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Trust Insider: where are the winners in a tough year for small-caps?

Trust Insider: where are the winners in a tough year for small-caps?
After many years of outperforming large cap stocks, smaller companies have been struggling this year although the underlying performance numbers of small cap investment companies are not that bad – the weakest of them seems to be Standard Life UK Smaller Companies, which has seen its net asset value fall by just over 10% year to date.

However, for the most part, the ratings on smaller company funds have been declining and discounts are getting wider. Standard Life Smaller’s shares are off by 19.1% this year and it now stands at an uncharacteristic 9% discount.

Not every fund has been as badly hit by the market rotation, however. A handful are still recording gains on their asset value for the year, most notably Strategic Equity Capital. One other fund that has caught my eye is Smaller Companies Dividend Trust (SDV) and I thought this week I might have a closer look at it.

SDV aims to provide a high income as well as capital growth. Its ordinary share asset value is up by 0.9% year to date, which is not massive but good relative to a 1.3% fall in the FTSE Small Cap ex investment companies and a 10.7% fall in the FTSE Aim Index. This rise in the asset value is maybe more remarkable given SDV’s ordinary shares are geared by a zero dividend preference share issue.

The fund has been around since 1999. It is not huge, the ordinary shares have a market cap of £28m, but it is attractive to many investors by virtue of its yield – at 4.1% it is higher than its rival Acorn Income, which yields 3.8% and which, until recently, was issuing new shares at a rate of knots. SDV currently sits on a discount of 6.8% but it is has traded at a premium for most of the last quarter. Its rating only really cracked over the past week or so.

SDV’s track record is not bad. Looking at its UK Smaller Companies High Income peer group, over five and 10 years it lags the Acorn Income Fund but is well ahead of Aberdeen Smaller Companies High Income. Over three years, it ranks second to Aberforth Geared Income. SDV ranks ahead of the whole group over shorter time periods.

SDV is managed by Citywire AAA-rated David Horner and David Taylor at Chelverton Asset Management. Chelverton was set up in 1998 to manage a micro-cap fund, now Chelverton Growth Trust. Chelverton was the appointed manager of the smaller companies portfolio of BFS Small Companies Dividend Trust in 1999. The fund dropped the BFS tag and its separate income portfolio some time ago.

Chelverton’s fee, at 1% of gross assets, is at the upper end of its peer group, though it might be reasonable to assume that, if the fund was larger, the fee could be lower, helping reduce the fund’s ongoing charges ratio of 2.2%.

SDV invests principally in UK companies with market capitalisations of less than £500 million. At the end of June it had 23% of its portfolio in stocks with market caps of more than £500 million. This stance gives it a bias away from the larger stocks in the Numis Small Cap index, the benchmark of choice for much of the UK small cap sector where, at the upper end, stocks can be a multiple of this size.

Chelverton’s emphasis on small cap stocks reflects a belief that the dearth of research available on these companies creates pricing inefficiencies a dedicated investment manager can exploit. The management approach focuses on measures such as cashflow. This helps Chelverton avoid over-hyped stocks, which is a common feature at this end of the market. The bias to stocks producing income also means the fund is light on biotech, mining and oil & gas exposure.

The portfolio is fairly diversified, with 75 holdings at the end of June 2014, and the largest exposures being to KCOM (telecoms – 2.34%), Connect Group (specialist distribution, formerly Smiths News – 2.3%) and Jarvis Securities (retail and outsourced financial services – 2.27%).

The current crop of zero dividend preference shares was introduced into SDV’s structure in 2013. The zeros have the benefit of boosting the income account for the ordinary shareholders and enhancing net asset value returns in the good times. They mature in January 2018 and had an initial gross redemption yield of 6%, though now they trade closer to a gross redemption yield of 3.9%. By my reckoning, they are covered 3.5x.

The managers have noted the small cap sector’s pause for breath but they do not see this as the end of the bull run in UK smaller companies. They point out that M&A activity is still relatively muted at this end of the market. I think that corporate management needs to be more convinced of the strength of the recovery in the UK economy.

If larger companies feel more comfortable about deploying their considerable cash piles, the likelihood is that M&A activity will pick up and additional capital investment will reinforce the recovery. Small cap funds should benefit.

James Carthew is a director at Marten & Co


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David Horner
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