Investment Trust Review: Small is bountiful

As a sector, this group of trusts has taken a pounding in the downturn, losing 28 per cent in terms of total return over the year to the end of May 2009. This will have been exacerbated by the credit crunch, during which companies have been starved of traditional sources of funding, and shrinking their operations in response to the collapse in demand.

The survivors will now be leaner and, historically, it is the smaller, nimbler companies that lead in the recovery from recession. Fund managers are alive to the sheer value that sits in this sector and, as the dearth of funding starts to free up, these companies will be set for accelerated growth prospects.

Recent data suggests markets found a level back in early March. It helps that base rates have been slashed and directors are buying their own companies' shares; which they have been doing. A number of economic indicators are showing signs of stabilising and even improving. UK plc's balance sheet is being repaired quite quickly as fund managers scramble to rotate into recovery stocks. Savers want more than the meagre interest on offer in the high street. All this amounts to a virtuous circle that points to the likelihood that smaller companies will have a big year in 2009.

The AIC reports Gervais Williams, manager of Gartmore Growth Opportunities as saying: "Most investors are radically underweight in the quoted UK Small Cap sector. For many years large cap financials and larger businesses have enhanced their business by taking advantage of the growth in credit to expand their earnings and dividends at a particularly rapid rate. With the arrival of the credit crunch UK Small Caps have been sold off to a greater degree. UK Small Caps are perceived as unattractive on account of their low liquidity, the fact that most are not included in the FTSE All Share Index, and because of their greater exposure to a UK economy which is in recession. However, in the next five years we expect this position to be reversed."

UK smaller companies have performed strongly since mid-March amid declining risk aversion; risk appetite could continue to strengthen, resulting in yet more outperformance. Significant value is now available in a broad range of smaller company sectors, and it is possible to buy good quality businesses with strong, often cash-rich, balance sheets. What's more, many of these companies have the potential to emerge from this recession with strengthened competitive positions.

In this time of near zero interest rates, dividends and dividend growth are becoming more and more important to investors. This has been a fundamental problem for smaller businesses, especially those listed on the AIM market that had been advised not to pay a dividend yield to investors and to reinvest any profit into the business. But a change their outlook on dividends in the long-term will bring new investment to UK smaller companies and help boost performance as the demand for shares increases. Mr Williams said: "Many UK small cap stocks will consistently surprise by paying good and growing yields, which will be particularly attractive in a time when dividends generally will be under pressure."

The AIC quotes Harry Nimmo, manager of Standard Life UK Smaller Companies Trust, who believes there are excellent opportunities to be found in smaller companies listed on the AIM market.

Although the AIM market has shown poor overall performance since its launch, there are opportunities to be found if you avoid the more esoteric 'blue sky' companies. Nimmo said: "Experienced investors with a good investment process are able to find some well priced smaller companies opportunities on AIM. In 2010 we will again see new launches on this market."

Financial Express data bears out something of a resurgence in this sector over recent months. After losing 28 per cent in the year to 29 May, the average total return has rebounded by 27 per cent in the past six months, and 22 per cent over three. Look deeper, and investors can find 6-month returns of 77 per cent from Henderson Smaller Companies and 59 per cent at Gartmore's Fledgling Trust.

Some investors will consider it too soon to call the bottom of the market, or to place confidence in a Lazarene resurrection of the smaller companies sector. But these are the numbers, history is on the side of the SMEs leading a renaissance and, for the intrepid, the tills have begun to ring in the past six months.