Investing in UK small-caps with investment trusts

Benjamin Graham, often called the ‘father of value investing’, gave this advice in his seminal work in 1949: “The intelligent investor is likely to need considerable willpower to keep from following the crowd. The best values today are often found in the stocks that were once hot and have since gone cold.”

It would be fair to say that UK equities, and small-caps in particular, have been at the colder end of the spectrum over the last decade, with record-breaking fund outflows as the ‘crowd’ shifted their money into the hot-to-trot US mega-caps.

However, investors keeping the faith have historically been well rewarded and the UK small-cap sector continues to offer an attractively valued and under-researched universe for stock-pickers. Indeed, the vast majority of investment trusts in the AIC UK Smaller Companies sector have delivered positive (and often substantial) net asset value returns over the last five years, despite the challenging backdrop.

Why invest in UK small-caps?

We look at six potential reasons for investing in the UK small-cap sector (which is generally defined as companies with market caps between £250m and £2bn).

1. Superior growth potential

Veteran investor Jim Slater is quoted as saying that “elephants don’t gallop”, meaning that small-caps often deliver superior earnings growth to their larger-cap peers.

The chart below shows that the average ten-year EBITDA growth of the FTSE UK Small Cap Index has been around three times higher than the mid and large-cap indices:

Beyond the simple arithmetic advantage of being easier to double revenue of £50m than £5bn, companies in the early stages of their life cycle may have a longer growth runway. Small-caps may also target niche or rapidly-growing markets that have not yet attracted the attention of larger operators.

In addition, more entrepreneurial and ‘flatter’ management teams lend themselves to quicker decision-making, whether exploiting short-term market opportunities or adapting to more challenging market conditions.

2. Attractive valuations

The UK equity sector has suffered a double whammy with UK equities trading on lower valuations than global peers and small-caps trading at a considerably larger discount to long-term valuations than larger-cap indices.

As shown in the chart below, all three FTSE indices are trading well below their decade averages, but this is most pronounced for the FTSE Small Cap (ex-ITs) Index which is trading at a near-50% discount. This could help to drive returns if valuations move back towards long-term averages.

Whilst investors have largely eschewed UK small-caps, depressed valuations have certainly attracted attention from potential acquirers, with Peel Hunt reporting that 10% of the FTSE Small Cap Index was acquired in 2023 alone.

Almost 60% of buyers were in the private equity sphere while overseas buyers accounted for more than half of transactions. With an average bid premium of more than 50%, M&A activity has proved a tailwind for many UK small-cap trusts.

3. Cash generative

There’s a preconception that small-caps are more highly leveraged and, as a result, lack the financial resilience (and have a higher sensitivity to interest rates) of their larger-cap peers.

However, a number of UK small-caps are in a net cash position and the average net debt to EBITDA ratio is currently 2.1 times for the FTSE Small Cap Index, only marginally above the 1.7 times of the FTSE 100 (as at 22/05/2024).

Small-cap companies are also often highly cash generative. The FTSE Small Cap Index achieved a 500% plus increase in free cash flow in the five years to the end of 2023, compared to 68% and 33% for the FTSE 250 (ex-ITs) and 100 indices respectively.

As a result, an attractive income stream has increasingly become a feature of UK small-caps. The chart below shows the rise in dividend yield for the FTSE Small Cap Index over a five-year period. By 2025, this index is forecast to offer the highest yield of the three indices shown, which may increase its appeal to income-seeking investors.

4. Large universe for stock-pickers

There are more than 1,000 small-cap companies across the main market and AIM, providing a broad universe of opportunities for stock-pickers.

The small-cap sector is also well-diversified, with the top ten companies making up less than 20% of the FTSE Small Cap Index by market capitalisation, in contrast to almost 50% for the FTSE 100. In addition, there’s a higher exposure to high-growth sectors (such as information technology, consumer discretionary, and industrials) than in the FTSE 100.

The UK small-cap sector is also less widely covered by analysts, leading to pricing opportunities for active managers. The average number of analysts covering the ten largest FTSE 100 companies (by market cap) is 18, compared to less than six for the FTSE Small Cap Index and coverage drops substantially thereafter.

5. Diversification

The UK small-cap sector provides the opportunity for investors to diversify their portfolios by both market cap and geography. The sector also boasts its fair share of international businesses that are not solely dependent on the fortunes of the UK economy.

In addition, the performance of small-caps tends to be driven by stock-specific factors whereas large-caps are more sensitive to broader macroeconomic factors. This can act as a counterbalance as well as offering active managers a potential source of alpha generation.

6. Superior returns

Due to the reasons discussed above, UK small-caps have outperformed their larger-cap peers over the long term, as shown in the chart below. The FTSE Small Cap Index has delivered a total 15-year return of more than 360%, comfortably in excess of the 230% return for the FTSE 100.

Source: Bloomberg (as at 21/05/2024)
Past performance is not a reliable indicator of future results

How difficult is it to invest in UK small-caps?

Investing in individual small-cap companies can be difficult for private investors due to the lack of research coverage, as mentioned earlier. This requires investors to carry out their own assessment of a company’s financial and competitive position, in addition to the quality of the management team, which can be difficult using desk-top research alone.

A lack of liquidity can also cause a challenge in terms of wide buy-sell spreads and difficulties in buying some shares through standard retail channels.

Active fund managers generally conduct in-depth due diligence and engage with management teams prior to investing. Some take more of a private equity style approach by working with management teams to help direct future strategy and improve shareholder returns.

However, the sector is better suited to a longer-term investment horizon due to its more cyclical nature and higher sensitivity to investor sentiment.

Why invest in UK small-caps with investment trusts?

Investment trusts are a type of fund that offers investors access to a diversified portfolio of UK small-cap companies, while managing some of the potential downside risks mentioned above.

There are currently around 25 trusts in the AIC UK Smaller Companies category, although the remit varies widely with some trusts targeting the larger end of the sector and others focusing on micro-caps (typically below £250m). There is also a range of portfolio sizes, with some managers running a high-conviction portfolio of 10-20 stocks, while others hold in excess of 100 companies.

Many managers have extensive expertise and experience of investing in small-caps. By way of example, the manager of BlackRock Smaller Companies has over 20 years of experience in the sector with a focus on high quality UK companies at the smaller end of the market cap spectrum.

The trust focuses on companies offering high quality management, a strong market position and track record of growth, sustainable cash generation and well-capitalised balance sheets. These are often capital-light business models with high recurring revenue and cash generation that underpin long-term growth.

Investment trusts vs open-ended funds

It’s fair to say that some of the benefits mentioned above also apply to open-ended funds. However, investment trusts have some unique attributes which may help them deliver superior returns to their open-ended peers.

Firstly, open-ended funds are not publicly traded (unlike investment trusts), meaning that the size of the investable fund will rise and shrink with the purchase and sale of units in the fund. This means that open-ended funds typically hold a sizeable proportion of cash in reserve in order to meet redemption requests for investors, which can create a ‘drag’ on returns, and also limits their ability to invest in less liquid stocks such as small-caps.

Investment trusts do not have this problem as publicly-traded companies, meaning that the buying and selling of shares in the investment trust does not impact the size of the investable fund. As trusts are not required to keep cash for redemptions, this can boost returns for investors and allow longer-term investment in smaller companies.

Another factor is gearing, whereby the trust can borrow money with the goal of enhancing returns (although it can also amplify losses). Trusts are typically able to borrow up to a certain percentage, for example 25% of the assets under management, whereas open-ended funds are not able to deploy gearing.

Lastly, investment trusts can use capital reserves to pay dividends (if required), which can provide income for investors in a sector which is more growth than income-focused.