Why small may yet be beautiful

These disappointments can largely be explained with that famous advice once given to President Clinton. “It’s the economy, stupid.” Concern about the UK economy has prompted investors to steer clear of companies that are more dependent on it. And many recent events contributing to the anxiety – expensive hikes in employers’ national insurance contributions and the minimum wage announced in the Budget, for example, appear to disproportionately impact smaller companies.

Changes to capital gains tax and inheritance tax rules have also caused consternation.

So where do we go from here? Well, the first point to make is that historically, UK smaller companies have been a good place to be. Track the data back to 1955 and you’ll find that smaller companies have outperformed large-cap stocks in roughly two out of every three years – and never lost money on a seven-year view. Over the long term, small cap shares in the UK have outperformed large caps by an average of around 4% a year, according to Bloomberg’s data.

Moreover, down periods for smaller company shares can create opportunities. One analysis looking at market performance following sell-offs of small-cap shares related to economic woes found that the average return following the down period was a gain of 42%.

James Carthew, head of investment trust research at QuotedData, says investors in smaller companies may be nearing the point of maximum despair. “Opportunistic buyers are taking advantage of the situation, but this is not yet lifting the mood” he wrote in a recent article for Citywire. “The good news is that once sentiment turns, the returns can be spectacular.”

If you share that view, there’s a strong case to make for using investment trusts to secure exposure to UK smaller companies.

For one thing, actively managed funds are more likely to shine in areas of the market that tend to be under-researched, since there is greater scope to uncover those hidden gems that can drive outperformance. Indeed, the typical actively managed large-cap fund has struggled to beat its market benchmark in recent years.

Small caps, on the other hand, have done much better, with the average actively managed small-cap fund outpacing its benchmark index by around one percentage point a year after fees over the past 25 years, according to Lipper data.

Investment trusts, of course, are actively managed. But they also have other advantages. Their closed-ended structure is a big strength in less liquid areas of the market, where open-ended fund managers may struggle to manage inflows and outflows of investors’ money. Investment trusts also tend to attract longer-serving managers; that’s important in an area of the market where experience is of particularly high value.

One other point is that shares in the average UK smaller companies investment trust currently trades at a 12.1% discount to the value of its underlying assets. In some cases, discounts are much higher. In other words, this is potentially a moment to get into smaller companies on the cheap.

All the usual risk warnings apply here. Smaller companies do come with greater risk and volatility. Investors have to be prepared to take a long-term view. And it’s a sector prone to false dawns. Performance was much stronger in the first half of last year, but progress was derailed by Rachel Reeves’ Budget last autumn.

Still, for adventurous investors seeking opportunity, investment trusts focused on UK smaller companies could be a good place to look.