Peter Hewitt has taken advantage of the sizable discounts on UK equity trusts, bolstering exposure to the country by 10 to 12 percentage points this year in the CT Global Managed Portfolio trust.
The UK is now his biggest geographic weighting in the £140m trust-of-trusts at 40%, but Hewitt said he “expects that will move a bit higher” throughout the rest of the year as more opportunities appear.
Cash sat at around 10% in the portfolio historically, but Hewitt brought that down to 2% after splashing out on UK equity trusts.
“I think UK equity trusts are really quite interesting and one of the main reasons is simply because UK market is so cheap. Since Brexit, it's been unloved and uninvestable for foreigners,” he explained.
Indeed, the average price to earnings (P/E) ratio in the UK is around 10, whilst investors are forking out more money on equities in the US where it stands at 19. Even regions typically considered cheap such as Europe and Japan are on higher P/E ratios of 14.
Similarly, IBOSS investment director Chris Metcalfe recently told Trustnet why the UK’s poor image on the global stage has dragged down valuations when the market is actually filled with strong companies.
Hewitt took the opportunity to add exposure to existing UK trusts such as Finsbury Growth and Income, Fidelity Special Values and Law Debenture, but the one area he is most excited about is smaller companies.
Smaller companies in the UK have been hard hit by high inflation and rising interest rates, but Hewitt said they could be in for a rebound once conditions improve.
“My hope is that as we move through the year and finally get to the peak of interest rates – which was looks like it's going to be higher than we thought – we’ll start to see the FTSE 250 and UK small-caps outperforming, which over the long run they definitely do.”
During the volatility of 2022, the FTSE Small Cap index dropped 13.6% while the FTSE 100 was more resilient, climbing 4.7%.
However, UK small-caps proved themselves to be outperformers over the long time as they beat large-caps by 36.9 percentage points over the past decade with a total return of 113.3%.
Total return of indices in 2022 and over the past decade
Source: FE Analytics
Tight momentary conditions remain a headwind against UK small-caps, but Hewitt said investors could benefit from having exposure to the sector for when interest rates eventually come down.
“We're going into a recession and even though smaller companies might produce horrible figures, their shares could go up on the announcement because markets are looking 12 months down the road to when the economy is bottoming and picking up,” he said.
“That's why UK mid- and small-caps might have some downside in the short term, but they may start to perform later this year or maybe next year.”
One trust Hewitt is using to gain exposure to this area is Aberforth Smaller Companies, which he added to the portfolio in February.
The £1bn trust is run by six manager who use a value approach to find underrated opportunities in the mid- and small-cap space.
This preference for undervalued companies didn’t match the growth-dominated markets of the past decade, with the trust underperforming the IT UK Smaller Companies sector by 33.3 percentage points over the past decade with a total return of 102%.
Hewitt said: “The last decade has been uphill into the wind and their performance not been disastrous, but they've always been in the middle or lower end of the peer group because of their value approach.”
Total return of trust vs sector and benchmark over the past decade
Source: FE Analytics
Nevertheless, Aberforth Smaller Companies became so undervalued that Hewitt said he “couldn’t go wrong” by buying it at such a cheap price.
It had a P/E ratio of 7 when Hewitt entered the position and shares in the trust are currently selling 12.7% below its net asset value.
“That's not a guarantee it is going to outperform now, but I think if you genuinely have a three- to five-year view, I don't think you can go wrong buying it at that rating,” Hewitt added.
“The UK may have high inflation and horrible politics and all the rest of it, but I'm happy to hold there. You have to have patience though.”
The average investment trust is selling at a 13.1% discount with those investing in private assets trading at even larger reductions, according to Ryan Lightfoot-Aminoff, fund research analyst at Kelper. Last week, he and a group of experts shared their top trusts to buy at a sizable discount.
Source: FE Analytics
Hewitt took the opportunity to buy trusts such as Aberforth Smaller Companies when they were trading at bargain prices, but he doesn’t see them returning to a premium anytime soon.
“I don't think average discounts are going to get a lot wider,” Hewitt said. “I sense it's stabilised now for about three or four months but that just tells you how uncertain the retail audience is about markets and investment generally. I think these wide discounts will go on for a while get.”
Two other trusts Hewitt bought at a discount to get exposure to UK small-caps were Henderson Smaller Companies and Mercantile.
They were both prior holdings in the portfolio and investors cautious of the volatility of smaller companies may be reassured to know that they each have a preference for mid-caps.
Henderson Smaller Companies was up 124% over the past decade and although it narrowly underperformed the IT UK Smaller Companies sector, Hewitt said manager Neil Herman was a “very good and experienced” investor.
The trust was beating the sector until August 2021, but has fallen 44% since then. It started 2022 on a P/E ratio of 18 but fell to 11 by November, with its current discount of 11.5% presenting an attractive entry point for new investors, according to Hewitt.
Total return of trust vs sector and benchmark over the past decade
Source: FE Analytics
He said: “You're paying for some decent companies – because most of the UK’s best growth companies are in the FTSE 250 index – yet you're paying 11 times earnings.”
Mercantile is selling at an even larger discount of 13.9% despite performing over twice as well as its peers in the IT UK All Companies sector over the past 10 years, climbing 111.1%.
Analysts at RSMR said that this high level of outperformance could be credited to its high weighting to small- and mid-cap companies, unlike much of the peer group.
Total return of trust vs sector over the past decade
Source: FE Analytics
This comes with higher volatility than other names in the IT UK All Companies sector, but the researchers added that manager Guy Anderson moderates risk by seeking companies that are attractively valued, high quality and have positive forward momentum.
“It can demonstrate higher levels of volatility than large-cap holdings,” they explained. “The focus on companies that demonstrate the three characteristics, coupled with behavioural finance, attempts to mitigate this to some extent.
“The trust would be suitable for clients who wish to gain access to UK small and mid-cap names that have a more long-term investment horizon and are comfortable with the level of increased volatility this part of the UK market can, at times, demonstrate.”