Smaller companies had been some of the main beneficiaries of the post financial crisis rally, especially in 2013, as improving economic data and a growing appetite for risk helped the sector.
However, as macroeconomic headwinds strengthened and valuations became more stretched, smaller companies were hit by sustained outflows last year. While open-ended funds had a poor year in 2014, their closed-ended rivals were hit even harder as not only did NAVs underperform but, due to selling, discounts widened at the same time.
As a result, Conway – who heads up the Hawksmoor Distribution and Vanbrugh funds with Daniel Lockyer and Richard Scott – says now is an attractive entry point into the sector.
“Generally speaking, only over the last few days we have been upping our exposure to UK smaller companies. We recently bought Aberforth Smaller Companies, for instance, due to its wide discount,” Conway said.
“We also use the Throgmorton trust across the firm. Investment trusts, as a whole, are trading on historically tight discounts but you can now find value on offer in the small-cap sector. After a very good 2013 but a difficult 2014, it seems UK smaller companies have been largely forgotten by investors.”
According to FE Analytics, the IT UK Smaller Companies sector lost more than 5 per cent last year as a result of the poor conditions, while the IA UK Smaller Companies sector was down 1.65 per cent and the FTSE All Share made a slight positive gain.
Performance of sectors and index in 2014
Source: FE Analytics
Data from the AIC shows the average trust in the IT UK Smaller Companies sector is now trading on a 13 per cent discount while every portfolio, except for Strategic Equity Capital and the recently launched R&M UK Micro Cap IT, is trading on a wider discount than its one-year average.
Conway’s recent purchase, Aberforth Smaller Companies, is trading on a much wider discount than in the recent past, for example.
The trust, which is different to many in the sector as the managers take a value rather than growth approach, is currently on an 11.23 per cent discount to NAV having traded on a 1 per cent discount at points over the last 12 months.
This value style means the £1bn trust – which was launched by Alistair Whyte and Richard Newbery in 1990 – had been one of the best performers in the recent rally and has still comfortably outperformed both the sector and its Numis Smaller Companies ex IT benchmark over three years with returns of 87.82 per cent.
Performance of trust versus sector and index over 3yrs
Source: FE Analytics
However, due to its poor NAV returns and wider discount, Aberforth Smaller Companies has struggled over the last year with losses of 4.62 per cent.
Nevertheless, the team at Hawksmoor is not alone in backing the closed-ended fund as in a recent FE Trustnet article we reported that Numis has recently moved Aberforth onto its recommendation list due to the quality of the management team, its progressive dividend policy and current discount.
The trust currently has a yield of 2.3 per cent, but it has grown its pay-out from 11p a share in 2005 to 25p in 2014. It has 1 per cent gearing and ongoing charges of 0.82 per cent.
Another of Conway’s holdings in the smaller companies space is FE Alpha Manager Philip Rodrigs’ R&M UK Micro Cap Investment Trust, which came to the market in December last year.
Hawksmoor bought into the trust at IPO due to manager’s track record and because of its unique structure, as the board will instigate compulsory redemption of shareholdings if the NAV were to grow between £110m to £125m to manage liquidity.
Conway says this is fantastic news for investors, as he says capacity is a hugely important factor in the micro-cap space.
“One of the problems you have in micro-caps is liquidity. However, with this trust, if they feel the size of the trust has grown too big, they will start giving capital back to shareholders. It means the manager always has access to his best ideas.”
“He is a fantastic manager and this trust is a really, really interesting and shareholder friendly trust for investors.”
There isn’t a huge amount of data on R&M UK Micro Cap given its recent launch, but Rodrigs has built up a decent track record in the open-ended universe as manager of the Investec UK Smaller Companies fund and, more recently, the five crown-rated R&M UK Equity Smaller Companies fund.
According to FE Analytics, the manager has returned 189.64 per cent to investors since he started running funds in the IA universe in June 2006, beating his peer group composite by more than more than 100 percentage points in the process.
Performance of manager versus peer group composite since June 2006
Source: FE Analytics
Thanks to its successful IPO, R&M UK Micro Cap is currently trading on a 5.1 per cent premium to NAV, but that doesn’t bother Conway as he describes it as a “buy, hold and largely forget about” trust due to the manager’s abilities and its portfolio’s unique structure.
While Conway has been upping his exposure to UK smaller companies recently, a number of experts have told FE Trustnet that they are avoiding the domestic market as much as possible due to growing political risk in the build-up to the upcoming general election in May – one of which was Neptune’s Robin Geffen.
“I see ahead of us the most difficult general election in several generations. We have UKIP who will, despite what many pundits think, take seats across the board from all three major political parties and you get left with a serious political conundrum,” Geffen (pictured) said in December.
“Markets don’t like uncertainty and there is massive uncertainty in the political landscape in the UK. Massive uncertainty.”
Conway fully understands that argument but is quick to point out that he and his team aren’t piling into the small-cap sector.
“We agree, as you have to recognise that there is an election on the horizon and there will be lots of uncertainty,” he said.
“It would be wrong to say we are jumping in with both feet as out portfolios are as lower risk as they have been for five or six years. However, because of the value on offer we think it is worth upping our exposure as we wouldn’t be doing if not for the mid-teen discounts on offer.”