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I continue today with my portfolio review ahead of the dawn of 2017. As I wrote about previously, as well picking out individual contrarian stocks I also like to focus on Macro themes and getting exposure to these through ETFs and quality Investment Trusts. I find this strategy allows me to make money by getting it right at a Macro level even if I make a few mistakes at a Micro level. Today’s focus is on UK listed Smaller companies, it’s an area I love and where I place most of own money when it comes to individual stocks. But after a bull run is this area still hot for growth and what is the best way to get exposure?
The Macro Picture for UK Smaller Companies
Ultimately a small company is tomorrow’s big company, so no matter what is going on in the broader macro environment there is always lots of potential in this area. The small company definition is fairly broad though and for investment trusts the selection criteria for companies to place their capital can be a market capitalisation of anything between £50m and £3bn.
As I discussed in my post last week on Vietnam opportunities, there are certain sectors that are for stock pickers rather than ETFs, which tend to track indexes. Smaller companies is another sector where active management is essential in my opinion. Smaller companies are inherently more risky, they tend to have more limited access to resources, this is financial capital but also human capital, i.e. experienced people. Smaller companies may also be earlier in the development cycle or more likely to be pursuing growth, which again makes them inherently more risky than their larger cap brethren. All this means failure rates are higher and consequently you need to be able to accept volatility in this sector.
The sector though is also full of promise for those with the eye. Overall the sector is relatively poorly researched too, in fact many smaller companies have no independent research published on them at all, so for a skilled asset manager there are massive opportunities for returns. Given the risks it is essential though to throughly research stocks and if possible look the management in the whites of the eyes.
What are the potential HeadWinds and Tailwinds for 2017 for the small company sector?
Always a tough assessment. Economic contraction is a risk to all stocks, but given the general restriction in capital that smaller companies have the risk is magnified in this sector. Bank’s lending books really dry up during times of toil. No surprise then that in the last major economic crisis of 2008, the smaller stocks were consequently hammered. The FTSE All share overall shed 45% value from peak to trough, the AIM All share 65% – see Figure 1.
So are we due another shock? I personally don’t like to plan for potential black swan events, it has been 8 years since the last financial crisis so I admit perhaps we are due one. However, equities over the long term deliver 7% a year, so by parking money in cash since 2008 waiting for the next black swan you would be giving up 72% of gains over the same 8 year period. My preferred strategy is therefore to keep 10%-30% of my portfolio in cash to buy into dips and leverage up when I see extreme buying opportunities. Given where we are in the cycle I am holding the upper end of the above range in cash and I’m certainly not thinking about leverage.
I’m not going to go into a full analysis of all the macro risks, but a flavour of what the ‘known unknowns’ are, just for fun. You need to look to the US, Russia, Europe and China in general, these are the only players that can really trigger an economic crisis. If any of these sneeze Britain will catch the cold. The biggest risks I see are slowing Chinese growth and the consequent credit bubble bursting, Donald Trump (catch all), Putin aggression and further pressure on the European project. As for the ‘unknown unknowns’, aliens landing in piccadilly circus…
What about Brexit?
This homegrown risk is a more tangible risk, but only just. Smaller companies tend to be more domestic led, therefore theoretically less vulnerable to the FX risks and new complexities of overseas trading that Brexit may bring. However, clearly the domestic economy is linked to the broader economy, it would be naive to suggest otherwise. On the flipside, a Brexit could also make doing business in the UK easier given the reduction in EU regulations to contend with.
I think at this stage though there are far too many variables to consider to ‘call’ this whole sector on the brexit factor. It will though for sure affect some companies more than others, exporters may be quids in but importers may struggle, this goes back to the importance of choosing a solid asset manager who can pick the right stocks…
So how can I get exposure to the UK Small Cap Scene?
There are 100s of funds, trusts and ETFs covering the sector. It is essential that you do your own research to find the right fund for your circumstances. My favourite though in the sector is Standard Life UK Smaller Companies Trust (SLS). This trust has performed exceptionally well over the last 10 years (Figure 2), an investment in December 2006 would have returned you 200%, against 10% decline for the AIM100 and relatively flat performances for the Numis SmallCo Index and the FTSE100.
Performance has been weaker this year (Figure 3) though, down 12% against the AIM100 benchmark. One of the drivers for the weak performance is the same reason for its outperformance over a longer horizon, the lack of exposure to resources sector. As a result the share price discount to the Net Assets has slipped to 7%, above the longer term discount of 5%. I have a lot of belief in the asset manager Harry Nimmo though and his long term track record is very good. I expect he may look to add in the resources sector as we enter 2017.
Another key factor for me is the size of the fund, £288m as at 23rd December. This makes it reasonably sized and thus able to operate relatively nimbly in the small cap area. As a result the trust is able to focus on a relatively small number of holdings, around 60. The trust also concentrates 56% of it’s NAV in it’s top 20 (figure 4). This means the asset manager Harry Nimmo can understand the companies inside out. The risk of funds getting too large is they end up having to take lots of positions, the Black Rock Small Cap Trust is a good example, it is double the size at £0.5bn and has 160 holdings. How can the asset manager keep track of this many holdings? Trusts can be often be victim of their own success, but as a shareholder I want the success to be returned to me via special dividends rather than through new investments in this sector. This keeps the trust nimble and hopefully performing well.
Final comment, the trust has exposure to AIM micro caps all the way to FTSE250 (Figure 5). This is a sensible weighting given the potential uncertain times we are entering.
Author Opinion – Positive on Sector / Positive on SLS Trust
Over the long term I expect the UK small company sector to continue to flourish, for as long as we have a government that is pro business. The SLS trust is an excellent way to get exposure, whilst 2015 has been a disappointing year I have confidence in the long term track record of Harry Nimmo.
Disclaimer – I have no positions in this stock. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.