Fund and investment trust ideas to play a small-cap comeback

UK smaller company shares are unloved, but for those prepared to be patient the history books show it is a rewarding place to invest. Kyle Caldwell considers the outlook for this part of the market, and shares fund and investment trust options.   

For investors looking for value opportunities in the run-up to tax year end the UK smaller company sector stands out like a sore thumb.

In 2022, it was a memorable year for this part of the market, but for all the wrong reasons. Stagnant economic growth, high inflation, and interest rate rises led investors to reduce risk, which caused share prices and valuations to slump.

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Smaller company shares are more domestically focused than the mega-caps in the FTSE 100 index. As a result, this part of the market “tends to be more sensitive to economic slings and arrows”, points out Neil Hermon, manager of Henderson Smaller Companies (LSE:HSL). The investment trust is a member of interactive investor’s Super 60 investment ideas.

Data from FE Fundinfo shows that the UK Smaller Companies sector lost 25.2% in 2022. This compares to a loss of 9.1% for UK All Companies, and a small decline of 1.7% for UK Equity Income.

The good news is that such a sell-off, while severe in 2022, was driven by sentiment rather than by most companies across the sector operationally performing poorly.

For investors sizing up smaller companies, now presents an opportunity to take advantage of knock-down prices. In addition, for those prepared to be patient there’s the prospect of benefiting from the long-term investment trend of smaller companies delivering higher returns than their larger company rivals.

As ever, there’s the danger of buying too early. Until inflation is brought under control, further interest rate rises cannot be ruled out, which would likely continue to hurt the smaller company part of the market. In addition, the economic outlook appears bleak, with a shallow recession over the next year or so being the consensus view.

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There’s a growing agreement that share price falls have priced in the prospect of an economy that will either be sluggish or contracting. This is a view that Ian Lance, manager of Temple Bar (LSE:TMPL) investment trust, made in a recent On The Money podcast episode.

However, as ever, sentiment is driven by expectations. If a recession is more severe and prolonged than forecast, then smaller company shares will likely remain unloved.

Therefore, drip feeding money into the market may be a better strategy for those attracted by smaller company shares trading on multi-year low valuations. Regular investing removes the risk of unfortunate market timing, and also helps to create discipline.

Why smaller company shares are poised for a comeback

It is not only dedicated smaller company investors who are talking up their own part of the market, various multi-cap fund managers have also been highlighting the attractiveness of the sector.

Chris McVey, fund manager of FP Octopus UK Multi Cap Income, says: “For equities, 2022 was clearly a challenging year. Economic and geopolitical concerns buffeted markets, and this uncertainty triggered a significant de-rating of growth equities. But, in our view, it also triggered one of the best buying opportunities for UK small and mid-cap stocks in over a decade.”

McVey focuses on quality-growth small and mid-cap companies, those with the ability to grow earnings throughout the economic cycle.

He adds: “We have been largely reassured by the underlying operational performance of many of these growth companies, despite many share prices de-coupling from these solid fundamentals.

“When market conditions normalise, many of these stocks should re-rate significantly, offering investors attractive returns over the medium term.”

McVey points out that the last time share prices deviated from earnings to this extent was during the financial crisis.

He says: “That turned out to be the buying opportunity of the decade. We are currently in that same valuation territory, although calling the market trough is clearly the key near-term challenge.”

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Another reason for optimism, according to Alex Wedge, co-manager of the Liontrust Economic Advantage team, is that company management teams have been putting their money where their mouth is.

Wedge, who keeps tabs on the overall ownership levels of the smaller company shares the team invests in, says the number of company directors buying smaller company shares rose notably in 2022. He points out that since 1999 the two other times ‘insiders’ were heavily buying were following the tech crash in 2002 and after the Global Financial Crisis in 2008.

“It can feel difficult to be optimistic in the current environment, but it is reassuring to see UK ‘insiders’ are putting their money where their mouth is. Judging by history, we may be wise to follow them,” says Wedge.

Sizing up smaller company funds and investment trusts

There’s plenty of choice among dedicated UK smaller company funds and investment trusts, with a respective universe of 51 and 24. Also to consider are ‘special situation’ and ‘multi-cap’ funds, some of which have a bias to small-sized shares.

When sizing up smaller company funds there’s an important thing to be aware of, which is that some funds have a significant amount of exposure to mid-cap shares – those listed in the FTSE 250 index. This is because some fund managers like to ‘run their winners’, which results in smaller company shares being retained when they grow into medium-sized businesses. There have even been instances when smaller company funds have held on to companies that have grown from an acorn into a great oak tree to enter the FTSE 100 index.

