Small is beautiful

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It has become commonplace to say that the UK is facing uncertainty: from its borders, to its trading arrangements, to its political make-up, Brexit brings plenty of potential pitfalls. In theory, UK smaller companies should reflect the vulnerability of the UK economy, but the Dunedin Smaller Companies investment trust has been increasing its weighting in smaller companies at the expense of mid-caps. Why?
Often, we find, the view on UK smaller companies has been informed by their behaviour during the Global Financial Crisis, when this part of the market saw a sharp sell-off and took some time to recover. However, it neglects the ways in which smaller companies have changed over the decade since the crisis.

There is a perception that smaller companies are far riskier than larger companies, particularly at times of economic turmoil. However, this isn’t borne out by recent reality. In particular, volatility has been lower among smaller companies over the last three years (1.). Size has also provided no protection against weakness. There have been a number of FTSE 100 companies that have seen serious structural problems and significant share price falls (2.).

There is also a pervasive myth that UK smaller companies are purely domestic in nature. This may have been true a decade ago, but it is not true today. Many smaller companies have overseas sales; some even have exclusively overseas sales. Even those that are domestic in focus are not necessarily vulnerable to a weakening UK economy or declining consumer spending. This might be companies such as smaller healthcare companies, whose products will see demand whatever the economic conditions.

Even within unloved sectors, there can be opportunities. There are a lot of real estate companies among the small cap sector, for example, and most are best avoided, particularly if Brexit proves to be more damaging than expected. However, there are also specialist real estate options, such as GP surgeries, where returns are likely to be more consistent and demand is likely to hold up whatever happens to the wider housing market.

At times, valuations have been higher for smaller companies than their larger equivalents, but today they trade at a slight discount. In many cases, investors can find faster-growing companies at a cheaper price. Certainly, the type of quality companies in which we invest command a premium, but we believe this is a reasonable trade-off for greater predictability of growth. Some businesses grow so fast they can leave themselves behind.
Smaller companies used to be seen as a pure capital growth vehicle for investors. However, there is an increasingly amount of income available among small caps. We are not too worried how we receive our return, but it means that the trust has a net yield of 2.4%.

Certainly there are times when smaller companies become flavour of the month, valuations may become extended and quality can slide. New companies come to market and investors become less discriminating about where they allocate capital. However, that does not appear to be happening today.

This shift in the profile and risk of smaller companies is reflected in the holdings of the Dunedin Trust. Over time, we have been agnostic on the size of the companies in which we invest, and the mid-250 weighting for the trust has been as high as 60%, but we have gradually been moving down the market capitalisation scale as the environment for smaller companies has changed. This is simply a function of where we are finding the most opportunities. This extends to the AIM market, which has also matured in recent years and now provides a rich pool of quality companies in which to invest.

Of course, this also brings some challenges. Governance and investor protections can be weaker among smaller and Aim-listed companies. Our focus is on quality. We look at the management team, and whether the balance sheet is strong enough to sustain the company through the business cycle. Management teams can have a greater impact on smaller companies and we believe it is important to get to know them in depth.

It can even be worth following a strong management team from company to company. We need to have confidence that individuals are going to represent our interests, and when we find those that do, we stick with them. This support has advantages for them as well. Once we invest we are committed shareholders, and provide a reliable source of capital. In this way we aim to avoid some of the pitfalls of poor governance that can lurk in the smaller company sector.

In many cases, smaller companies offer stronger growth for a lower valuation. It is important to keep an eye on quality, but the opportunities are there for those with the time and patience to find them.

1. http://www.ftse.com/Analytics/FactSheets/temp/8047b5df-eb51-46e0-96f1-99119cc59be3.pdf
2. https://www.ft.com/content/941d8edc-8d8a-11e7-9084-d0c17942ba93?mhq5j=e6

Important information
Risk factors you should consider prior to investing:
• The value of investments and the income from them can fall and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• The Company invests in the securities of smaller companies which are likely to carry a higher degree of risk than larger companies.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• In the event that certain performance criteria are met the Company will pay its investment manager an additional management fee. Details of the criteria to be met and the amount of any payment are given in the Company’s annual report.
• Specialist funds which invest in small markets or sectors of industry are likely to be more volatile than more diversified trusts.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.

Other important information:
Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1YG. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments.

FTSE International Limited (‘FTSE’) © FTSE 2017. ‘FTSE®’ is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. RAFI® is a registered trademark of Research Affiliates, LLC. All rights in the FTSE indices and/ or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

 

Find out more at
www.dunedinsmaller.co.uk

 

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