Funds to play the UK small company sell-off – Investors Chronicle

With huge gains in 2021 and phenomenal falls this year, smaller company shares have very much lived up to their high-risk/high-reward reputation. Small-caps across major markets have tended to underperform their bigger counterparts in the recent sell-off, reflecting a notable exposure to ‘growth’ characteristics and the perception of a heightened reliance on fragile consumer sentiment.
That has certainly been reflected in the funds world, with small-cap sectors among the worst performers as markets have turned. Looking at domestic smaller company plays, all 73 funds in the Investment Association and Association of Investment Companies UK Smaller Companies sectors made money for investors in 2021, with 67 racking up double-digit total returns. But this year, so far, is very different: between the start of the year and early August all but two of these funds had made losses, many of them substantial.
So what is now priced in? As in areas such as US tech, investors have seen plenty of shares and funds sell off even as compelling long-term growth stories appear relatively unblemished. Many companies have also held up relatively well so far in terms of their fundamentals.
See ‘Is technology sentiment nearing the bottom? IC, 29.07.22.’
Investors with a long view and money to deploy may therefore be tempted to dip a toe into beaten-up portfolios in the hope of future gains. But patience and a long-term view are a must, given the unknowns that still lurk. Analysts at broker Liberum recently highlighted cuts to UK earnings per share estimates in July, especially for the mid and small-cap segment of the market. This is likely to reflect concerns including the cost of living crisis and the very real threat of a severe economic downturn. With the Bank of England suggesting there could be a 15-month recession and prolonged period of high inflation, plenty of small-cap challenges remain.
Any bargain hunting, therefore, should be done with caution and patience. As Ben Yearsley, investment director at Shore Financial Planning, puts it: “In my view, the sell-off has left lots of small and mid-cap decent value, as long as you can look through the coming recession because they may take another leg down. The biggest risk is probably a deep recession – small-caps inevitably get hit hardest as they are closer to the consumer and find it harder to secure funding. However, in the long run – 10 years plus – I would expect small-cap to outperform large.”
 
Funds can offer a diluted, albeit steadier route to small-cap exposure than direct shareholdings at a time of extreme volatility, but can differ from each other notably. The small-cap universe as a whole and many such funds have a growth bias, but there are some blended and value smaller companies funds. Smaller companies funds also come with plenty of dividing lines, from the size of company they favour to the fund’s own size, whether or not they tend to run winners, their level of concentration, process, cash weightings and sector preferences.
On the style front, Yearsley favours a growth or blended approach rather than value.
“I have nothing against that approach, but you are buying small-cap for dynamism and that favours growth style funds for long-term investors,” he notes.
Plenty of smaller companies funds invest via a growth style. Yearsley favours Montanaro UK Smaller Companies Investment Trust (MTU). Its share price total return is down around 30 per cent over the past year, but is strong over five and 10 years. The trust buys companies with a market cap smaller than the biggest constituent of the Numis Smaller Companies index at the time of initial investment, and recently had decent allocations to industrials, technology and consumer discretionary stocks.
The trust’s investment manager has an in-house team of 12 analysts serving as sector specialists who use a range of proprietary screens. Their investment approach shares similarities with those of other quality growth funds, with the investment team seeking companies in markets that are growing, and which have good and experienced managements, deliver high, sustainable returns on capital employed, enjoy high and ideally growing profit margins, and provide something that is in demand and likely to stay that way. The trust’s investment team likes businesses which can deliver ‘self-funded’ organic growth and stay focused on core areas of expertise – as opposed to businesses with an acquisitive nature.
 
 
Like other quality growth portfolios’ holdings, Montanaro UK Smaller Companies Investment Trust’s holdings should theoretically be able to exert pricing power. Prominent holdings recently included Big Yellow (BYG), Clarkson (CKN) and Biffa (BIFF). It’s also worth noting that the trust pays a quarterly dividend equivalent to 1 per cent of its net asset value (NAV), and its shares recently traded at a 9.4 per cent discount to NAV versus a 12-month average of 5.3 per cent.
But there are plenty of other growth-minded trusts and funds with enviable long-term performance records including BlackRock Throgmorton Trust (THRG) and Liontrust UK Smaller Companies (GB00B8HWPP49).
 
ES River and Mercantile UK Equity Smaller Companies (GB00B1DSZS09) has successfully blended different investment styles and this has resulted in robust long-term returns and less of a fall over the past year than that experienced by some of the growth stalwarts. Funds such as Aberforth Smaller Companies Trust (ASL) take a value approach, though in the first half of this year recession fears hurt the share prices of companies it holds, given the economic sensitivity of many value holdings.
Other considerations when picking smaller companies funds include their processes, and personnel and fund composition. Rob Burdett, head of multi-manager solutions at Columbia Threadneedle, says: “Over the long run the best small-cap managers tend to be ones who love their job the most and stay in job the most.”
So one fund he favours is TM Tellworth UK Smaller Companies (GB00BDTM8C53) run by former Schroders managers Paul Marriage and John Warren. Burdett views this experienced team as a “safe pair of hands” but also likes the support they have from Seb Jory, another Tellworth fund manager and former sellside analyst who has built proprietary models to help better forecast UK economic data.
Other fund characteristics are worth bearing in mind. Some funds in smaller companies sectors tend to run their winners and end up holding mid-cap companies, or hold a mixture of small and mid-caps such as BlackRock Throgmorton Trust tends to. Likewise, concentrated funds and those that limit their own size can be more targeted: concentrated portfolios like Odyssean Investment Trust (OIT) have held up well, while River and Mercantile UK Micro Cap Investment Company (RMMC) takes a strict approach to the size of companies it holds, and returns cash to investors when the trust exceeds a certain size.
Having said that, many funds have performed strongly over the years despite building up good scale or diversifying widely. For example, IFSL Marlborough Special Situations (GB00B907GH23tends to have a long list of holdings, but still boasts a strong long-term track record.
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