Two small cap investment trusts with growth potential

Since 1955, the Numis Smaller Companies index, representing the bottom 10% of the UK market, has returned a compound 14.1% per annum compared with just 11% for the FTSE All-Share index. But its outperformance has been far from consistent. 

Small caps underperformed for most of the decade to 1998 before bouncing back strongly in 1999. They have underperformed again since 2016, and now trade at less than 12 times expected earnings, below the long-term average. This is more expensive than the FTSE 100, which trades at a 15%-20% discount to its long-term average. 

But, it is argued, there is much more growth potential in smaller companies than in large ones. Small-cap managers such as Robin West of Invesco Perpetual argue that small caps’ performance will bounce back, as it did in 1999. 

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“Average returns when small caps were this cheap have been 22% over the next 12 months and 42% over the next 24 months,” he says. With the shares of small-cap trusts, such as his, trading on discounts to net asset value (NAV) of 10%- 15%, this precedent promises excellent returns. 

Two small cap trusts under the spotlight

It depends, however, on growth in corporate earnings, which hasn’t been helped by the increase in the rate of corporation tax from 19% to 25%. A small-cap manager needs to find companies with exceptional prospects to overcome political and fiscal headwinds, to take an active role in shaping the company’s management and strategy, and to guide the company towards a sale at a premium. 

That is what two trusts under Harwood Capital Management’s banner, Rockwood Strategic (LSE: RKW) and the Odyssean Investment Trust (LSE: OIT), seek to do. Rockwood is managed by Richard Staveley and has a market value of £90m; Odyssean is managed by Stuart Widdowson and Ed Wielechowski, and has a market value of £230m. Both have concentrated portfolios. 

Odyssean has fewer than 20 holdings, while Rockwood aims for between 25 and 30. Rockwood typically invests in companies with a market value of below £200m while Odyssean’s companies are larger. It focuses on higher quality growth companies, while Rockwood is keener on “recovery” plays (struggling companies with the potential for a turnaround).

Index-beating five-year returns

Both trusts trade at a premium to NAV, which has enabled them to issue new shares. Although Odyssean returned an underwhelming 9% over the last year against 14% for the Numis index, its five-year return of 66% is far ahead of the 26% for the Numis index. Rockwood’s numbers are even better: 23% over one year and 129% over five.

Odyssean’s fortunes appear to be picking up, with a second-quarter return of 10.4%, twice that of the Numis index. Two of its largest holdings, Elementis (13% of the portfolio) and XP Power were bid for by private equity this year. Both bids were rejected as undervaluing the companies, despite XP’s bid representing a 70% premium to the prevailing share price. 

Widdowson and Wielechowski are optimistic about their other large holdings, cybersecurity consultant NCC (14%), inkjet manufacturer Xaar (9%) and industrial LED specialist Dialight (6%). Proceeds from the takeover of Ascential, previously a 10% holding, were received in May and “we are not short of good investment ideas”, say its managers.

Takeover benefits

At Rockwood, Staveley has also benefited from a series of takeovers and he expects more as the small-cap sector continues to shrink. Like Odyssean’s managers, his approach is “to engage with companies rather than be hostile. 

The key is to come up with a good idea”, although that often involves installing a new chairman or CEO. Rockwood’s holding in a company may be modest, but if other Harwood funds also own shares, management will listen. Rockwood’s largest holding, at 11.6% of the portfolio, is RM, a supplier to the UK education market. The company “has agreed to dispose of two divisions, enabling it to pay off £50m of debt”. That will leave it with market-leading positions in “assessment services”, marking exams internationally, and in educational supplies to primary schools in the UK. In exam marking, it has recently been awarded a new contract with International Baccalaureate “worth £100m”, underpinning growth of 10% per annum and 22% margins. RM is currently valued at £70m, but Staveley thinks it is worth £175m.

Filtronic, 10% of the portfolio, was once a telecoms technology high-flyer but made a disastrous acquisition and its market value fell to £25m, when Staveley started buying. It is still a market leader in walkie-talkies technology, but the excitement comes from its emerging interest in space, where it has gained key contracts with SpaceX’s Starlink phones network and expects to win business from Jeff Bezos’s space venture. 

SpaceX has acquired warrants in Filtronic and its market value has multiplied to £160m. Other holdings include Capita, “the biggest blind spot in the UK market: everyone who has tried to own it has lost money”. The market value fell to £240m compared with £2.6bn of sales, but Staveley thinks the target of margins of 6%-8% is “unambitious”. 

The pension problem has been solved, the debt is mostly repaid following the sale of a software business and the stock is recovering. Staveley has also bought 3% of lending platform Funding Circle, which listed at a value of £1.5bn in 2018, but has never made money. Its share price fell by over 90% despite “£175m of unrestricted cash”. Costs have been cut, a loss-making US business sold and “Investec thinks profits could reach £35m in two years”. The share price has trebled since Staveley started buying.

The end of the index is just the beginning

Investment bank Peel Hunt has pointed out that the number of companies in the FTSE Small Cap index (which excludes Aim) has fallen from 160 in 2018 to 114 at the end of 2023. “If this decline continues, the index will cease to exist in 2028,” it says. This has caused much anguish among small-cap managers, but it may prove too alarmist. 

Whether the UK’s small cap sector disappears or recovers, the managers of these two trusts at Harwood see plenty of opportunity for profit, whether from companies prospering or being taken over. The former will often lead to the latter and Harwood, unlike most managers, takes an active role in guiding them in the right strategic direction, using considerable in-house private equity experience. 

The toughest call is to decide which one to buy. Perhaps both?

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