One of the main factors that determines the average investment trust discount in a particular sector is investor sentiment towards that part of the market.

The most out-of-favour areas currently include the UK small and mid-cap funds, which creates a contrarian opportunity for those who are prepared to take a long-term view.

According to data from Numis Securities Research, the UK Smaller Companies sector was recently trading at an average discount of 14.7% with many of the individual funds available at 15% to 20% less than their underlying net asset value.

The small and mid-cap stocks in which these funds invest tend to be more dependent on the UK economy for their earnings than the multi-nationals in the FTSE 100 index. This suggests that it is likely to be concern about the possible impact of Brexit that is responsible for the negative sentiment at present.

COULD THE UK DO BETTER THAN EXPECTED?

June’s general election could ultimately be good news for the UK economy.

Small and mid-cap funds with large UK exposure could do extremely well if the economy holds up better than expected. They would also be less vulnerable than the large cap and global funds if the pound continues to recoup some of its post Brexit losses.

Investment Opportunities

Analysts at Stifel have recently highlighted the contrarian opportunity offered by UK small and mid-cap trusts. Their report points out that these areas were a notable laggard in 2016 and experienced widening discounts.

One of the funds they highlight is the £173m Schroder UK Mid Cap (SCP) which aims to generate a total return in excess of the FTSE 250 index. It is trading on a 20% discount to net asset value (NAV) despite the fact that it has a decent long-term track record with the share price and NAV returns comfortably outperforming its benchmark over 10 years.

Stifel has a positive recommendation on the £287m BlackRock Throgmorton Trust (THRG) that is trading at a discount of 20%. The small cap fund has a strong long-term track record and is unusual as the manager can short stocks that he thinks will fall in value.

SMALL CAN BE BEAUTIFUL

The team at Numis Securities Research favour Aberforth Smaller Companies (ASL), which has a well-defined value approach; and Henderson Smaller Companies (HSL) which has a good record under manger Neil Hermon through a diversified portfolio focused on growth at a reasonable price.

Numis acknowledges that Aberforth’s returns look dull, but it rates the management team highly and says there is a role for a value-orientated fund. Aberforth Smaller Companies has a market value of £1.16bn and is trading on a 15% discount to NAV. The share price is up 118% over 10 years, which is slightly behind the benchmark and sector average.

Henderson Smaller Companies has a market cap of £547m and Numis considers it to be an attractive core holding for those who want exposure to small cap stocks. Its manager looks for undervalued companies with good growth prospects, sound financial characteristics and strong management.

It is trading on a 15% discount, which is in line with its 12-month average. It has a diversified portfolio of 112 stocks with the share price up 171% over 10 years.

BEST IDEAS LIST

The investment companies team at Winterflood Research have included three UK small cap funds in their 2017 Model Portfolio. These represent their best ideas and are the funds that appear well-placed to outperform their peers on an 18 to 24 month view through a narrowing of the discount or outperformance of the underlying portfolio.

Their recommendations in this area are: BlackRock Smaller Companies (BRSC), River & Mercantile UK Micro Cap (RMMC), and the aforementioned Henderson Smaller Companies.

They note BlackRock Smaller Companies has an impressive performance record, both in terms of its relative performance and consistency, having outperformed the benchmark in each of its last
13 financial years. It also has a good record against the sector average.

Mike Prentis, the manager, looks for companies that have five sustainable growth characteristics, namely: strong management, strong market position, sound balance sheet, cash generative, and with a track record of growth.

He has put together a diversified portfolio of 167 stocks with the 10 largest positions accounting for just 20% of the assets. The shares are trading on a 17.5% discount to NAV and have returned 235% over the last 10 years.

River & Mercontile UK Micro Cap aims to generate long-term capital growth from a diversified portfolio of UK micro-cap equities that typically have a free float market value of less than £100m. Its manager, Philip Rodrigs, believes this part of the market is often overlooked, but has historically generated superior returns.

The £104m fund was created in December 2014 and has generated an NAV return of 50% since the launch. Its shares are currently trading on a 3.6% discount, which is slightly less than the 4.6% average discount calculated over the last 12-months. (NS)

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