Small cap investment trusts can be a good way of getting exposure to stock market tiddlers.
Many posters on the Motley Fool's discussion boards are in love with small cap shares. They know that historically, small caps have delivered better returns than large caps. There's also evidence that the small cap market is less efficient, meaning stock pickers have more potential to outperform.
So far, so sensible. But where we go wrong is that after a couple of good years we compare the performance of our small cap portfolios with the FTSE 100 -- often posting our results on the boards when we're bored with just patting ourselves on the back.
Eventually, someone pipes up that the Hoare Govett Smaller Companies Index -- the UK's most widely used barometer of the small cap sector -- has delivered similar returns to the poster's portfolio. Often, of course, it's done better.
Index tracking works! Deluding yourself doesn't.
What no index tracker?
The trouble is it's hard if not impossible to track the UK small cap sector. There's no passive funds that do so, at least as far as I'm aware. This is a big contrast to the US, where you can even pick up small cap ETFs tilted towards value or growth.
One alternative is a small cap investment trust, which invests across the sector and so also diversifies your portfolio. The downside here is you'll pay more in annual fees than you would for an ETF -- though possibly a lot less than you pay in dealing fees on trading shares for yourself.
Another potential danger is that your trust's skilled fund manager turns out to be not so skilled, or has a bad year compared to the index. There's no getting away from this but to spread your money between two or three trusts, and to try to pick those with a decent longer-term record.
Step forward Aberforth
If you're tempted to pay someone to do your small cap share trading for you -- or if you'd just like any easy way to bolt-on some small cap exposure to a portfolio dominated by large companies -- then you might consider the Aberforth Small Companies Investment Trust (LSE: ASL).
Launched in 1990, the fund's remit is to invest in companies in the Hoare Govett Smaller Companies index, which currently means an upper market capitalisation limit of just under £1.2 billion. The Trust's portfolio normally holds around 80 shares, and when management think it's wise (like now) they can gear up modestly to take advantage of cheaper share prices.
Management fees are 0.2% per quarter, and there are no performance fees. The total expense ratio last year was 0.85%, which isn't any dearer than many specialised ETFs.
Aberforth's trust has delivered excellent total returns over the past 15 years, both in absolute terms and relative to the Hoare Govett index.
Periods to
28 February | Hoare
Govett
Index | ASL's NAV | ASL's
share price |
|---|
| 1 year | 66% | +55.4% | +44.2% |
| 3 years | -4.5% | -8.3% | -8.7% |
| 5 years | 6.3% | 2.8% | 1.6% |
| 10 years | 5.0% | 10.0% | 10.9% |
| 15 years | 9.3% | 12.1% | 11.0% |
Source: Aberforth Partners
These are total returns, so they include reinvested dividends, and tax credits prior to 1997 (when they were abolished).
The results are pretty remarkable. If you'd invested £1,000 in Aberforth in February 2000 and reinvested your dividends, it would now be worth £2,593 (ignoring costs and tax). So much for the lost decade!
It's also notable that Aberforth's managers beat their index over 10 and 15 years, although they underperformed in last year's huge rally.
Big value in little companies
Nobody knows if smaller companies will beat bigger companies over the next 10-15 years, of course. But that's an argument for diversifying across the spectrum, not for ignoring small caps.
At least Aberforth's managers seem confident that their trust is looking cheap, stating in the annual report (published on 26 January) that:
"On both an absolute and relative basis, the portfolio is offering what is approaching its best value over the trust's history. Crucially, in your managers' opinion, this has not been facilitated by a deterioration in quality."
There are several good reasons for Aberforth's confidence.
Firstly, the average historic P/E of smaller companies during the past 19 years of the trust's existence is 14, going as high as 18 in the recovery of the early 1990s. Yet at the end of January the historic P/E of the Hoare Govett index was 11, while the average historic P/E of the companies owned by the trust was just over 8.
Another sign of the value credentials of the Aberforth Trust's portfolio is that over a third of its holdings have net cash. And despite widespread dividend cuts in the past couple of years, the portfolio delivers a reasonable yield -- 3.6% as of the year-end -- and has revenue reserves to top up this payment if required.
Better yet, the managers were basing their P/E figures on a year-end share price of 534p. In 2010 the trust's share price has followed smaller caps down into the doldrums, dropping below 500p at once point.
Yet in my opinion smaller this drift is more due to nerves over the economy and fears of a hung parliament rather than any deterioration in business conditions. (In fact I believe the economy is bouncing back).
Go Aberforth and conquer
Shares in the Aberforth Smaller Companies Trust are currently 508p, offering a 3.7% dividend yield that has been held for the past couple of years. Dividend income more than doubled between 1999 and 2009, and there's every chance it could motor upwards again once the recovery gains steam.
The discount of Aberforth's share price to net asset value is 14.9%, which is greater than the average over the past five years.
I rate this share a buy -- indeed I bought some more last week!
More from Owain Bennallack:
Note: Owain owns shares of the Aberforth Small Companies Investment Trust.
