Trustnet Magazine Issue 37 February 2018 | Page 24

IN FOCUS
/ SECTOR PROFILE /
MISSED
THE BOAT?
Anyone who thinks Brexit worries have created a value opportunity in
UK small caps may be a year too late, warns Adam Lewis
I
NVESTORS IN UK
SMALLER
COMPANY
INVESTMENT
TRUSTS enjoyed a
bumper 12 months last year, as the
sector continued its recovery from
the shock of Brexit in 2016.
Having made a meagre return of
3.98 per cent in 2016, the average
IT Smaller Companies trust posted
gains of 27.62 per cent last year as
UK domestic stocks rallied.
As a result, the sector re-rated
heavily, with the average discount
narrowing from 14 per cent at
the start of 2017 to its current
figure of 9 per cent. Alex Paget,
a research analyst at Kepler
Partners, says that with the benefit
of hindsight, early last year was
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the time to buy UK small caps and
that the sector could be due a bout
of volatility in the short-term.
“Mid and small caps, more
generally, witnessed a degree of
mean reversion following painful,
Brexit-induced declines in 2016
while many active managers
in the space boosted returns by
shifting their portfolios towards
more internationally exposed
stocks,” says Paget.
A MISSED OPPORTUNITY
“Before we go any further, it is
clear an allocation to UK small
caps makes sense for any long-
term investor,” Paget continues.
“In fact, we would argue they
should form a core allocation
within a long-term portfolio.”
“However, over the shorter term,
we see a variety of risks, which
in the context of narrower than
average discounts, could dampen
appetite for small caps. For
example, rightly or wrongly, mid
He points to the narrowing
of discounts over the last 12
months as evidence of what may
have been a missed opportunity,
with the current figure standing
below the five-year average of
about 11 per cent.
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and small caps are likely to be the
worst hit if there are any hiccups in
the ongoing Brexit negotiations.”
GROWING COMPLACENT
More generally, however, Paget
says there is clearly a growing
sense of complacency among
investors and this, combined
with high multiples across the
market, leaves equities open to a
correction if there is any change to
the status quo.
“Smaller companies, with their
higher-beta characteristics, would
likely be hit hard in such an
event,” he says.
Despite a significant re-rating in
2017, the average IT UK Smaller
Companies discount remains
wider than the average for the
investment trust universe – 3.3
per cent at the end of 2017,
compared with 5.1 per cent 12
months earlier.
To put 2017’s figure in historical
context, the long-run average
discount for the investment
trust universe since the end of
1989 stands at 9.4 per cent. As
such, Winterflood also warns
that with 2018 marking the 10th
anniversary of the global financial
crisis, and with the bull market
now entering its ninth year, there
is reason to believe discounts
could widen again in the not-too-
distant future.
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PERFORMANCE OF IA AND IT SECTORS
3yr (%) 5yr (%) 10yr (%)
IA UK Smaller Companies 24.79 58.92 104.23
205.43
IT UK Smaller Companies 24.6 67.05 117.7
244.57

1yr (%)
Source: FE Analytics
Innes Urquhart, a research
analyst at Winterflood, says
another reason why UK Smaller
Companies trusts trade on wider
discounts is because of the
element of illiquidity in their
assets. In this sense he says the
investment trust structure, which
doesn’t force managers to buy
and sell shares based on inflows
and outflows, works particularly
well for UK smaller companies, in
particular at the micro cap level.
This contention is backed up
by the figures. The average fund
in the IA UK Smaller Companies
sector made 24.79 per cent last
year, marginally ahead of its
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