Looking ahead: The UK small-cap universe

Roland Arnold, Portfolio Manager of the BlackRock Smaller Companies Trust plc, explores reasons to consider UK equities in 2021 and why he believes that innovative and nimble UK smaller companies can navigate the current market challenges, whatever is thrown at them.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Is 2021 likely to be a better time for UK equities?

With the UK ahead in its vaccine rollout we are cautiously optimistic around the pace of reopening in the UK and the potential for economic recovery. There are many reasons to be cheerful in fact. Government policy has supported individuals and industries, and whilst sadly unemployment and corporate insolvency will rise, we still expect a strong recovery in domestic consumption this year. However, UK equities are about much more than just UK consumption, the UK is home to many world leading growth businesses, and with much of the Brexit uncertainty now behind us, we expect government policy to focus on supporting and attracting those businesses.  

You’re more diversified than most of your peer group: what’s the reason and how has this helped you in volatile markets?

We have always believed that the best way to manage risk within the portfolio is through position sizing and suitable diversification. One of the core attractions of our universe is the sheer number of fantastic growth companies which are available to us, and there is never a shortage of potential ideas for inclusion in the portfolio. By maintaining a well-diversified portfolio, we can appropriately size new positions that might be less liquid, and as we see evidence of our investment thesis playing out, allow positions to grow organically over time as they become core holdings. Importantly we ensure we are not overly exposed to single stock disappointments, because as we all know with smaller companies, things can, and often do go wrong and by maintaining a well-diversified portfolio we ensure that the outcome of the Trust won’t be dictated by one stock.

Do smaller companies demonstrate any competitive advantage in these more extreme market conditions?

We have often argued that one of the key attractions of investing in small and mid-caps is their ability to adapt quickly to change. The outbreak of COVID-19 and disruption caused to many industries has been unlike anything that many businesses will have ever experienced. Smaller companies tend not to demonstrate the organisational inertia of their larger cousins; there are fewer layers of decision making, managers are often the owners, there is a strong entrepreneurial spirit and often there is less capital employed. We have seen in lockdown how a number of our businesses have rapidly adapted to new distribution or have responded to shifting customer requirements. Coronavirus has changed many industries, but often these changes are an acceleration of existing trends, and the companies that were leading that change pre-COVID-19, are the ones that are benefitting now.

In a secular low growth environment, once ‘normality’ resumes, can smaller companies continue to grow their earnings?

Smaller companies have typically grown their earnings at a greater rate than larger companies, by something in the order of 3% pa over the last thirty years. But that excess growth isn’t uniform, typically in tougher years the immature business models can be impacted more than the diverse mature revenue streams of larger companies. If we are predicting a secular low growth world I would expect to see a return to smaller companies leading the charge as the attractive characteristics of their businesses return to the forefront; their ability to develop new markets and adapt to change whilst agitating and disrupting existing markets.

What are the advantages to investing in small caps via an investment trust structure?

There are several advantages. The first is the ability to utilise leverage to augment the investment returns, amplifying the already attractive return characteristics of the SMID sector. BlackRock Smaller Companies Trust has the ability to to gear up by 15%.

The second benefit relates to liquidity. The closed-ended nature of an investment trust means the manager doesn’t have to worry about outflows, reducing fund liquidity as a consideration and allowing the manager to invest with confidence in less liquid companies. This can be vital with smaller companies, where it can take time to get the potentially substantial returns.

An investment trust structure allows a proportion of the dividend income received to be retained in a revenue reserve. This means in times when companies may be holding back on the cash they return to shareholders, the Trust has more options with regards to dividend policy.

Finally, it is often possible to buy investment trusts when they trade at a discount to their net asset value, and who doesn’t like that?

To invest in this type of investment, it may also be worth holding it in an ISA, making the most of your tax-free ISA allowance and sheltering it from income and capital gains tax. You can also use an ISA as a regular way to save rather than putting a lump sum in the market in one go. ISAs allow up to £20,000 to be sheltered from income and capital gains tax.  Much like an open-ended fund, you can also buy shares in the Trust through most online platforms or through a stockbroker.