This sector has some strong performers and wide discounts. Kyle Caldwell explains why.
As discounts and premiums are driven by the supply and demand of an investment trust’s shares, the performance of its underlying investments – the net asset value (NAV) – is an important influence over its rating.
In theory, if a trust is performing well over both short and long time periods, you would expect investor demand to be high.
However, this does not always play out. For various reasons, a trust can persistently trade on a discount even when it is a consistently good performer; such as when it has a small amount of assets. This is a reflection that demand for shares is low, which can cause dealing spreads to be wide and also limit the narrowing of a discount, especially when there's no discount control mechanism in place.
Of course, this can change. But if it doesn’t, investment performance alone will not necessarily lead the trust to grow significantly in size (which improves dealing spreads), as trusts typically only issue new shares when trading on a premium in order to avoid diluting existing investors.
Another factor at play behind a longstanding discount is if the region or part of the market that the trust invests in is out of favour, or permanently unpopular.
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UK smaller company trusts, for example, typically trade on discounts. The sector has some strong performers, but it never normally tops the popularity poll. Some trusts in the sector have a small amount of assets, but it is the higher risk nature of investing in smaller-sized companies that is perhaps the main reason that dampens demand for the sector overall.
As a recent note from investment trust analyst Stifel points out, the sector has performed well over the past year having benefited from the broader Covid-19 market recovery for various domestic-facing sectors and industries. According to Morningstar, the average trust’s share price total return is 45.5%. Despite this, the average trust is trading on a discount of 8.9%.
That’s not to say the sector should be written-off from a bargain-hunting perspective. While trusts in this sector tend to trade on discounts, most discounts do not remain static. As the note from Stifel points out, over the past year a number of trusts in the sector saw their discounts narrow significantly during the sharp recovery from the Covid-19 market turmoil.
But since the start of September, discounts have widened as UK mid- and small-cap stocks have underperformed their large-cap counterparts. Stifel puts this down to a mix of some profit-taking, following the strong recovery for mid- and small-caps, as well as concerns over the UK economy and potential interest rate rises to combat rising levels of inflation.
Stifel argues that this has created a potential buying opportunity and notes that a number of trusts in the sector are “trading on relatively wide discounts”, with some close to 12-month highs.
It noted last week, on 4 November: “For example, Invesco Perpetual UK Smaller Companies (LSE:IPU), which has seen a NAV of 51% over the past year, is on a 13% discount (its 12-month range is 17% to 3%). Similarly, JPMorgan UK Smaller Companies (LSE:JMI) has widened to an 11% discount (its 12-month range is 11% to a 4% premium), and Henderson Smaller Companies (LSE:HSL) to a 7% discount (its 12-month range is 11% to 0%). All these trusts have delivered NAV total returns in excess of 50% over the past year.”
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Two of the trio highlighted by Stifel boast sector-beating performance over five years. JPMorgan UK Smaller Companies is up 192.8% and Henderson Smaller Companies has gained 127.3% versus 104.5% for the wider sector. Over the same time period, Invesco Perpetual UK Smaller Companies is up 84.1%.
Henderson Smaller Companies is a member of interactive investor’s Super 60 list. Fund manager Neil Hermon has been at the helm for 18 years and has outperformed the trust’s benchmark in 16 of those years. Its benchmark is the Numis Smaller Companies Index.
Separately, analyst Winterflood picked out Aberdeen Smaller Companies (LSE:ASCI) as having a wide discount despite its strong long-term performance. Shavar Halberstadt, a research analyst at Winterflood, says the trust has outperformed its Numis Smaller Companies ex-Investment Companies Index benchmark over the past three and five years on a NAV total return basis. Abby Glennie has managed the trust since August 2018, while co-manager Amanda Yeaman joined in June 2019.
Halberstadt points out that its “quality growth” investment style is well placed to profit from the post-pandemic recovery. In addition, its discount is 15.2%. This is higher than the UK smaller company sector average, of 8.9%, and its own 12-month average discount figure of 13.6%.
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However, the trouble is that given this is small trust with just £79 million of assets, there’s a lack of supply and demand. Therefore, as Halberstadt observes the attractiveness of the trust and its discount is “limited”.
He added: “We rate the team at Aberdeen Smaller Companies Income highly and think that their approach of maintaining the dividend through defensive positioning in 2020, and subsequent rotation into companies with higher upside as visibility improved in 2021, was sensible. Nevertheless, we believe that the attractiveness of the fund is limited by its small size, with a market cap of just £79 million and an average daily traded volume of only £79,000 over the last 12 months.”
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