Income investors who want access to the outsized returns available from small-cap stocks but who cannot afford to give up the higher yields available from further up the market cap scale may wish to consider the Invesco Perpetual UK Smaller Companies investment trust.
The trust, headed up by Jonathan Brown since June 2002, rebases its yield to 4 per cent at the start of every year – which is almost double the 2.2 per cent average from the IT UK Smaller Companies sector.
Because businesses are less mature in this area of the market and attractive dividends are harder to come by, it uses a mix of income from the portfolio and a small payment out of capital to achieve the 4 per cent figure.
“We look for the best total return when we’re investing and the method of paying a bit out of capital means that we can continue to do that and not be forced into high-yielding stocks we may not fancy on a five-year view,” said Brown.
The kind of stocks that Brown does fancy are high-quality businesses with a unique and sustainable competitive advantage that “allows them to continue winning”.
He also likes companies that have undergone some sort of a change – such as in their valuation, margin profile or growth rate – and said he and co-manager Robin West’s combined 40 years of experience in small caps means they have visited most of the businesses in his investable universe and are likely to notice if a former laggard is turning itself around.
One example of this is media business Future. Because it is a magazine publisher it was assumed to be in structural decline and largely ignored by the market. However, Brown became interested when the management team responsible for transitioning Autotrader from a print magazine to an online platform came in and set about doing the same with Future’s titles.
Performance of stock vs index over 10yrs
Source: FE Analytics
“It has got some well-known online brands such as TechRadar – so if you Google ‘best mobile phone 2019’ it generally comes out on top of the search with independent reviews of products,” Brown said.
“The way it monetises this is through digital advertising, obviously, but there is also a proprietary price comparison it adds on to the end of each review, which pulls in prices from dozens and dozens of retailers for that product. If you click through and buy it, it gets a small percentage of the cost of that product as a finder’s fee.”
Brown said Future is now in the process of buying up magazine titles and then implementing the online monetisation strategy. For example, he said it bought What Hi-Fi? from Haymarket a few years ago and transformed the profitability of that title, while its purchase of Tom’s Guide means that, along with TechRadar, it now has the number-one position in the US for online technology reviews.
“We think it can keep expanding by buying new titles and launching in different geographies – for example, it launched a Spanish language site – and it can continue to do that for quite some time,” the manager continued.
“And these magazine assets are often in decline and very cheap to buy. So it’s been a real success story, but we think it has got a lot of legs to come over the next five years.”
In terms of his outlook, Brown said that while there are signs of economic weakness in most markets, central banks remain accommodative and money is more likely to flow into equities than bonds. As a result, he thinks markets can continue to make progress.
Looking closer to home, he believes better days for UK small caps could be just around the corner.
“It’s a sector that has been ignored for the last few years,” he said. “There’s been a lot of uncertainty, you wouldn’t want to put your clients in UK small caps only for there to be a hard Brexit and you end up looking very silly, so I do think there is pent-up demand.
Source: Invesco
“Valuations of smaller companies are below their 10-year average, and, you know, we’re on a P/E of around 11x for smaller companies which is obviously a discount to large caps, but it’s also a discount to where the sector typically trends.
“Speaking to investors over the last few years, a lot of them have said one of the characteristics of small caps is that they outperform pretty consistently, but they don’t feel now is the right time.
“Well, I suspect if a [Brexit] deal does get across the line it will be seen as an area that you can now invest in with some confidence. So, I would expect money to come in to the UK, but more specifically smaller companies because they have greater domestic exposure than the FTSE 100.”
Invesco Perpetual UK Smaller Companies has made 723.92 per cent in total return terms since Brown took charge, compared with gains of 444.43 per cent from the IT UK Smaller Companies sector and 419.96 per cent from the Numis Smaller Companies ex ITs index.
Performance of trust under manager vs sector and index
Source: FE Analytics
It is currently on a discount of 2.4 per cent, compared with 4.46 and 4.7 per cent from its one- and three-year averages.
The trust has ongoing charges of 0.97 per cent. It is not currently geared.