Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by BlackRock Smaller Companies. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
It’s a common refrain among investors that better buying opportunities present themselves when the news flow is bad. There is certainly some logic to this. Negative sentiment drives down prices irrationally, which leads to companies being undervalued.
But is this true in practice? If some recent work by US firm Stansberry Research is anything to go by, then the answer may be yes. An analyst at the firm started by looking at the Investor Movement Index. This is produced by US retail broker TD Ameritrade and gives some idea as to how optimistic the broker’s 11m customers are feeling. Unsurprisingly, sentiment is very negative at the moment, having been extremely positive in 2021.
They then compared past returns for 12 month periods after the index had hit a low, like we’re seeing today, relative to average 12-month period returns. The results were that returns after low points in the index were more than double those produced in the average 12 month period. In other words, investing when people were pessimistic drove better returns than the norm.
This should not be seen as an invitation to go and start buying shares indiscriminately in the hope they’ll see some massive surge in value. But if (and it’s a big if) the theory is accurate and assuming all other things are equal then some investment trusts, particularly in the UK small cap sector, may now be at an interesting juncture.
One example of this is BlackRock Smaller Companies (BRSC). The trust is managed by Roland Arnold, who looks for high quality smaller companies with strong growth prospects listed on the London Stock Exchange. Roland has a broad remit and can invest in sub-£150m market cap stocks listed on AIM up to firms with a £2bn market cap.
BRSC’s discount has widened substantially over the past 18 months. The trust was trading at a discount of -13.5% as at 16/03/2023, compared to a peer group average of -10.7% and a five-year historical average of -6.2%. That is likely the result of negative sentiment towards the smaller, more growth-oriented businesses that Roland invests in.
This is being driven in part by interest rate hikes, which tend to have, at least in the short term, an inverse relationship with growth stock valuations. To illustrate this, research from Montgomery Investment Management found that in all the periods where the yields on 2-year treasuries rose from 1980 until today, there was no occasion where the forward price-to-earnings ratio of the S&P 500 did not fall.
Another factor likely impacting BRSC’s share price is the view that smaller companies are as a rule less well equipped to survive during economic downturns. This view is not a particularly nuanced one but there is a sense that smaller companies, whether because of a lack of diversification in their revenue streams or a higher risk of default are less likely to survive a recession. Valuations also play a role here as earnings growth, which ultimately drives higher valuations, can be difficult to sustain when a recession kicks in. This last point may partly explain why BRSC’s discount has widened so much as well.
Even if we assume these points are valid and should apply to BRSC, the trust has already seen its NAV and share price, on a total return basis, fall by close to 40% since the start of Q4 2021, which is when inflationary fears and interest rate hikes started to come into play. So there is an argument to be made that, along with the widened discount, the potential fallout from a recession has been priced in.
But then it’s worth keeping in mind that all of the above is essentially macroeconomically driven and has only a theoretical connection to the companies in the trust’s portfolio. And this is where the BRSC’s emphasis on quality may prove its worth.
Roland invests in companies that have strong balance sheets, cash flows and management teams. These are not long shot bets on future growth but are instead the sorts of firms you’d expect to be more resilient during an economic downturn.
For instance, BRSC’s largest holding is currently 4imprint Group, which makes promotional products for companies. Last year the firm increased its pre-tax profit more than three-fold to $104m. The firm had been hit hard by Covid but even then 2022’s pre-tax profit was close to double the previous high from 2019, with the management team also hitting a long-term goal of delivering over $1bn in revenue.
It’s a somewhat similar story with veterinary group CVS, BRSC’s second-largest holding, which delivered 22.1% growth in its pre-tax profit in the six months up to the end of 2022, its last half-year reporting period. The company also refinanced its debt in February at the same rate it had previously and with access to more capital, a sign that the company’s finances are strong. Management have also noted that they are continuing with an ambitious growth plan over the next five years, despite a possible economic downturn.
These sorts of results are not certain to continue indefinitely. BRSC also has 120 holdings, which means it’s always plausible there will be underperformers in the portfolio. However, given what is arguably priced in and how the managers approach the markets, there may be room to be cautiously optimistic – even if everyone else does seem rather glum.
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