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Value to be found in discounted small-cap investment trusts

Small-cap and fledgling investment trusts are now near universally trading on double-digit discounts.

The trusts suffered a savage de-rating as investors begun favouring large-cap stocks. But the de-rating has been indiscriminate and has left some attractive investment opportunities in its wake.

Recent volatility and concerns over a liquidity crisis have also hurt sentiment in the sector, with some investors wondering where the support will be for smaller firms in troubled times.

By mid November the 13 investment trusts in the AIC UK Smaller Companies sector were trading on an average discount of 15.3%, while the three trusts in the AIC Fledgling sector, Active Capital , Eaglet and Gartmore Fledgling, were faring slightly worse, averaging a 15.6% discount.

Eaglet , which until October was managed by Unicorn Asset Management founder Peter Webb, has seen a well-documented corporate action led by Knox D’Arcy, QVT and Laxey, who together with other arbitrageurs control around 39% of the trust.

After its EGM on 11 December, the arbs had successfully managed to put three new directors onto the board, with a potential brief to change the investment strategy to improve performance.

Perhaps in acknowledgement of the difficulties facing the sector, Gervais Williams’ £98 million Gartmore Fledgling trust is looking to boost its investment powers by having the flexibility to invest up to 20% of the portfolio in companies that have dropped down to AIM from the main index.

Renowned arbitrageur Laxey Partners has taken a stake in the third fledgling trust, Active Capital managed by Bill Brown of Bluehone Investors, which has a commitment to grow its share price from 100p at launch to 222p by its annual general meeting in 2009.

The last three years have been weak periods for all three managers but their longer-term track records are strong.

This, coupled with the fact all three trusts seem to be facing shareholders or using strategies set on closing the discounts, make all three trusts an option as an each-way bet.

Close Wins analyst Charles Cade said the ultimate closing of these discounts is likely to take place in the wider smaller companies sector as well.

He says: ‘The small-cap arena is unloved and has been so since the first quarter. Discounts cannot remain this wide for ever.

‘Many of them have a decent track record and are now on quite attractive discounts, which could mean a good mid-term buying opportunity.’

Trusts in the sector that catch the eye at current discount levels include Aberforth Smaller Companies and JP Morgan Smaller Companies, which are trading on 18.1% and 17.2% discounts respectively.

One year ago, Aberforth was trading at around an 8% discount but has been affected by the negative sentiment to the sector.

However, Smith & Williamson’s AA-rated James Burns sees Aberforth as a good mid-term bet and currently has more than 3% of his Smith & Williamson Global Investment fund in the trust.

Burns says: ‘Aberforth are a very solid team. The open-ended Aberforth fund is at par, while the trust version is at an 18% discount but both funds have an almost identical portfolio.’

Citywire Verdict
Small and micro-caps are currently one of the most unloved areas of the market and have suffered this year when compared to large-cap rivals. Yet they also contain some highly successful and well-known managers. The fact that the asset class is so unloved throws up opportunities for shrewd investors to pick up stakes in some well managed trusts at very attractive discounts. However, investors need to be aware that the sector may be set for a period of short-term relative underperformance.

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