Data stretching back to the 1950s reveals a “smaller-companies effect”: small stocks outperform larger ones around the world. They are less liquid, riskier and less well-known than their bigger counterparts – outperformance compensates for these shortcomings.
In recent years, though, smaller companies have been left behind. In the UK, for example:
- The Numis index, comprising the bottom 10% of the market, has returned 11% over the last three years and 5% over five.
- The All-Share index has returned a respective 34% and 23%.
- The MSCI World Small Companies index has returned 15% in sterling over three years and 28% over five.
- The All Countries World index has returned 24% and 52%.
This trend of underperformance discourages people from investing in smaller companies, creating a vicious circle. At some point, this cycle will reverse suddenly and dramatically, but the timing is impossible to predict.
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If times are bad for smaller companies in general, they are worse for small-cap funds, especially investment trusts. Most of them have underperformed their benchmark indices and the discounts to net asset value (NAV) at which their shares trade have widened dramatically. The average global fund has lost 5% over three years, 20% behind the index, in NAV terms, but the average share-price decline has been 13%, according to Winterflood Securities. In the UK, the average fund has returned 12%, 23% behind the index in NAV terms and 15% in share-price terms, as discounts to NAV have narrowed a little.
Not all small-cap funds are lagging their benchmark index. The winners are overwhelmingly those that focus on investing in “value” rather than “growth” companies. This is in marked contrast to larger companies, where “growth” has outperformed thanks to the startling performance of the top eight US mega-caps in the S&P 500 index. Also notable is that the outperforming small-cap funds are mainly “active value” trusts in which the manager doesn’t just wait for the management of an undervalued and underperforming company to instigate a recovery strategy, but prods them into action.
What makes this possible is that the stake owned by a trust’s manager and associates will be larger than in a big company, so management is much more likely to respond if shareholders agitate for a general meeting to oust the directors. In the UK and much of the world, the recovery strategy of a large or medium-sized company is left to management, which means it can be a long wait for shareholders. Here are the most conspicuous outperforming small-cap trusts:
1. North Atlantic Smaller Companies
The £675m North Atlantic Smaller Companies (LSE: NAS) trust, managed by Christopher Mills since 1982, has risen 200-fold, including dividends, in the last 40 years. Mills is very much an active-value investor, combining a persuasive and nearly always successful combination of carrot and stick. He has sat on the board of over 100 companies in his career, founding Harwood Capital, which has £2bn under management, in 2013.
The portfolio is invested in sister trusts, such as Oryx and Odyssean, private-equity funds and companies such as Polar Capital and Ten Entertainment. UK exposure is significantly higher than in the past. Performance over the last year has been just 3%, despite a flurry of takeovers in the portfolio, but the three- and five-year numbers are well ahead of the benchmark at 23% and 41%. Despite this, the shares trade at a 31% discount to NAV. With a personal stake of over 28% of the company, nobody can doubt Mills’s commitment.
2. Aberforth Smaller Companies
With over £1bn of assets, Aberforth invests solely in the UK market as a passive value investor. The Aberforth Smaller Companies (LSE: ASL) trust has returned 39% over three years. Although the 7% over five years, reflecting more difficult times for value investing in 2019 and 2020, is mediocre, the annualised return since launch in 1990 of 11.6% is more than 2% ahead of the Numis index. Despite this, the trust trades at a 12% discount to NAV and yields a relatively generous 3.5%.
The trust is broadly spread with no holding over 3% of the total. Borrowings at just 3.7% of net assets are low and annual expenses comprise just 0.8% of net assets; 39% of the portfolio is in the FTSE 250 midcap index, against 70% for the Numis index. In May, the managers pointed out that the valuation of their portfolio was “unusually low” at just 7.5 times historic earnings, close to the lowest since inception, despite “resilient earnings. The stockmarket is more than pricing in a recession”. The shares remain great value.
3. Odyssean Investment
Odyssean Investment (LSE: OIT) is a £166m trust in the Harwood stable, launched a little over five years ago and managed by Stuart Widdowson and Ed Wielechowski. The underlying performance over three years has been 29%, but the shares have returned 41% thanks to the discount of the shares to NAV disappearing. Over the last year, performance has been disappointing.
