Selected small caps prove rewarding

Rather than replicating the Aim index, SVM UK Emerging trust seeks out special situations, which fund manager Donald Robertson claims will benefit as recessionary pressures moderate.

Small caps were unforgiving during the slowdown and SVM UK Emerging suffered a 30%-plus net asset value (NAV) decline over 12 months to the end of March.

However, while the investment trust’s NAV fell 31.7%, this still represents a considerable outperformance of its benchmark, the Alternative Investment Market (Aim) index, which fell 56.3% over the same time span.

After a long period of trading at a premium, the trust was caught up in general market upheavals towards the end of 2008 and was savagely marked down, although it has rallied in recent months.

Donald Robertson, manager of the fund, maintains a focused portfolio of 35 holdings, with more than 80% in Aim companies, seeking out special situations rather than trying to follow the benchmark.

“Many small-cap funds end up with 150-200 holdings and basically replicate the index, which we see as a recipe for disaster,” he says.

“Our favoured app­roach is a smaller number of large positions, with a view to understanding these companies better. That means higher stock-specific risk but our performance is more resilient when the whole sector collapses, which is what happened last year.”

Selected holdings exhibit higher-than-average growth potential, with modest valuations. Robertson says that these will benefit as recessionary pressures moderate.

“Most are financially sound, growing and profitable but are priced on low single-figure multiples, so there is substantial upward potential as sentiment improves,” he adds.

Over a difficult 2008, the fund’s relatively defensive position protected against the worst market falls and Robertson also retained a liquidity cushion after realising holdings early in the year.

This buffer remains at about 10% as Robertson says it is still too early to put the money back to work in the market, despite the recent rally.

“People are talking about green shoots of recovery but we struggle to see them yet and expect an uncomfortable summer,” he adds.

“Our view is for a more sustainable rally at the back end of the third quarter and we will look for further opportunities at that stage.”

Despite the defensive stance, UK Emerging has caught most of the rally this year largely owing to its positions in the surging resources sector.

Other key overweight positions include industrials and consumer services, with little held in financials.

Robertson says it is not unusual for small companies to perform well early in the year, although this is often against a background of positive markets overall and the FTSE was down in the first quarter of the year.

“The suspicion is that part of the rally was a reversal of underperformance suffered in the second half of 2008 and the other reason is probably the high weighting of commodity-reliant companies in the universe,” he adds.

On the stock front, Robertson highlights Australian gold miner Norseman, which suffered a de-rating from 50p to 2-3p on some operational delays but has subsequently rallied to 30p.

Another key position is AMZ Holdings, a property development firm. The company has built up acres of beachfront property on the Island of Penghu, Taiwan, with the area approved for an International Tourist Hotel building permit.

Charles Murphy, the head of investment funds research at Matrix, says the SVM trust is at the smaller end of the small-cap space in terms of assets and not among his picks in the sector.

Overall, he says UK small-cap trusts are fair value after a recent rally but doubts whether some could liquidate at bid price if necessary. “Small caps are basically a call on economic growth and how strongly people feel the country will come out of recession,” he adds.

“The sector has already enjoyed a strong rally compared with the FTSE and many trusts have been re-rated after the pain last year.”

Murphy also says the sector is varied and can offer different performance profiles, ranging from Aim-focused trusts such as SVM UK Emerging to long-short strat­egies like Throgmorton and more value plays like Aberforth Smaller Companies.