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Navigating the small-cap universe via an investment trust

sponsored by BlackRock |

Investing in smaller companies offers the potential for growth and income. Portfolio manager Roland Arnold explains how investors can make the most from this vast selection of stocks.

The UK smaller companies sector is home to some of the most exciting businesses listed on the London market. These companies offer a long runway of growth potential as they develop new products or markets or are bought out and fundamentally shift their operations to capitalise on market opportunities.

The small-cap sector has consistently demonstrated greater earnings growth than its larger peers (FTSE, 2018), which has in turn manifested itself in greater long-term returns for shareholders. The small-cap story is particularly attractive in the UK, where investors may benefit from legal protections and accounting and listing standards greater than those available in many other equity markets globally.

None of this is in dispute, so how best can investors gain exposure to the opportunities available in UK small and medium sized companies?

There is no guarantee that any forecasts made will come to pass.

Going it alone?

Direct investment sounds simple, but to find genuine opportunities individuals would need to conduct fundamental research into each of the companies in the investable universe, which is no easy task if you consider that there are over 1,200 companies in our benchmark. They would need to understand the potential each stock presents and build a portfolio of the best opportunities. This takes time and given that the smaller companies sector is an under-researched part of the market, getting adequate information is difficult. Then there is the cost of building a portfolio of well-diversified stocks, which is important if investors are to avoid exposure to individual company risk.

Essentially, it is difficult for individuals to invest in smaller companies and achieve appropriate diversification and adequate risk management.

Strength in numbers

An alternative to going it alone is to outsource the research and portfolio construction by investing in a fund which can also spread the cost.

Investing in a closed-end fund – or investment trust – in this way may have several possible benefits. An investment trust is a registered company and issues a fixed number of shares to investors. This means the portfolio managers do not have to worry about sudden inflows – or outflows – of money. It also means the manager can invest confidently in companies that might be harder to sell quickly – known as illiquid investments – which is vital with smaller companies since it can take time to get returns. Being closed-ended may also limit the potential challenges if the fund suddenly becomes flavour of the month since it cannot accept a sudden influx of investment. This can be an advantage over open-ended funds because they must invest new inflows even when the manager may find it difficult to identify suitable investment opportunities.

BlackRock has not considered the suitability of this type of investment against your individual needs and risk tolerance. We recommend you seek independent professional advice prior to investing.     

This structure also means that the trust does not need to hold a cash buffer to pay exiting investors.  Instead, shareholders who want to exit can sell their shares to other investors through the secondary market. This means clients’ investments are always fully exposed to the market.

It’s a company

Investment trusts can also borrow. This means managers can invest even more in smaller companies on behalf of investors. Different trusts will adopt different levels of borrowing (usually referred to as ‘gearing’), and they can borrow more or less in the face of different market conditions. Clearly this can work against investors in falling markets, so understanding how different trusts borrow is key before committing any money. The current gearing level of the BlackRock Smaller Companies Investment Trust plc is 8% (as at 31 July 2018), and we traditionally operate in a 7% to 10% range.

Investment trusts also have a greater degree of flexibility over the size and frequency of dividend distributions when compared to open-ended funds. An open-ended fund has no choice over distributions and has to pay out all dividends received. An investment trust can retain up to 15% of revenues earned in each financial year which means that trusts can build up revenue reserves over time so, even in difficult markets, they can still make a smooth schedule of payments. The BlackRock Smaller Companies Trust has increased its dividend every year of the past 15 years and most recently grew the dividend by more than 23% in the year ending 28 February 2018.

Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy.

Additional safeguards

Importantly, investment trusts also provide investors with an additional layer of governance. Independent boards act on behalf of investors, ensuring the fund manager is adhering to the investment philosophy of the fund and, if necessary, the board can appoint a new manager if they are unhappy with performance.

Finally, the share price of an investment trust on the open market can often trade at a premium or a discount to the value of its assets. For instance, the BlackRock Smaller Companies Trust currently trades at a 8.5% discount (as at 31 August 2018)[i], allowing you to buy £1 for 92p, and who doesn’t like that?

For more information on this Trust, the risks involved and how to access the potential opportunities presented by smaller companies, please visit www.blackrock.com/uk/brsc

Trust specific risks

The Trust’s investments may have low liquidity which often causes the value of these investments to be less predictable. In extreme cases, the Trust may not be able to realise the investment at the latest market price or at a price considered fair. Investment strategies, such as borrowing, used by the Trust can result in even larger losses suffered when the value of the underlying investments fall.

Capital at risk: All financial investments involve an element of risk. Therefore, the value of your investment and any income from it will vary and your initial investment amount cannot be guaranteed. Smaller company investments are often associated with greater investment risk than those of larger company shares.

Important Information:

BlackRock have not considered the suitability of this investment against your individual needs and risk tolerance. To ensure you understand whether our products are suitable, please read the Key Investor Documents (KIDs) and the Annual and Half Yearly Reports available at blackrock.co.uk/its which detail more information about the risk profiles of the investments. We recommend you seek independent professional advice prior to investing.

Non-mainstream pooled investment products status: The Company currently conducts its affairs so that its securities can be recommended by Independent Financial Advisers to ordinary retail investors in accordance with the Financial Conduct Authority (FCA) rules in relation to non-mainstream investment products and intends to continue to do so for the foreseeable future. The securities are excluded from the FCA's restrictions which apply to non-mainstream investment products because they are shares in an investment trust.

Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.

The Company is managed by BlackRock Fund Managers Limited (BFM) as the AIFM. BFM has delegated certain investment management and other ancillary services to BlackRock Investment Management (UK) Limited. The Company’s shares are traded on the London Stock Exchange and dealing may only be through a member of the Exchange. The Company will not invest more than 15% of its gross assets in other listed investment trusts. SEDOL™ is a trademark of the London Stock Exchange plc and is used under licence. 

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[i] http://www.lse.co.uk/regulatory-news-article.asp?ArticleCode=d3sgxklx&ArticleHeadline=Portfolio_Update

 

BlackRock

At BlackRock we see investment trusts differently. The world is undergoing political, economic and demographic change. For some, change means challenges but at BlackRock we see opportunity. We have a range of 10 investment trusts, from multi-asset to specialist. We use leading systems and experts to invest in the fastest growing countries and most successful companies across the world.