A buying opportunity has opened up in Aberforth Smaller Companies and Henderson Smaller Companies, according to leading industry experts, who say both investment trusts offer significant value and decent long-term returns thanks to their management teams and current double-digit discounts.
There has been a strange trend in the UK equity market as while smaller companies have considerably outperformed their large-cap rivals over the past 12 months, those gains have not been reflected in the current share prices of IT UK Smaller Companies funds.
Performance of indices in over 1yr
Source: FE Analytics
In fact, data from the AIC shows that the average closed-ended small-cap fund is trading on an 11 per cent discount to NAV, while more than half of the 13 trusts which have a long enough track record are trading on wider discounts than their three-year averages.
A number of reasons have been given for this trend, such as consistent outflows from the equivalent open-ended sector over the past year or so.
Nevertheless, many experts now feel smaller companies look attractive given their exposure to the UK economy (which has been strengthening over recent years as shown by the talk of higher interest rates), lower sensitivity to global trade than large-caps which could be hit by China’s woes and the ongoing Greek debacle, and because it is an area of the market where earnings growth is improving.
What’s more, given their ability to gear, relatively wide discounts and the fact their managers don’t have to deal with inflows or outflows, investments trusts are arguably better suited to play this trend than their open-ended counterparts.
Therefore Alex Whiting, investment director at Canaccord Genuity, and Charles Cade, head of research at Numis Securities, highlight two of their favourite portfolios in the sector.
Aberforth Smaller Companies
We start with Whiting, who thinks Aberforth Smaller Companies – which is headed up by the five man team of Alistair Whyte, Richard Newbery, Andrew Bamford, Euan Macdonald and Keith Muir – is attractive on its current 11.18 per cent discount to NAV.
The £1bn trust differs from many of its peers in the sector as the managers have a value approach, by which they focus on companies which are out of favour with the market, rather than the more widely used growth strategy.
This is, in part, why Whiting believes the trust looks attractive.
“Long-term statistical analysis suggests that a ‘value’ based approach to investment outperforms ‘growth’, but for a protracted period, since the financial crisis the reverse has actually been true,” Whiting said.
“However, the managers continue to believe in their strategy and expect that over the longer term ‘value’ will revert to its long-term trend of providing attractive performance. Considering their impressive 25 year track record we are inclined to give them the benefit of the doubt.”
“As a result of their ‘value’ bias it is worth highlighting that they have underperformed against their more ‘growth’ orientated peers in recent times.”
As Whiting points out, Aberforth went through tougher patch before and immediately after the financial crisis, meaning it is underperforming against both the sector and its Numis Smaller Companies ex IT benchmark over 10 years.
Nevertheless, their approach has started to pay dividends over recent times (it is top quartile over three years) which is more in keeping with the trust’s longer term track record.
Performance of trust versus sector and index over 20yrs
Source: FE Analytics
Whiting added: “This bout of weakness now presents an exciting opportunity for potential investors especially since the shares are now trading at an attractive discount to net asset value.”
Aberforth – which has an active share of 75 per cent, is made up of 90 stocks and has never cut its dividend since its launch in 1990 – has 35 per cent in industrials, 23 per cent in services and 18 per cent in financials.
It is currently geared at 5 per cent, yields 2.1 per cent and has ongoing charges of 0.82 per cent.
Henderson Smaller Companies
For those who want slightly different exposure to UK small caps, Cade recommends Neil Hermon’s Henderson Smaller Companies trust which is also trading on an 11.3 per cent discount to NAV.
It is more growth-orientated than Aberforth’s offering and Cade says it is an attractive option for investors who want more broad-based exposure to the asset class.
“Henderson Smaller Companies is one of the largest, most liquid UK smaller company trusts and we believe it is an attractive core holding for investors seeking exposure to this asset class,” Cade said.
He added: “Furthermore, the fund has outperformed the benchmark in 11 of the past 12 financial years.”
Hermon has managed the £500m Henderson trust since November 2002, over which time it has been the third best performing portfolio in the sector with gains of 905.7 per cent. Its Numis Smaller Companies ex IT benchmark has returned roughly half that amount over that time.
Performance of trust versus sector and index under Hermon
Source: FE Analytics
It is also one of the top three performing trusts and has beaten its benchmark over one, three, five and 10-year periods.
Cade explains that, like the Aberforth trust, Hermon is overweight the industrials sector.
“The fund is overweight industrials, favouring companies with leading positions in niche global markets, including Spectris and Victrex,” Cade said.
“The portfolio also includes a number of housebuilders, notably Bellway and Crest Nicholson, although the weighting has been reduced following the sale of Taylor Wimpey. Miners are typically avoided, due to the uncertain nature of exploration, and food producers, due to low margins.”
The trust also may be attractive to investors given the recent changes to its fee structure. Cade notes how the board have reduced the management fee to 0.35 per cent, while keeping a performance fee of 15 per cent of NAV total return in excess of its benchmark.
“In our view, the fee changes are a sensible compromise, rewarding the manager for strong performance, but keeping the base fee at a very low level,” Cade said.
“Although performance fees are unpopular with some investors, we believe that they can be an attractive fee structure for investors, so long as they are measured against an appropriate benchmark, with a high watermark and cap (to ensure that volatility is not rewarded).”
Henderson Smaller Companies is geared at 7 per cent.
