Funds to buy UK small-cap stocks on a discount

Investment trusts investing in smaller companies are recovering, yet share prices haven’t caught up, says Max King.

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.

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.

Recommended

HubSpot: a tech stock set to tumble
Trading

HubSpot: a tech stock set to tumble

US tech stocks have had a fantastic couple of years. But this year is unlikely to be so bullish for high-fliers that can’t turn big profits.
18 Jan 2022
Unilever slides and GSK bounces after GSK knocks back £50bn bid
UK stockmarkets

Unilever slides and GSK bounces after GSK knocks back £50bn bid

Unilever shares fell to their lowest level in around five years, after its £50bn takeover bid for GSK’s consumer health unit was rejected. 
17 Jan 2022
Cladding crisis: what new proposals for mean for housebuilders and leaseholders
Property

Cladding crisis: what new proposals for mean for housebuilders and leaseholders

The government is seeking an extra £4bn from house developers to fix the UK’s cladding crisis. Saloni Sardana explains how the new proposals affect bo…
17 Jan 2022
Seize these investment trust bargains in 2022
Investment trusts

Seize these investment trust bargains in 2022

Attractive investment trusts are trading at a discount, and those waiting for the perfect time to buy will miss out. Max King picks a selection of the…
17 Jan 2022

Most Popular

Five unexpected events that could shock the markets in 2022
Stockmarkets

Five unexpected events that could shock the markets in 2022

Forget Covid-19 – it’s the unexpected twists that will rattle markets in 2022, says Matthew Lynn. Here are five possibilities
31 Dec 2021
US inflation is at its highest since 1982. Why aren’t markets panicking?
Inflation

US inflation is at its highest since 1982. Why aren’t markets panicking?

US inflation is at 7% – the last time it was this high interest rates were at 14%. But instead of panicking, markets just shrugged. John Stepek explai…
13 Jan 2022
Interest rates might rise faster than expected – what does that mean for your money?
Global Economy

Interest rates might rise faster than expected – what does that mean for your money?

The idea that the US Federal Reserve could raise interest rates much earlier than anticipated has upset the markets. John Stepek explains why, and wha…
6 Jan 2022