The “fierce” value recovery from the Covid-19 pandemic appears to be coming to an end, according to FE fundinfo Alpha Manager Harry Nimmo and Abby Glennie.
Updating investors in the Standard Life UK Smaller Companies Trust’s full-year results to the end of June, the pair said that the trust failed to beat its benchmark due to the latest market rotation into unloved stocks, but that this would soon reverse.
Indeed, in the year from the end of June 2020, the trust made 48.4%, a strong performance in any ordinary year, but underwhelming when compared with the 52.3% gain for its benchmark – the Numis Smaller Companies plus AIM excluding investment companies index – and a 63.5% rise for the average IT UK Smaller Companies trust peer.
Total return of trust vs sector and benchmark over 1yr
Source: FE Analytics
“It feels like the recovery rally phase is over and has been fierce but short term. We expect to be able to look forward to sustained strong performance from small and mid-sized companies and more robust relative performance from our process as the cycle develops,” the managers said.
They noted that the recent rise in value stocks was “typical” for the early part of an economic cycle, which started when the short-lived recession in the first and second quarters of last year ended.
The investment trust invests using Nimmo’s Matrix system, which scores and ranks companies based on their ‘quality’, such as earnings growth and valuation.
This skews it towards a quality growth approach, buying stocks that can consistently grow their earnings over time, rather than undervalued, unloved companies that can rebound.
Although improvements will come in “fits and starts”, the “assumption that Covid will soon be on the retreat” and Brexit in the rear-view mirror, there is a positive outlook for UK stocks and in particular smaller companies, which are broadly more dependent on the domestic economy.
“The biggest issue currently looks likely to be the risk of inflation. We are seeing significant supply chain dislocation and a return to labour shortages and wage inflation, not seen for a very long time,” Nimmo (pictured) and Glennie said. 
“Our best guess is that this is short term and relates to the sudden and binary aspects of the influence of Covid.”
There are also other clouds on the horizon, such as new variants of the coronavirus delaying a return to normality, potential vaccine issues and a rise in unemployment as the furlough scheme comes to an end this month.
However, they were confident that the trust would perform well as the high-quality, defensive stocks would cushion the blow against rising prices.
“Bearing in mind that the market typically looks two years ahead, we are comfortable that we are past the worst, that we are in a new economic cycle and that the next couple of years will be a good time for smaller companies relative to large caps,” they said.
Elsewhere in the report, the duo said that the new issues market had been a “pleasant surprise” this year, following a fallow period.
“The recent crop of new issues suggests that the UK is punching above its weight at developing new world leading businesses that are transformational,” they said.
Indeed, the trust invested in five newly listed companies in the year to the end of June 2021: IT firm Bytes Technology Group, online auction company Auction Technology Group, greetings car seller Moonpig, review site Trustpilot and plumbing firm Victorian Plumbing. All new issues were ahead of their float price, with ATG the standout, up 126%.
In contrast, the top half of the FTSE 100 index is “a dull place, with a last century feel about it,” the managers said, dominated by companies with “great futures behind them”.
“This is not the case in the UK small- and mid-cap world, certainly judging by some of the current crop of British companies coming to the market,” the pair said.
They also noted that many of the trust’s largest holdings were cheaper than usual, with four of its top 10 valued on a price-to-earnings ratios in the teens.
“We haven't seen the largest positions trading on such low multiples for a while, which suggests to us that, after the recent market rotation, a significant number of our quality, growth and momentum-led holdings are looking cheap,” they said.