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Alice Rigby
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Updated 05 May 2023
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Disclaimer

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.

Small-caps are often considered a tricky area of the market in which to invest. Some investors outright fear their illiquidity and volatility, to the point of avoiding them altogether. Many, if current valuations are anything to go by, clear out of them at the whiff of a recession, fearful of their ability to withstand a period of economic malaise.

The outlook for the UK is yet to see much of a silver lining. Inflation is proving to be unexpectedly persistent, despite aggressive rate rises by the Bank of England. Yet, a long-promised recession has yet to materialise, as growth has simply fallen to muted levels rather than receding altogether. None of this instinctively points to the attractiveness of domestically-focused small companies.

Yet, economic orthodoxy tells us that a recovery will emerge at some point. History tells us that smaller companies could be the ones that benefit. While smaller companies tend to be excessively punished on the way into periods of economic uncertainty, they also tend to be rewarded on the way out of them.

Data published by Liberum analysing recessions since 1986 suggests that FTSE 100 stocks rose by around 3% on average in the final two quarters of a recession and first two quarters of a recovery, compared with 14.1% for the FTSE Small Cap. While there is no guarantee that this pattern will be repeated in the future, it makes for interesting reading at such a challenging economic time.

From an investment trust perspective, the small-cap sector has certainly experienced a tough two years. The AIC UK Smaller Companies sector currently sits on an average discount of -12.38%, compared to -6.18% two years ago.

Two of the trusts currently sitting on discounts of around this average offer two different routes into UK Smaller Companies.

The first, Invesco Perpetual UK Smaller Companies (IPU), seeks to provide outsized returns with lower-than-average volatility by investing in quality names across the UK small- and mid-cap segments. Crucially, the trust combines both growth-oriented companies and those that would be considered more of a “value” name. The trust also pays a dividend that is considerably above the sector average.

At the other end of the scale is Downing Strategic Micro-Cap (DSM). The trust invests in the UK’s very smallest listed companies, seeking those where its managers see considerable potential for revaluation, either through growth or the correcting of perceived or actual problems. The trust has struggled in its early years but is starting to see some of its investment cases bear fruit. Its approach is unique within the market.

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