Get ’em while they’re hot

Wide discounts in the UK smaller companies sector may present long term investors with good entry opportunities….writes Nicholas Todd

The sell-off over the past year has seen many investments trusts trade at substantial discounts to NAV. Discounts have widened markedly in the small cap and mid cap space, leading to some potential opportunities for investors to exploit.

What has happened to discounts?

Over the past 12 months (to 04/08/2022), the FTSE 100 has held up well versus international peers, with the UK Smaller Companies’ indexes and investment trust indexes underperforming disproportionately. The FTSE has been driven by the outperformance of the oil and gas majors, as well as by its pronounced value tilt.

This has been reflected in the relative discounts of the sector. As the below graph shows, the UK All Companies has traded on narrower discount than the UK Smaller Companies sector. In fact, as at 05/08/2022, the UK Small Cap sector is trading on a discount significantly wider than the five-year average of -8.9%, a c. 1 standard deviation move away from it.

Oil and gas and mining in particular provide global revenue streams, as well as dollar revenue streams. These factors have supported the FTSE 100 and the large cap trusts and have helped create good cash flow to back dividends in UK equity income funds. The small caps, however, don’t benefit from these factors and are generally more driven by the domestic economy. According to research by FTSE Russell and a separate study by the London Business School, c. 76% of FTSE 100 revenues come from outside the UK versus c. 51% for the FTSE 250 and c. 43% for the FTSE SmallCap Index.

A domestic focus was helpful in 2021 as the UK recovered from the pandemic, with the UK Smaller Companies sector generating a return of c. 48% over this period. In the main, we think the UK handled the impact of the pandemic relatively well with a successful vaccine programme, a more flexible lockdown protocol alongside the further easing of monetary conditions and fiscal benefits provided by the government. Another major concern for investors has been the uncertainty around the finalization of the Brexit deal, and although there are some details yet to be settled, the impacts of Brexit have been less severe than some expected.

Since Q4 2021, various factors have contributed to a broad equity market sell-off which has particularly impacted strategies focused on smaller companies. The FTSE 250 is down 15.6% in total return terms and as we go further down the market cap spectrum, we see an even greater decline in performance with the NUMIS Smaller Companies plus AIM Ex. Its Index generating a loss of 17.7% year-to-date, as at 04/08/2022.

In light of this, we have also seen a significant de-rating across the UK Smaller Companies Investment Trust Sector. The average discount in the sector has widened out to -11.3% compared to a -2.8% average for the UK Equity Income sector for example, and close to the levels seen at the height of the pandemic. As at 28/07/2022, there are 16 trusts out of the 24 in the UK Smaller Companies sector trading at below their three-year average discount/premium value and we will touch on some examples later in this article. So, is the sector oversold?

What has happened with the NAVs?

Year-to-date, the Morningstar UK Smaller Companies sector has delivered an average NAV total return of -12.5%, as at 05/08/2022. The table below illustrates the performance of UK Smaller Companies trusts year-to-date.

Some of the growthier focused trusts have performed exceptionally well over the longer term but have suffered since the start of 2022. One example is BlackRock Throgmorton (THRG) which as at 28/07/2022 is down c. 35% in share price total returns over the past 12 months. In addition, of the more micro-cap focused trusts), Miton UK MicroCap (MINI) is currently down c. 25% over the same period.

On a NAV total returns basis Downing Strategic Micro-Cap (DSM) has maintained the strongest performance in the sector maintaining a flat year-to-date performance of -2.4%– an admirable achievement given the market turmoil. In addition, Aberforth Smaller Companies (ASL) and Invesco Perpetual UK Smaller Companies (IPU) have also performed relatively well in the space: the former has struggled in recent years however the managers have stuck to their guns and maintained a disciplined value approach.

Source: Morningstar

What is the outlook for NAVs?

The UK market has been unloved for many years – at least since 2016. When looking at the data, relative valuations still look attractive for the major UK indices such as the FTSE 100 and 250 versus their international peers. However, using the IA sectors to compare international small cap markets, we see the UK Smaller Companies sector’s average P/E ratio doesn’t look outstanding value versus international peers with a value of 16.4x versus the North American Smaller Companies at 17.1x, European Smaller Companies 13.8x and Japanese Smaller Companies 13.6x.

Equity returns are driven by multiple changes and underlying earnings. While the prospects for earnings growth are obviously hindered by the recession most expect, we believe there are lots of interesting companies in the UK. We note that many of the trusts within the sector have de-levered significantly, which reflects some caution. For example, JPMorgan UK Smaller Companies (JMI) and THRG have net cash levels in their portfolios of c. 9% and c. 7% respectively. Many of the smaller cap managers, although seeking to generate capital growth over the long-term, aim to ensure that their companies are high quality but also trading at the right price. Many will seek to invest in those companies that are undervalued but are able to generate positive cash flow early on in order to invest into company growth. We think those that are less dependent on external forms of financing may prove more resilient than they are currently being given credit for.

Some managers see lots of opportunity in the current market. MINI’s managers Gervais Williams and Martin Turner believe we are entering an inflection point. In short, they believe the era of ‘cheap’ credit availability and globalisation which has acted as an advantage to big business will prove unsustainable in light of elevated levels of geopolitical tensions, supply-chain constraints and persistent inflation. As interest rates continue to rise this will increase the costs of long-duration assets along with increased pricing competition which will impact balance sheets and profit margins. This is likely to benefit smaller, more domestically focused companies which haven’t experienced such stretched valuations as seen in international markets and may be more nimble from an operational perspective.