“Though a few things have not been going quite the right way,” says Wielechowski, “we are very, very confident about the medium to long term as we see a lot of potential value in the portfolio.”
The portfolio consists of no more than 25 holdings (the top ten currently account for 83% of the total), bought with a three- to five-year investment horizon. The market value of these companies lies between £100m and £1bn and an international focus means that under 25% of their sales stems from the UK. The trust seeks “constructive corporate engagement” through large “influencing but supportive” stakes.
4. Rockwood Strategic
Rockwood (LSE: RKW) has been in the Harwood stable for barely a year but is already shooting the lights out, returning 21%. The £47m trust is managed by Richard Staveley, who brought the trust over from Gresham House against its will. The investment style is very similar to Odyssean’s, but the companies are smaller. The top seven holdings account for nearly half the portfolio and all have a market value below £100m.
The shares trade at NAV which has enabled modest share issuance. Significant further issuance is likely and merited.
5. Strategic Equity Capital
Strategic Equity Capital (LSE: SEC), once managed by Stuart Widdowson, is now managed by Ken Wotton at Gresham House.
Performance of the £150m trust continues to be strong – 43% over three years and 19% over one – but the shares have slipped to a 9% discount to NAV. The style, unsurprisingly, is similar to Odyssean’s, applying “a private-equity approach to public markets”. The top ten holdings account for 74% of the portfolio with the largest, XPS Pensions, 17%.
6. European Smaller Companies
Although European Smaller Companies (LSE: ESCT) has only returned 16% in the last three years, the comparative index has returned just 6% and ESCT’s three competitors are down by double digits. Despite this, its shares trade at a 13% discount to NAV, in line with its competitors.
Ollie Beckett, the manager, describes the trust as investing in “the winners of tomorrow in areas where you tend to find growth”, but “we are more valuation-focused than some of our peers. Valuation does matter, but ultimately we are seeking undervalued growth companies”. In addition, “unlike others, we will also invest in recovery names”.
The £725m portfolio has over 120 companies, none over 3% of the total, with an average market capitalisation of £1bn. Industrials make up a hefty 39% and management is passive. The shares yield 3.4%, dividends having been increased at an impressive compound annual rate of 17% in the last nine years.
7. Nippon Active Value Fund
Nippon Active Value Fund's (LSE: NAVF) 56% return over the last three years, helped by a 26% fall in the yen relative to sterling, has enabled the trust to absorb two less successful trusts, Abrdn Japan and Atlantis Japan. This has turned it into a £290m trust trading at an 8% discount and yielding over 2%.
The trust follows an “activist approach”, but the activist approach in Japan needs to be a lot more discreet and polite than in the UK or the US. “You have to find companies willing to change,” says co-manager Gifford Combs. This requires local expertise and extensive knowledge: the team has been investing in Japan for over three decades.
The portfolio focuses on manufacturing companies, which have benefited from the yen’s weakness. “We can buy companies trading at less than book value [and] three and nine times current earnings.” So there is plenty of upside in the portfolio.
8. Asia Pacific ex-Japan trusts
All three small-cap trusts in the Asia Pacific region have performed well, returning between 35% and 50% over three years, as have the two small-cap-focused India trusts, both almost doubling.
These are all passive rather than active value funds and, although value-aware, have no particular style bias to growth rather than value. Their markets have been favourable to smaller companies, resulting in good performances, but the discounts to NAV have still widened to 10% (in the case of Fidelity Asian Values, LSE: FAS) and 15% (Abrdn Asia Focus, LSE: AAS and Scottish Oriental Smaller Companies, LSE: SST). This makes them attractive.
A recovery in the performance of smaller companies in developed markets is likely to be led by a return to favour of the “growth” style and accompanied by narrowing discounts and trusts outperforming their benchmark indices. The “value” trusts, now on relatively low discounts, may well be left behind. The passive funds, like Aberforth, have a long record of swinging from the top of the performance table to the bottom and back again, while active value funds may find fewer opportunities as share prices rise.
This should not put investors off but rather encourage them to invest in both growth and value trusts for the long term. The small-cap effect was first highlighted by studies in the late 1980s, but it has, for now, been discredited. In five years’ time, it may become accepted wisdom again.
This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
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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