Investment trusts invested in UK smaller companies are trading at wide discounts despite their outperformance this year, according to data compiled by Morningstar Direct. Thanks to Brexit uncertainty, even those highly rated by Morningstar analysts are going cheap.
Of the 62 investment trusts positively rated by Morningstar analysts, 46 of them are trading at discounts. Dunedin Smaller Companies (DNDL), a Bronze Rated trust investing in the UK small-cap equity space, is trading at a 20.4% discount, the widest discounts among all rated trusts.
Four other highly rated UK small-cap trusts are also trading at double digit discounts. They are Bronze Rated Henderson Smaller Companies (HSL), Silver Rated BlackRock Throgmorton Trust (THRG), Gold Rated BlackRock Smaller Companies (BRSC) and Silver Rated Aberforth Smaller Companies (ASL).
Together with the Gold Rated Standard Life UK Smaller Companies (SLS), which is trading at 6% discount, these four trusts dominate the small cap sector, accounting for £3.3 billion assets and near 70% of the sector’s overall assets, according to Morningstar data.
Investment Trusts at Discount Despite Gains
Looking at year to date performance, UK small-cap equity investment trusts have delivered positive double-digit returns. Dunedin Smaller Companies has gained 20% year to date while Henderson Smaller Companies is up 19.3%.
Values in the smaller companies sector as a whole is always more volatile relative to the average discount level of the UK all-companies sector, which will impact their attractiveness to investors, said David Holder, senior fund analyst with Morningstar.
“You can clearly see the divergence of discounts around the Brexit vote between the UK smaller companies and the UK all companies sector average,” said Holder.
“UK Smaller companies are considered to be a pure play on the UK. Given the weaker GDP numbers we have seen recently and the uncertainty around Brexit, there are plenty of reasons for investors to be shunning the sector and therefore for discounts to be widening. However, some of the investment trusts have recovered to some extent post the Brexit shock.”
In the 12 months before the EU Referendum, the average discount was 8.3% compared to the 12.8% average seen in the following 12 months, according to Morningstar data. The sector’s discount reached 15.6% in July 2016 after which it has recovered to the current level of 11.6%.
However, within the sector, there are specific reasons as to why some of these trusts are trading at wider discounts than their sector average, Holder added.
“BlackRock Throgmorton trust is trading at a discount because it is not particularly well understood or marketed, while Dunedin is because of the impact of the merger between Aberdeen and Standard Life,” said Holder.
Dunedin Smaller Companies was acquired by Aberdeen in 2003, said Holder. BlackRock Throgmorton Trust amended its fee structure in August, reducing the base fee from 0.7% to 0.35% of gross assets. To offset this reduction the performance fee was increased from 10% to 15% of NAV total return outperformance of the benchmark measured over a two-year rolling basis.
Share Buybacks Lead to Wider Discounts
Another factor at play that leads to wide discounts is share buybacks, Holder explained. He added that the requirement to control the discount needs to be balanced with these effects on trust liquidity and ongoing charges.
“Aberforth Smaller Companies has engaged in share buybacks over the past 12 months, which should provide share price support, possibly leading to a narrower discount,” said Holder.
Other investment trusts trading at wide discounts, the Gold Rated Aberdeen Asian Smaller (AAS) trust, Silver Rated JP Morgan Emerging Markets (JMG) and Bronze Rated Witan Pacific (WPC) have also engaged in share buybacks over the past 12 months that lead to wider discounts.
Aberdeen Asian Smaller is trading at 13.8% discounts, while JP Morgan Emerging Markets and Witan Pacific are trading at 12.7% and 12.4% discounts respectively.
Recent Underperformance Drives Discount
Due to its recent underperformance, it comes as no surprise that Silver Rated Montanaro European Smaller (MTE) is trading at 12.3% discount.
“Recent relative returns have affected some of the fund’s longer-term performance numbers, with 2013 being one of the main causes of this, as the fund produced strong absolute returns but struggled to keep pace with the sharply rising index as lower-quality stocks rallied,” said Samuel Meakin, fund analyst with Morningstar.
Meakin said the fund’s quality-growth style was out of favour in a year when lower-quality issues outperformed, and the underweight position in peripheral European stocks also hurt relative returns. 2016 was similar in that small-cap value outperformed the market, and this fund underperformed, with the consumer staples stock selection also detracting, Meakin added.
“Despite the recent underperformance, we retain our conviction that the consistent quality-growth-orientated approach, coupled with the support of the very well-resourced team, has the potential to reward investors over the long term,” said Meakin.
The Bronze Rated Aberdeen New Dawn (ABD) is facing a similar situation, as performance has been challenging, said Mark Laidlaw, senior fund analyst with Morningstar.
“The trust’s relative poor performance showings in 2013 and 2015 have impacted longer-term returns, as shown by the bottom-quartile position in the Asia-Pacific ex-Japan Morningstar Category over the trailing five years annualised through November 2016,” said Laidlaw.
While Aberdeen New Dawn remains an attractive choice, it is no longer one of analysts’ top picks in this space; its peer group has been getting stronger and Laidlaw’s conviction in Aberdeen Asia has wavered.
