11/02/2008
Investment Trusts plus Smaller Companies equals extra returns for investors | Investment Week - 11th February 2008
I’m often asked by potential investors why they should invest in a UK Smaller Companies Trust. This answer invariably falls into two parts – why smaller companies and why an investment trust?
For the investor with a long term horizon, investing in smaller companies can be an extremely rewarding experience. Academic studies, such as the highly respected work of Professors’ Dimson and Marsh of the London Business School, back this up. Statistics from the Investment Trust industry suggest that the average Smaller Companies Trust are up 179% in the last five years while UK Growth Trusts are up 147% and Income Trusts up 105% (source; Closewins, share price over 5 years to 5/2/08). Most companies out there, even Shell and Glaxo, were small once upon a time. To me it makes perfect sense to get involved with the larger companies of tomorrow. I’m old enough to remember when Microsoft listed on the American Nasdaq market with an initial value of less than $300m. I see it as my job to seek out these opportunities and run with them in the long term.
I firmly believe that holding great small companies over the long term is one of the soundest way to generate excellent returns for investors. Take Intermediate Capital Group (ICG). They are Europe’s leading specialist in mezzanine finance, a form of high yield corporate debt. The 10 year capital return from this share has been 343% (Datastream: 10 years to 4/2/08). The so called “credit crunch” gives ICG the opportunity to use their specialist knowledge, experience and balance sheet to lend when others have withdrawn from the market. ICG are not about explosive growth, they are about controlled growth year after year. The internet has thrown up a number of mould breaking growth businesses. Asos, the on-line clothing retailer is one of these. Even in more traditional sectors, investing in the best companies over the long term can bring its rewards. The 10 year, 558% capital return (Datastream: 10 years to 4/2/08) of the diversified construction group Kier is testament to that.
Some investors, however, have concerns about smaller companies. They fret about what will happen to smaller companies in an economic downturn. They say smaller companies are over-valued. Indeed, they say smaller companies have had a great run from 2003 to 2007 but that it must all come to an end. As a group, smaller companies are economically sensitive and they certainly have experienced strong performance in recent years. But since the end of May 2007 smaller companies are down around 22% (datastream, to 31/5/07 to 4/2/08) and valuations are now, if anything, at a discount to their larger company equivalents. Much of the bad news is now in the price, particularly as decisive monitory action is being taken in the USA to improve the lending environment. This gives me confidence that some time in 2008 smaller companies can start to move up again. There is likely to be a difficult reporting season in spring and perhaps again in autumn, however markets tend to look through these difficulties if they detect action by the authorities designed to turn sentiment around. In hindsight I think 2008 will be seen to have been a great time to invest in smaller companies.
It is, however, advisable to hedge your bets. Difficult economic conditions can lead to unforeseen twists and things rarely pan out exactly as expected. It is advisable to invest in the best, most risk-averse growth models that will be less affected by a difficult economic backdrop. Traditionally, smaller companies can be risky so why compound this tendency. Avoid stretched balance sheets, avoid penny shares and avoid conceptual stocks that are no more than ideas. Avoid basic manufacturing. Look for growth. Look for revenues and profits. Look for high profit margins. Look for barriers to competitive market entry. Look for companies that can control their pricing environment. Look for recurring revenue streams and companies that really know where next years profits growth is going to come from. Get on board with the new ways of doing business, like ASOS. Look for a trust and fund manager that offers these attributes and has the depth of experience to weather turbulent market conditions. Always invest in the longer term with smaller companies trusts and I mean preferably with a five year horizon. If you do this, smaller companies can indeed be a rewarding place to be. Above all, look for a trust and fund manager that offers these attributes and has the process and experience to weather turbulent market conditions.
What, then, are the advantages of an investment trust over other investment vehicles? Firstly, their closed end structure gives stability to cash-flows in and out of the trust.
Secondly, the ability to use gearing gives the manager the ability to back positive views on stocks and markets and thus in theory enhance returns. In general if you compare investment trusts and unit trusts/OEICs in the same asset class the investment trust will have the performance edge because of structural gearing and the tendency for stock markets to rise in the long term.
Thirdly, an investment trust is overseen by an independent board of directors. Unlike other types of mutual funds, investment trust managers are required to meet with the Board a number of times a year. Although the Board is made up of non-executive directors, it takes an active role in developing and reviewing a trust’s strategy, share buy-back policy and gearing. The directors also tend to own a significant number of shares, demonstrating their confidence in the trust’s ability to add value for shareholders over the long term.
UK smaller company investment trusts as a group have traded at a significant discount to the underlying net asset value (NAV) for some time. This can represent a cheap way of gaining exposure to the asset class. Persistent discounts attract active investors who may be looking at ways to crystallise the underlying asset value. Indeed, the number of smaller company trusts has fallen from 24 to 12 since October 2002 (Source: Closewins). A really quite spectacular attrition rate, especially when you consider how well the sector has performed over the period. At the current rate there may be only a handful available in three years time. There will come a time – and I feel this is in the not too distant future – when rarity value and improved sentiment will cause discounts to narrow dramatically.
The current sizes of these discounts give the investor with a longer time horizon the ability to benefit in an extra way that is not just open to the unit trust or OEIC investor. Add to this the benefits of an investment trust structure - stable capital, independent reviews from a board of directors – and you have a trust that offers a geared play on a great asset class with good long-term prospects.
Harry Nimmo, Manager of the UK Smaller Companies Trust PLC at Standard Life Investments.
This article was published in Investment Week on 11th February 2008
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
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