Access to smaller companies a bonus

This article is part of
Investment Trusts - October 2015

Smaller companies are frequently considered more risky than those further up the market-cap scale and more vulnerable during downturns. So what do investment companies in this space have to offer?

The smaller companies’ space is one where the closed-ended structure has real benefits as it is better suited to illiquid asset classes. In a closed-ended fund, managers have flexibility to invest without the need to worry about redemptions.

As the trading volumes of smaller companies tends to be smaller, liquidity is a much bigger issue for open-ended funds than closed-ended funds and may restrict them from investing in what may otherwise be very profitable opportunities.

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There are 15 funds in the Association of Investment Companies’ (AIC) UK smaller companies sector, excluding Gresham House, which is transforming itself into an asset manager.

The definition of small cap varies between funds, but there are two benchmarks that are generally used – the Numis Smaller Companies index, which has a slightly larger average market-cap bias, and the FTSE Small Companies index. Some, such as Miton UK MicroCap and River & Mercantile UK Micro Cap, are focused on even smaller companies, typically below the £100m to £150m market-cap range.

During economically straitened times, investors tend to be more concerned about a smaller company’s ability to finance its ongoing operations.

This is particularly relevant if the company has big ambitions and limited cash to finance them. Such stocks tend to exhibit price volatility. However, some small caps give exposure to a niche where there may be limited competition.

A few of these funds, including both micro-cap funds, may also look a bit small to some advisers, and this may raise questions about liquidity. The Miton fund is keen to expand, but River & Mercantile wants to keep its fund small so it isn’t forced to move up the scale or diversify away from its tightly focused portfolio.

Some may also be deterred by these funds’ relatively low yields. Many smaller companies retain cash for reinvestment rather paying dividends. This tends to mean small-cap funds offer lower yields.

However, within this peer group Invesco Perpetual UK Smaller Companies and Athelney Trust pay yields of more than 3 per cent.

There are other funds outside the AIC sector that invest in smaller companies yet pay dividends. These include Acorn Income, Aberdeen Small Companies High Yield, Diverse Income, Smaller Companies Dividend Trust and Shires Income. A few of these are split-capital trusts, which enhance the income they pay through gearing. For example, Acorn Income yields 3.73 per cent.

Turning back to the UK Smaller Companies sector, the star is definitely Strategic Equity Capital (SEC), managed by Stuart Widdowson.

SEC has a distinctly different strategy from its peers. It runs a relatively concentrated portfolio and applies private-equity-style valuation techniques to listed companies. The trust aims to generate an internal rate of return of 15 per cent per annum.

SEC is now in the top 10 investment trusts across sectors over a five-year period, according to figures from QuotedData. It has seen a marked improvement in demand on the back of strong, sustained performance and so, unsurprisingly, is one of the trusts trading on a premium. The other is the Miton UK MicroCap trust.