Investment Co. Briefing: Smaller companies offer opportunities, as well as risks
They might still be struggling to achieve a presence for their products; they might face huge expansion costs; and they might not be generating enough revenue to survive longer-term.
For these and many other reasons, smaller companies offer risk challenges to the ordinary investor. But the flipside, of course, is that some small companies explode into growth, rapidly gaining market share for their products, overtaking bigger rivals, creating huge revenue streams and profit. If you back one of these, your gains can be great.
Investment trusts, like other collective funds, offer a less risky way of accessing these investment opportunities via smaller company trusts – and some top- performing trusts exist out there.
The UK Smaller Companies sector has outperformed the average investment company over one, three, five and 10 years.
Moreover, while the average investment company discount has widened in recent months, the UK Smaller Company sector has held up well and has moved in slightly from a double-digit discount of 10% at the end of July 2015 to 9% on 12 October 2015, according to trade body The Association of Investment Companies (AIC).
At a roundtable hosted by the AIC, several leading investment company managers discussed how the UK Smaller Companies sector might fare in future.
Stuart Widdowson, manager of Strategic Equity Capital, said future returns may not match past performance but that didn’t mean there weren’t strong gains to be made.
“Genuine smaller caps have performed well in recent years, and although returns may not quite match that for the next three to five years, there are plenty of reasons to be optimistic,” he began. “Value can be found if you are willing to look for it.
There also remain a few opportunities among higher-quality, higher-margin businesses, some of which have fallen out of favour, although valuations are not uniformly attractive.”
He believes low double-digit growth is possible, provided that earnings forecasts are achieved by companies.
Harry Nimmo, manager of Standard Life UK Smaller Companies, argued that the major academic studies on long-term smaller company performance (by those such as Ibbotson, Dimson & Marsh) are testament to the power of the ‘smaller company effect’ globally.
The studies indicate that, in a fast-changing world, smaller companies can adapt more quickly to new and disruptive ways of doing business. “What is more, these smaller companies are generally less well researched than their larger brethren, which itself provides opportunities for the diligent researcher,” argued Nimmo.
The best-performing smaller company investment trust of the last decade is Nimmo’s vehicle, turning £100 into £538 in the 10 years to 31 October 2015.
“Experience and a solid investment process, which has been tested through several economic cycles, does count in the world of smaller companies. Larger companies in their turn have been found wanting in terms of their ability to grow and adapt to changing market conditions.
“Going forward, smaller companies’ greater exposure to the comparative safe haven of the UK economy in an uncertain world feels right.Their greater prospects for profit and dividend growth suggests that the long-term outlook for smaller companies remains robust.”
If the best smaller company investment trusts perform as well in the next five years, investors could be in for some decent returns. In the five yearsto 31 October 2015, Strategic Equity Capital turned £100 into £333.37, followed closely by Henderson Smaller Companies (£267.58), Chelverton Growth Trust (£259.46), Invesco Perpetual UK Smaller Companies (£248.80), and BlackRock Smaller Companies (£233.04).
Even the worst-performing smaller companies vehicle generated a return of 33% in the past five years.
Jonathan Brown, manager at Invesco Perpetual UK Smaller Companies Investment Trust, said: “One of the major attractions of investing in UK smaller companies is that you can find companies that can continue to show good growth, largely irrespective of economic conditions.
“UK smaller companies have much greater exposure to the UK economy, with larger weightings to domestic- biased sectors including retailers, pubs and restaurants, and house builders.The UK economy has been one of the fastest growing global economies in 2015 with that growth helped by rising levels of employment, low inflation and rising wages. The UK consumer is feeling more confident, encouraged by rising household cash flow, which should continue to help drive economic growth in 2016.”
Henderson Smaller Companies
If you were 128 years old, you might be feeling a little tired in 2015 – but Henderson Smaller Companies shows no signs of slowing down.
At the end of last year, manager Neil Hermon – who has been at the helm since November 2002 – raised the dividend he pays shareholders by 23% to 13.5p, and in the past three years he has more than doubled investors’ money.
How has it done it? Henderson Smaller Companies swears by its research into the smaller company arena, targeting high-quality firms with strong growth potential. If a smaller company grows so fast that it enters the FTSE100 index, Hermon will sell it within six months of its inclusion.
In its last full financial year, the companies that drove its performance were housebuilders Bellway and Taylor Wimpey, the AA, Howden Joinery, e2v Technologies, Greggs, and Betfair, among others.
One look at that list and it’s clear that this vehicle is targeting well-established – if small – firms, rather than fledgling companies without much of a trading record. And it’s working.
In the year to 31 October, Henderson Smaller Companies turned £100 into £128, rising to £201.63 over three years, £267.58 over five years and £419,86 over 10 years.
It is worth pointing out that the vehicle doesn’t come cheap. There is a performance fee of 15% of any outperformance of its benchmark index (the Numis Smaller Companies Index), calculated on a total return basis over the trust’s financial year. Moreover, that fee was previously capped at £2 million but that cap has now been removed.
However, there is a new cap on the total amount payable by investors – including management and performance fees – of 0.9%.
So what does the future hold? At his last annual report, Hermon said: “Corporate profitability has proved robust but has not shown much growth in recent years. It is difficult to see the market making material progress from current levels without an increase in corporate earnings. However, given an improving economic backdrop, we are hopeful that the outlook for corporate profitability is improving. The small company market continues to throw up exciting growth opportunities, in which the company can invest.”
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
Usually charged as a percentage of returns for performance above a specified benchmark, such as an index. The fee can range from 10% to 20% of total investment returns on a low starting benchmark such as Libor and investors could find themselves paying extra fees for merely average performance. Note that these funds do not compensate investors when the manager underperforms the benchmark.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
A standard by which something is measured, usually the performance of investment funds against a specified index, such as the FTSE All-Share. Active fund managers look to outperform their benchmark index. Cautious fund managers aim to hold roughly the same proportion of each constituent as the benchmark, while a manager who deviates away from investing in the benchmark index’s constituents has a better chance of outperforming (or underperforming) the index.
All limited liability companies registered in the UK are compelled by law to compile a report once a year on the company’s accounts and directors’ statements must be issued to shareholders and filed at Companies House. A report details a company’s activities throughout the preceding year and its contents will include chairman’s statement, auditor’s report and detailed financial information such as cash flow and balance sheet statements.