However, investors may still remain reluctant to allocate capital into the UK at this time. From a monetary standpoint we note the Bank of England has instigated the biggest single rate rise in more than 25 years, raising the base rate by 50 basis points to 1.75%. With this came stark warnings around the increased ‘possibility’ of a recession, which is likely to persist for much of 2023, alongside revised inflationary forecasts expecting inflation to peak at 13% before showing any signs of slowing. This is likely to put pressure on already historically low levels of consumer confidence which look set to remain persistent along with the diminishing savings buffers that were built up during the pandemic (the household savings ratio was back down from a peak of 24% to 6.8% in Q1 2022 (Source: ONS)), this may prove difficult for the more domestically focused smaller companies in the medium term.

In addition, investing in smaller companies is inherently more volatile compared to a large-cap focused strategy as demonstrated by the three-year annualised standard deviation levels and the three-year maximum drawdowns of the Numis Smaller Companies plus AIM Ex. ITs Index versus the FTSE 100 in the table below. Interestingly, when we compare the UK Smaller Companies Investment Trust sector versus the IA UK Smaller Companies sector (open-ended funds) we can see some evidence of the superiority of the closed-ended structure. The statistics indicate a significantly less volatile sector with lower drawdowns and a reduced downside capture ratio.

Source: Morningstar

Conclusion: Where are the opportunities?

We are wary of trying to call the bottom of the market; however, we do believe that as in many bear market scenarios the selloffs can be overdone, leaving a selection of opportunities for investors to participate in the rally. In a previous article, ‘Five small cup trusts on very wide discounts’, we highlight the outperformance of the Numis Smaller Companies Index versus the FTSE All Share Index following recessionary time periods in the past. While the pattern may not hold, we think there may be an opportunity for investors to allocate into the diversified offerings the UK Smaller Companies space can offer.

The table below displays some potential opportunities for investors to exploit the current discount levels. When looking at the Z-scores across the UK small cap sector we get some indication of how far the discounts have moved beyond the trusts’ historical mean discount. We highlight a few opportunities below.

Source: Morningstar, JPMorgan Cazenove, Kepler calculations
Past performance is not a reliable indicator of future results

ASL is a dedicated value strategy, which is hard to come by in the UK small cap space. The managers’ investment strategy aims to exploit undervalued companies they believe are likely to outperform those more expensive peers. ASL did particularly well in the reflationary rally following the emergence of vaccines for COVID-19, when value outperformed strongly. ASL has also outperformed its sector and benchmark year-to-date, albeit during a falling market. Value typically outperforms growth in a rising interest rate environment and given the stickiness of inflation, we think rate hikes are likely to continue. Over the past month we have seen the discount widen somewhat, but we have also seen what can be achieved when the market favours such a value focused strategy. Whilst ASL still trades at a -13.4% discount, wider than its three-year average of -9.7%, this may provide a good long-term entry point.

IPU is on a wide discount of -15.7%, which is significantly wider than the trust’s one, three and five-year averages. The managers Jonathan Brown and Robin West are focused on identifying high-quality companies whilst also remaining valuation aware. This barbell approach is central to the portfolio’s construction and leaves it capable of performing across varied market conditions. At the same time, the valuation-led stock-picking leads to a strong sell discipline as the managers look to recycle capital from strong performers into better value opportunities. The trust has experienced a strong record of performance and has generated a NAV total return of c. 29.2% over five years. This has been combined with relatively low levels of NAV volatility, which when compared to peers, is testament to the consistent focus on ‘quality’ throughout the investment process. A bonus is the attractive dividend and therefore yield premium offered by IPU. With the board’s policy to pay out all income earned from the portfolio and to enhance it annually through the use of realised capital profits with a target dividend yield of 4% (currently c. 4.8%) of the financial year-end (31 January), the share price is attractive when compared to the peer groups average yield of 2.4%.

As mentioned earlier, DSM has been the top performing trust in the sector over a 12-month period and year-to-date from a NAV total returns perspective, but what is surprising is that this has not translated into share price performance. DSM’s discount has been trending lower since the start of the year, with it currently at -21.2% which is significantly below its five-year average of -9.9% but is also a wide discount in absolute terms. This in itself is unusual because the trust traded at a premium in the first two years following its IPO, albeit trending lower over this period, before widening significantly during the market volatility in 2020. It is yet to fully recover and with a three-year average discount of -16.5% this has remained a feature of the trust more recently. Up until now the board has been reluctant to actively buy back shares with the chairman – in our view, rightly – stating there was “no point in trying to stand against the tide” during the height of the coronavirus pandemic. The highly concentrated portfolio that ranges between 10-25 holdings, investing in the riskiest area of the small cap universe, namely micro-caps, meant the board wanted to ensure liquidity was maintained. However, the persistency of the discount has led DSM’s board to buy back shares regularly at wide discount levels with the latest purchased at an average discount of 17% in May 2022. In its most recent annual report, the board provided clarity around the plans for an investor redemption opportunity in May 2024, enabling shareholders to redeem or have a matched sale for up to 50% of their holding. For these reasons along with the uniqueness of the managers’ investment philosophy in the smaller companies’ space, we believe DSM may provide investors with an opportunity to diversify their current portfolio with the wide discount, and that the likely continued share buy backs will be accretive to shareholders.

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