Small caps’ big rebound potential
Take advantage of the wide range of investment trusts covering this frequently overlooked sector
It has been a long time since anyone from overseas tipped British shares. So when Brian Chingono of US investment firm Verdad recently wrote an article entitled “Rule, Britannia!”, it was time to take notice. Chingono says the UK “seems mired in 1970s-style stagnation”. He adds that “Brexit seems to have been a negative inflection point” for small firms’ valuations and corporate margin spreads, the difference between UK and European profit margins. He compares these for the three years up to 2020 with the three years after, which appears to support the argument of a modest fall in margins (from 11.8% to 10.5%) and a larger one on spreads (from 2.5% to 0.9%).
Brexit may have been a factor, but there were others, such as differing consequences of Covid and varying points in the economic cycle. Overseas investors also became averse to UK shares just as domestic institutional investors were divesting. Fund inflows before 2016 turned into outflows in six of the eight following years. As a result of this and lower profit margins, UK stocks “used to trade at higher valuations than those in continental Europe, but now trade at a discount”.
Lagging global rivals
Now, small caps in the UK trade on a price/earnings (p/e) ratio of 10.4 compared with 11.5 in Europe and 13.9 in the US, while yielding 4% against 3.8% and 1.6% respectively, “reflecting investors’ opinion of the relative growth prospects in each region”. However, “it appears that the bad news around Brexit has been priced in, but what’s not priced in is the upside from here”. This stems from the potential for acquisitions. Chingono notes 27 in 2022 and 2023, half from private equity, the latest being Currys. It is also not clear that economic growth in the UK will remain lower than in Europe, nor that profit margins will be lower. UK small caps derive less of their turnover and profits from overseas than large caps, but the proportion is still large, reducing dependence on the UK. The UK, like Europe, has fewer listed growth companies than the US, but Verdad thinks “there is a strong case for upward mean reversion” in the valuation of UK and European small-cap value stocks, “which trade at their widest discount to growth since 1975”.
What Chingono misses is that there is a broad choice of UK-listed investment trusts specialising in small caps, with a long-term record of outperforming the Numis Small Cap index (NSCI, the bottom 10% of the UK market) and trading on attractive discounts to net asset value (NAV). The average discount for the 20 trusts in the sector is 12% and the mean investment return over five years is 29%, compared with 22% for the NSCI excluding investment trusts.
These trusts should benefit from four trends. First, small caps globally have been left behind large caps and are due to catch-up. Second, UK small caps should catch up with European valuations, if not US ones. Third, small-cap investment trusts should outperform as performance picks up. Finally, discounts should narrow as the sector returns to favour. It might be presumed that the bestperforming small-cap trusts trade on narrower discounts than average, but this is not the case. The Aberforth Smaller
Companies Trust (LSE: ASL), with a market value of £1.1bn, has returned 22% over three years, but trades on an 11% discount to NAV and yields 3.1%. Value has outperformed growth in small caps in recent years and Aberforth is valuefocused. The historic multiple of its holdings is just 7.9 times compared with 12.8 for the index. But it does not invest in shares on Aim, which excludes much of the small-cap universe.
Where to look now
Odyssean Investment Trust (LSE: OIT) and Rockwood Strategic (LSE: RKW), both managed by Harwood Capital, have market values of £192m and £58m respectively and three-year investment returns of 21% and 64%, but trade on small premia to NAV. Their approach is “active”: they acquire meaningful stakes in underperforming companies and precipitate an improvement or sale. The Mercantile Investment Trust (LSE: MRC) is the giant of the sector, with a market value of £1.7bn. But it is focused on mid, rather than small, caps and some of its holdings are large caps. This has bolstered its performance (8% over three years). The shares yield 3.4% and trade on a 12% discount to NAV. The Schroders UK Mid Cap Fund (LSE: SCP), with a market value of £200m, is smaller but has no FTSE100 stocks, trades on an 11% discount and yields 3.6%. The UK mid-caps have performed better than small caps in recent years, so they are not as cheap.
JPMorgan also manages the JPMorgan UK Small Cap Growth & Income trust (LSE: JUGI), recently formed from the merger of separate mid- and small-cap trusts. Both had negative performances over three years, being growthorientated, but the small-cap trust was a star performer over five. The shares of what is now a £400m trust trade on a discount of 14%. BlackRock manages two UK small-cap trusts: the Throgmorton Trust (LSE: THRG) and the Smaller Companies Trust (LSE: BRSC), with £640m and £580m of market value respectively. Being growth-orientated, both have negative returns over three years but good long-term records. Smaller Companies has the better yield at 3% versus 1.8%.
The Henderson Smaller Companies Investment Trust (LSE: HSL) yields 3.3% and the Invesco Perpetual UK Smaller Companies Investment Trust (LSE: IPU) 4.3%. They too are growth-orientated, so they have negative returns over three years and trade on double-digit discounts, but the former has a market value of £580m; the latter only £140m. Abrdn UK Smaller Companies Growth Trust (LSE: AUSC) with £350m was once, as Standard Life Smaller Companies Trust, the star of the sector, but the manager retired and it merged with an Abrdn trust. That leaves Montanaro UK Smaller Companies Investment Trust (LSE: MTU), trading on a 16% discount and yielding 4.6%, with £166m of market value and an investment record in line with the other growth trusts; and the similarly sized Strategic Equity Capital (LSE: SEC) trust, with an active value approach and formerly managed by the Odyssean team. That ensures a three-year return of 20%, in line with Odyssean. The shares trade close to NAV, but have a yield below 1%.
There’s much choice among growth trusts, but less among activist ones. Aberforth is on its own in terms of value. There’s a good case for owning more than one trust, but don’t avoid the sector entirely.