UK equities performed dismally in both absolute and relative terms in the first half of the year with the FTSE All-Share index returning -17.5% while the MSCI World index gained 0.5% in sterling terms. The performance of small caps was even worse; the Numis Small Cap index (excluding investment trusts), which represents the bottom 10% of the UK market by value, returned -25%. Explanations for this included the greater domestic focus of smaller companies, the exodus from UK active funds – nearly all of which are overweight mid and small caps – and the relentless move to passive investing, which favours large caps.
Few expected or even noticed a dramatic turn-around in the third quarter. The All-Share index still performed poorly, returning -3.8%, but the Numis index returned 4.7%. Small-cap trusts matched this and mid-cap trusts did even better, yet share prices lagged with discounts to net asset value widening. Trusts that had been trading at, or very close to, net asset value are now on discounts in the mid-teens, with the exception of the long-term star performers, Throgmorton (up 72% over five years) and Standard Life UK Smaller Companies (up 75%), which are on discounts of 2% and 7% respectively.
Better than the FTSE 100
Is this scepticism about small-and mid-cap stocks justified? At the start of the year, they did not look cheap. The price/earnings multiple of the Numis index had increased to 14.9, well above the long-term average of 12.8 and only slightly lower than the All-Share index, according to Paul Marsh and Scott Evans of London Business School. The recent outperformance of small-and mid-cap specialist trusts – by up to 25% in 2019 alone – justified discounts disappearing, but it was hard to see much to attract investors in 2020.
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The situation now looks very different. While the FTSE 100 is weighed down with firms that stopped growing 20 or more years ago, managers of small-cap funds are spoiled for choice. “We fundamentally believe that small- and mid-cap investors shouldn’t be looking at value,” says Roland Arnold, manager of BlackRock Smaller Companies Trust. “If companies haven’t grown historically, they won’t in the future without a catalyst for change. This means a focus on growth and quality, for which we pay a slightly higher multiple of earnings.” The managers of Aberforth Smaller Companies Trust, which is the only value fund in the sector, might not agree with that, but its five year return of -11% is not encouraging.
And investors should not be put off by current problems. “Despite the wider economic malaise, there are plenty of companies doing very well,” says Dan Whitestone, manager of Throgmorton. “The outlook for these companies is probably more compelling today than before Covid-19… There is lots of uncertainty, but there are also some incredibly exciting stocks, secular business trends that have accelerated due to Covid-19 and shares on depressed ratings with recovery potential.”
Stick with tried and tested
When equities are cheap, the best strategy is usually to buy the shares you dare not buy when they are expensive. That points to the Standard Life UK Smaller Companies Trust (LSE: SLS), one of the most growth-orientated in the sector, run by the highly regarded Harry Nimmo. JP Morgan Smaller Companies Trust (LSE: JMI), managed by Georgina Brittain, has an even better record over one and three years, while its shares trade on a discount of 15%.
The Invesco and Henderson smaller companies trusts and the three mid cap ones (JP Morgan, Mercantile and Schroders) also look attractive. But the new Buffettology Trust now being marketed does not. The record of its managers, Sanford DeLand, is excellent but it is for a fund investing across the market, not just in smaller companies. There is no reason to buy shares in a new trust without a proven record at a premium to net asset value when better value is available.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
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