the discount on the shares of the highly specialist Polar Capital Global Financial (PCFT) trust suggests the market is yet to fully buy into the notion that banks are back.

 

BlackRock Latin American

Economic prospects in Latin America look as though they could be set to pick up, and particularly in Brazil where BlackRock Latin American (BRLA) has 63 per cent of its assets. The Brazilian economy has been rocked by political turmoil and recession in recent years, although its stock market actually bottomed out in early 2016 and has been on a tear since then. The political situation in Brazil has started to look more stable again recently, which should allow the government to focus on economic reforms. Meanwhile, inflation is falling, which should give the Brazilian central bank more leeway to loosen monetary policy and aid a recovery. Firmer commodity prices have also helped the resources-heavy economy. As well as Brazil, the BlackRock trust is keen on Argentina due to a political push towards economic reform.

 

Biotech Growth Trust

The US is the home of big biotech companies, and that is where 93 per cent of Biotech Growth Trust’s (BIOG) investments are to be found. The Trump presidency has had quite an impact on sentiment toward the sector. Despite much sabre-rattling about drug prices and plans to repeal Obamacare, little has really happened to affect the industry since Trump became president. And while concern about tough reforms has lifted, hopes are now building that tax reform, the next item on the presidential agenda, could prove good news for healthcare companies due to the prospect of repatriating overseas earnings without a swingeing tax hit. The Biotech Growth trust has a discount control mechanism aimed at keeping the discount at or above 6 per cent. Given the current discount is below that level, the board is likely to be thinking about going into the market to bring the discount in.

 

Henderson High Income

Like BlackRock Throgmorton, the Henderson High Income Trust (HHI) stands out for its level of gearing. For investment trusts, gearing normally involves borrowing money to invest in the market. If the return on the investments made is greater than the costs of borrowing, then gains are enhanced, but the reverse is true when investment returns are poor. For Henderson High Income the gearing contributes to its aim of producing a high dividend from a portfolio of predominately UK shares, along with some fixed-interest investments, which currently represent about a tenth of the portfolio. The trust has a firm focus on valuation to guide its investment decisions and currently has about a quarter of its portfolio invested in financials and about 35 per cent split between consumer goods and services companies.