Why timing is so important to small-cap investors

Last year was not a vintage one for investors in UK small-caps. Between September 2021 and the end of 2022, the Aim All-Share fell by more than a third, wiping out more than six years of gains. The junior bourse’s largest names, grouped into the Aim 100, did even worse.

That led me to declare on 5 January this year that “with many small caps now trading at multi-year valuation lows, there are signs that some of the sell-off has become indiscriminate”.

So far, the call isn’t faring too well. Aim has declined 1.9 per cent, the FTSE Small Companies index is off 2.2 per cent, and the small-cap mini-screen included in our 50-stock Ideas of the Year portfolio is down 5.3 per cent. If a rebound is coming, it’s making an inauspicious start – although to stay consistent to this column’s regular moans about short-termism, I’ll refrain from reaching summary judgement after an 80-day trading window. As ever, it pays to take the long view.

Fortunately, the Association of Investment Companies (AIC) was on point this week when it published a list of the 36 trusts whose birth pre-dates that of the soon-to-be crowned King. What interested me more than the tenuous hook – although I do admire the AIC’s effort to crowbar its favourite topic into the news cycle – was the way the list’s returns have ebbed and flowed over the decades.

This is especially true of the three smaller companies trusts that began investing up to 60 years before baby Charles’ arrival: Blackrock Smaller Companies (BRSC), Henderson Smaller Companies (HSL) and the Global Smaller Companies Trust (GSCT).

Since 2013, the trio’s average annual returns have been a solid if middle-of-the-pack 9 per cent. But spring back another decade, and those average annual gains jump to 15 per cent, putting the trusts first, fourth and fifth, respectively, in the ranks of that notable if arbitrarily assembled cluster of funds that started investing before 1948.

How, then, do we explain the difference? Personnel changes, stockpicking and broader market appetites will have naturally played roles. But the biggest factor behind the success of these trusts since 2003 is timing, and specifically what happened to small caps in the 2008-09 financial crisis.

While the sector’s investors often point to smaller firms’ capacity to innovate and grow as the primary driver of long-term returns, market routs have a huge effect, too. Not only does heightened fear and greater illiquidity magnify the small-cap sell-off on the way down, but the inverse is often true when markets eventually rebound.

This dynamic played out to spectacular effect post-2008, which helps explain the stellar 20-year records above. In the five years to the end of 2013, during which time the FTSE All-Share compounded at 10 per cent a year, BRSC and GSCT’s average annual returns were both 38 per cent.

One investor who knows this phenomenon well is Richard Penny, who led the small-cap-focused L&G UK Alpha Trust to a 168 per cent total return in the 26 months after the market bottomed in March 2009. As the lead investor on the TM Crux UK Special Situations Fund (GB00BG5Q5X24), he again outperformed the UK market in the trough-to-peak pandemic rebound between March 2020 and January 2022.

Sensing some “enormous” opportunities, and with near-perfect timing to last year’s slump, Penny launched a second UK Smaller Companies Fund (GB00BQV37J70) on 31 October. Since then – and despite a sweet-to-suddenly-very-sour punt on Wandisco (WAN) – the high-conviction fund has returned 13.5 per cent, versus 3 per cent from Aim.

With a bias to software, financial services, health and semiconductor stocks, the fund mirrors what Penny describes as his own contrarian growth investing leanings. While this raises risks, it also exposes fund investors to companies Penny thinks capable of “pulling the rabbit out of the hat”.

“We have a huge bias to periods of recovery,” he tells me. “That’s why I know we can make money from here.” It might require patience, and may never be truly reflected at index level, but the worse things appear for small caps, the greater the individual long-term opportunities might prove.