Investing significantly in mid-cap shares can also be down to the fund growing in size. The bigger a smaller company fund, the smaller the investment universe becomes. This is due to the potential liquidity risk of not being able to sell easily when owning a large stake in a smaller company.

As a rule of thumb, fund analysts take a closer look when a smaller company fund is around £1 billion, as this is the point at which a UK smaller company fund may start to become constrained.

To manage liquidity risks, smaller company funds tend to not have most of the portfolio in micro-cap stocks, which are classified as companies with market capitalisations of less than £100 million.

Robert Burdett, head of multi-manager solutions at Columbia Threadneedle, says that “there’s no right or wrong” in running winners, but he prefers “to focus on genuine smaller-company exposed funds”.

The only UK smaller company fund Burdett currently holds is LF Gresham House UK Smaller Companies. Managed by Ken Wotton, the 40-stock portfolio aims to identify niche growth businesses with strong long-term financial performance. Top holdings include radiology services provider Medica Group (LSE:MGP), and price comparison website Moneysupermarket.com Group (LSE:MONY).

“The fund showed ability to be adept when going into the risk-off trade last year,” points out Burdett. Indeed, the data shows (to 6 February) a return of 5.9% over the past year versus an average loss of 5.9% for the sector. Over three years, it is up 36.1% against 13.3% for the sector.

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Other funds Burdett rates include TM Tellworth UK Smaller Companies, Montanaro UK Smaller Companies (LSE:MTU) investment trust, and TB Amati UK Listed Smaller Companies.

Paul Marriage, fund manager of TM Tellworth UK Smaller Companies, currently holds 46 stocks, a mixture of growth and value. In an interview with interactive investor last year, Marriage explained that he looks for four attributes in all companies. “We're looking for management who own stock, market leadership of the niche, a differentiated product, and the ability to grow the margin.” Top holdings include software firm Gresham Technologies (LSE:GHT), and retailer Card Factory (LSE:CARD).

Montanaro UK Smaller Companies investment trust favours quality growth companies and pays a 4% dividend to its net asset value (NAV).

TB Amati UK Listed Smaller Companies, part of interactive investor’s Super 60 investment idea, also favours quality growth stocks that have clear competitive advantages in their respective sector or industry. It invests in some of the smaller AIM-listed companies. Overall, this fund has a smaller market-cap profile than other UK smaller company funds, according to Morningstar.

Is a value focus the best way to buy into the sector?

Gavin Haynes, investment consultant at Fairview Investing, thinks smaller companies investing in value stocks are the best way to play a smaller company recovery given the economic backdrop.

“Funds with a value style have done reasonably well over the past year, and the same rings true for smaller company funds that focus on this style of investment. In contrast, the more growth-focused smaller companies funds have been hit hard. During an economic downturn, I think the same trend will continue to play out – value outperforming growth.”

Haynes named Aberforth UK Small Companies, and Artemis UK Smaller Companies as his favourite picks from the sector.

Aberforth UK Smaller Companies invests in ‘deep value’ stocks – those it believes have share prices that are below the intrinsic value of the businesses. Among its top 10 holdings are bus and rail operator FirstGroup (LSE:FGP), van rental business Redde Northgate (LSE:REDD), and gold miner Centamin (LSE:CEY).

Artemis UK Smaller Companies follows the ‘growth at a reasonable price’ approach - investing in well-managed growth companies that do not have expensive price tags.  

Haynes prefers smaller company funds that “do what they say on the tin” rather than having significant mid-cap exposure.

Lucy Coutts, an investment director at JM Finn, named four investment trusts as her preferred choices in the sector: Henderson Smaller Companies, Fidelity Special Values (LSE:FSV), BlackRock Smaller Companies (LSE:BRSC) and JPMorgan UK Smaller Companies (LSE:JMI).

Coutts points out that as investment trusts can trade either more or less than the sum of their parts they are easier to value than funds.

She says: “I like to see a good long-term track record as this gives comfort when investor sentiment is negative. Over long time periods, smaller companies have outperformed larger companies, but what comes with that is the price of volatility. A four letter word – time – is all that matters.”

Short and long-term performance of the UK smaller company funds tipped  

Source: FE Fundinfo. All data to 6 March 2023. * Does not have five-year performance track record.