Various explanations have been given for this phenomenon, ranging from general profit taking from 2013’s stellar gains and outflows from notable multi-cap funds to worries over economic growth and other macroeconomic headwinds.
Whatever the reason, the IA UK Smaller Companies sector has seen net outflows in each of the last nine months. But it has been investment trusts that have been hit hardest by this negative sentiment as not only have NAV returns been poor but discounts have widened considerably.
Data from the AIC shows 12 out of the 13 trusts in the IT UK Smaller Companies sector – which fell 5 per cent last year – are now trading on wider discounts than their one-year averages, while 10 of them are now trading on double-digit discounts.
The UK equity market clearly faces challenges this year such as the election in May and the high possibility of a hung parliament and most agree that small-caps would be most exposed to an environment of heightened volatility.
Nevertheless, given the wide discounts on offer and long-term growth potential, some now believe it is a great opportunity for those investors who are willing to stomach volatility. With that in mind, we ask analysts from Numis, Winterflood and Cantor Fitzgerald which small-cap trusts they would recommend for contrarian investors.
Aberforth Smaller Companies
First on the list is Aberforth Smaller Companies, which Ewan Lovett-Turner – director of investment companies research at Numis – says is one of the best offerings in the small-cap space.
Lovett-Turner says this is a good time for investors to buy into this area of the market as a lot of the hot money has now left the sector and, with its focus on value, he thinks Aberforth is a good choice for those wanting to take advantage of a rebound.
“Discounts had become a bit narrow to be honest with some trading close to asset value – which hadn’t been seen for a decade or so,” Lovett-Turner said.
“However, there is some good variety in the sector and one that we like is Aberforth Smaller Companies which has a value approach. You do get periods when you have to wait for that style to come through, but over the long term it has been a good performer.”
According to FE Analytics, the trust – which was launched by Alistair Whyte and Richard Newbery in December 1990 – has massively outperformed the sector and its Numis Smaller Companies ex IT benchmark over 15 years.
Performance of trust versus sector and index over 15yrs
Source: FE Analytics
However, returns have been more disappointing over five and 10 years as growth has been the preferred style.
Aberforth is outperforming over three years thanks to its market-beating returns in 2012, 2013 and 2014. Lovett-Turner expects the trust to continue to outperform over the long term, but notes that it isn’t the cheapest small-cap portfolio on offer.
“It’s on an 11 per cent discount, which is one of the narrowest in the sector but I think it is a good solid trust.”
Despite its relatively narrow discount compared to the sector average (13.6 per cent) it has traded on 1 per cent discount at times over the past 12 months. The trust’s board also have a progressive dividend policy, increasing the pay-out in each of the last 10 years.
Aberforth Smaller Companies has ongoing charges of 0.82 per cent, gearing of 3 per cent and a dividend yield of 2.3 per cent.
Dunedin Smaller Companies
Cantor Fitzgerald’s Charles Tan is a big fan of Ed Beal’s Dunedin Smaller Companies trust as it is one of the highest yielding in the sector (2.7 per cent) and has a very good history of increasing its dividend.
The trust has lost more than 10 per cent in share price terms over the last year, leaving it on an 18.1 per cent discount to NAV. However, Tan says it is a high quality trust and that Beal is in good shape to replicate his performance since he took charge of the trust in December 2005 in the future.
Performance of trust versus index since December 2005
Source: FE Analytics
“The manager has described last year’s performance as disappointing, but I would point out that one of the likely reasons for this relative underperformance is the fact that Ed Beal’s investment strategy focuses more on the higher-quality, high-growth, but more ‘boring’ names,” Tan said.
“This is quite the opposite to the stereotypical exciting, less profitable, zero-dividend stocks (tech/biotech, for example) that have really driven the sector. My suspicion is that the current ‘dash to trash’ is not sustainable and, therefore, Ed Beal’s strategy will return to favour sooner rather than later.”
“It is one of the better trusts to back for investors seeking exposure to the UK smaller companies sector, especially since they can buy it now at a 18 per cent discount to NAV, and get paid an almost 3 per cent yield while they wait.”
Dunedin Smaller Companies is slightly different to others in the small-cap sector as the trust is benchmarked against the FTSE Small Cap index – rather than the Numis Smaller Companies index – which means it typically focuses on companies with lower down the market cap spectrum.
The trust has gearing of 3 per cent and ongoing charges of 0.8 per cent.
Aberdeen Smaller Companies High Income
The final trust on the list is Aberdeen Smaller Companies High Income, which as the name suggests invests in small-caps, but it actually sits in the IT UK Equity & Bond Income sector as it has around 10 per cent in debt issued by smaller companies.
However Simon Elliott, head of investment companies research at Winterflood, says it is a good option for investors as not only does it have an attractive yield of 3 per cent, but there is valuation support as a result of its 18.36 per cent discount.
“We believe that Aberdeen Smaller Companies High Income is an attractive mandate that has delivered a strong performance record under the management of Phil Webster.”
Webster has managed the trust since April 2008, over which time it has returned 98.44 per cent while its benchmark – the FTSE Small Cap ex IT index –has gained 85.58 per cent.
Performance of trust versus index since April 2008
Source: FE Analytics
Aberdeen Smaller Companies High Income had a phenomenal 2012 and 2013 when it returned more than 50 per cent in both of those years. It had a shoddy 2014, however, as it lost 15 per cent thanks to poor NAV returns and a widening discount.
The trust’s current discount is much wider than its one and three-year average, as its shares had traded on a 5 per cent discount at points over the past 12 months.
However, Elliott expects the trust to bounce back sooner rather than later as he thinks there is good scope for dividend growth in the future and because of Webster’s disciplined approach to the market.
“In our view the fund benefits from Aberdeen’s well‐established investment approach, with its emphasis on quality and value. Furthermore the fixed income portfolio has allowed the fund to generate a yield that differentiates it from the majority of its peers,” Elliott said.
“In common with the rest of the UK small-cap sub‐sector the fund has been de‐rated over the last year and we believe that this presents a decent value opportunity at its current discount of 18 per cent, particularly given a covered yield of over 3 per cent.”
Aberdeen Smaller Companies High Income has gearing of 15 per cent and ongoing charges of 1.62 per cent.