View the article online at http://citywire.co.uk/money/article/a882842
Will UK Smaller Companies funds recover?
Managers of BlackRock Throgmorton investment trust explain why smaller company investors don't have to fear the worst.
Smaller company funds and investment trusts have been among the best stock market performers in recent years but they have borne the brunt of the 2016 sell-off.
No fund illustrates this about-turn better right now than BlackRock Throgmorton Trust (THRG ). Its annual results released late last week show the £286 million portfolio grew nearly 22% in the year to the end of November. That’s double the return of its benchmark, the Numis Smaller Companies index, which excludes AIM stocks and other investment trusts.
Shareholders actually received a higher return of 26% after the discount – or gap between the trust’s share price and its underlying net asset value – narrowed slightly over the period, giving investors an extra boost.
Much of this growth came from co-manager Mike Prentis’s successful stock picks. Out of 150 stocks in the portfolio the big winners were CVS Group (CVSG), the acquisitive vet chain; Fevertree Drinks (FEVR), the provider of trendy mixers and Hutchison China Meditech (HCM), the rapidly growing biotech company, which boosted its share price with plans for a secondary listing on the US Nasdaq technology exchange.
It’s an impressive performance as the trust also saw investment income jump 55% as lots of companies paid special dividends. It was not an easy 12-months either with stock markets gripped by the slowdown in China and emerging markets, uncertainty over US interest rates and large falls in oil and commodities markets.
But what goes up, must come down at some point and for Throgmorton and rival smaller company investment trusts the decline has come with a sudden bump.
From the start of the year to last Friday Throgmorton shares tumbled 18%, an alarming slide that’s galling for any shareholder looking at the 10% fall in the portfolio and wondering what’s going on?
Again, the answer is the discount, always a mixed blessing for investments trusts, which in Throgmorton’s case has widened since the New Year from 6% to 15% as investors marked down the shares, assuming the worst as stock markets went into meltdown.
The six-week retreat has dented the trust’s performance numbers: leaving the one-year gain at just 8% although its three-year returns of 43% still look respectable.
UK trusts slide
Throgmorton investors have not been alone of course. Shares in Henderson Smaller Companies (HSL ), another good performer run by Neil Hermon, also fell 18% since 1 January, leaving its one- and three-year returns at 4% and 48%.
On average, investment trusts investing in UK smaller companies have fallen over 15% since the start of the year, while UK Equity Income trusts investing in bigger, better dividend-paying stocks have done better with a 10% average decline.
UK All Companies trusts which tend to invest in bigger companies, but are less focused on income, have shed just over 12%, according to figures from Numis Securities.
... UK funds fall a bit less
Rival open-ended investment companies and unit trusts have done slightly better, according to Lipper data, although few investors will cheer at average declines of 9% in UK Smaller Companies funds, 10% from UK Equity Income funds and 11% from UK All Companies funds.
Why have open-ended funds fallen slightly less on average than investment trusts so far in 2016? The short answer is they have tended to go up less in the past three years and so there has been less to unwind.
The longer answer is that unlike trusts, open-ended funds can’t boost their returns with gearing (borrowed money) which can make trusts rise faster in good markets and fall faster in a downturn. Also, their share (or unit) prices can’t trade at premiums above and discounts below NAV in the way that trusts can.
Of course it’s no surprise to learn that funds investing in higher risk smaller companies are volatile. The big question is what happens next: will these funds continue to be punished as investors tread the stock market boards with extreme caution? Or will they bounce back when sentiment improves?
A 'blip', not a recession
Prentis has no idea what will happen to the Throgmorton share price but told Citywire today he had confidence in the companies in his portfolio, such as 4-imprint Group (FOUR) and JD Sports (JD) which were achieving good organic sales growth and high margins, despite the economic storm clouds emanating from the East.
The manager also remains a fan of his long-term holding in Workspace Group (WKP). Shares in the provider of office accommodation in London and the South East have been hit by fears of a UK ‘Brexit’ from Europe that would cause an exodus from the City and hurt its business. ‘Operationally, it’s still a great business,’ said Prentis.
Although Prentis won’t get full-year results and outlook statements from his companies until next month, he said their end-of-year trading statements had been good, which makes him think that what we have seen has been ‘a sell off in momentum stocks that have done very well in last six to 12 months’.
‘We don’t believe that we’re heading for a global recession. It’s bit of a blip, a mid-cycle setback,’ he said.
Prentis explained that a lot of the falls in smaller company shares had been caused by hedge funds taking profits where they could after finding themselves over stretched when markets plunged.
‘We suspect most long-only investors, which we consider ourselves to be, have been watching the market with interest,’ said Prentis.
'Shorts' and 'longs'
Testament to this reassuring belief is what co-manager Dan Whitestone is doing with the CFD (contracts for difference) portfolio of the trust.
Throgmorton is different from other investments trusts in having two parts. Around 70% of the fund is invested by Prentis conventionally in the shares of smaller companies he thinks will do well.
But up to 30% of its assets can be deployed in CFDs, a form of derivative that allows Whitestone to trade in companies’ shares cheaply and – when he thinks they are vulnerable – ‘short’ the stocks and make money if their share price falls.
Throgmorton doesn’t borrow money in the way that many other trusts do because the CFDs help to gear, or increase, its exposure to markets. For example, it currently has 15% of them in ‘long’ positions often in companies Prentis already invests in. Put the two together and the fund would have 115% exposure to the stock market. However, 10% of the CFDs are in ‘short’ positions which reduces the net exposure to 105%.
This is down from 108% a few months ago and is a sign of some caution from the managers. However, it’s nothing like the position the trust had in the 2008 financial crisis when it first used CFDs. Back then all of the CFDs were shorting stocks which meant the trust had exposure of 100 minus 30, or 70%.
In theory this defensive stance shielded the trust from the chaos on world markets. However, that’s open to some debate as the portfolio halved in value in 2008, although it bounced back dramatically with a 64% return in the following year.
That said, the CFD portfolio has apparently produced positive returns in six of the last seven years and, said Prentis, has added to the trust’s performance in each of the last 15 months.
Nevertheless, analysts at Winterflood Securities are a little sceptical, preferring Prentis’s other trust, BlackRock Smaller Companies (BRSC ), which also has good five-year returns, with similar volatility but does not use CFDs.
‘While both funds are currently trading at discounts wider than their 12-month and peer group averages, given that they are trading on similar discounts, our preference would be BRSC,’ said Kieran Drake of Winterflood in a note to investors today.
Whatever you think of CFDs, the way the Throgmorton managers have positioned them does demonstrate their faith that markets will recover.
Smaller company investors will also watch Prentis and Whitestone’s progress with interest and hope they’re right.
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Look up the shares
- CVS Group PLC
- Fevertree Drinks PLC
- Hutchison China MediTech Ltd
- 4imprint Group PLC
- JD Sports Fashion PLC
- Workspace Group PLC
Look up the investment trusts
- BlackRock Throgmorton Trust (Ordinary Share)
- Henderson Smaller Companies (Ordinary Share)
- BlackRock Smaller Companies (Ordinary Share)
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