Shareholders in Abrdn Smaller Companies Income (ASCI) woke up to news on Monday that the investment trust’s board of directors had launched a strategic review that would ‘include consideration of a combination of the company’s assets with another suitable investment trust, possibly coupled with a cash exit’.
The board noted that the combined problems of the trust’s small size and wide discount to NAV had ‘created challenges in generating improved liquidity in the company’s shares and will also restrict the company’s ability to grow over time’.
But while this particular case has created a flurry of speculation over likely suitors to take on the trust’s £74m portfolio – currently managed by Abrdn’s Abby Glennie and Amanda Yeaman – it also raises a broader question: are UK smaller companies a viable option for income-seeking investors?
While the resource-heavy FTSE 100 index recently reached all-time highs, smaller companies have struggled by comparison, with open-ended funds posting an average 25.2% decline in 2022. Investors may instinctively feel that the large-cap index is a more reliable source of dividend income, and see smaller stocks as riskier growth bets.
Of the 49 funds in the IA UK Smaller Companies sector, only three currently yield above 2%, with the top income payer offering 2.2% – hardly attention-grabbing for income investors when the risk-free rate is closer to 4%. The investment trust space looks a better option, with an average dividend yield of 3.2% for the 24-strong AIC UK Smaller Companies sector, although this drops to 2.3% if the clear outlier – a fund in wind-up, whose recent dividends partly reflect the return of investors’ capital – is excluded. ASCI itself yields 3.6%, which is less than some peers that do not have a specific income mandate.
ASCI once sat in the AIC’s UK Equity & Bond Income sector, which has had only one constituent – Henderson High Income – since the liquidation in 2021 of Acorn Income Trust (AIF), another small-cap specialist, albeit one with a more complex and highly geared structure. While 45% of AIF’s ordinary shareholders opted for a cash exit, the remainder of the trust’s assets were rolled over into the open-ended Unicorn UK Income Fund, which is run by AIF’s former fund managers, Fraser Mackersie and Simon Moon.
The Unicorn UK Income Fund – while not labelled as a small-cap vehicle – is limited to 20% of its assets in FTSE 100 stocks and cash combined, and still features many of the stocks that were in AIF’s portfolio. Like AIF, the UK Income Fund has a high-conviction portfolio, with only around 40 stocks. However, Mackersie says he misses some of the freedoms inherent in running a closed-ended small-cap strategy, such as the ability to look further down the market cap scale at stocks that might be too illiquid for an open-ended fund.
That aside, the manager is still a big fan of the income qualities of UK smaller companies. “The core thesis is that our portfolio companies should be able both to grow and to pay an above-market dividend, with the added ability to grow the dividend over time,” he says. “The attraction of going down the market cap scale is that you can get both growth and income; the growth side of the equation is harder for large-caps to achieve”
Mackersie’s colleague Alex Game works with Moon on the Unicorn UK Smaller Companies Fund, which does not have an income mandate but still features many dividend-paying small-caps. “Paying dividends is a good discipline for a company,” says Game, adding that the de-rating of small- and mid-caps versus the FTSE 100 means the income on offer is far more compelling on a relative basis.
“Before Covid-19, the yield on the FTSE All-Share [which is about 80% large-cap] was materially higher than for small-caps, but a lot of large companies rebased to lower payout ratios during the pandemic, and, coupled with the strong recent performance of the FTSE 100, that has reduced the All-Share yield to a level that is quite low relative to history. If you are looking for yield, small- and mid-cap is where to look at the moment.”
However, he adds that the lack of a specific income target has meant he and Moon have also recently been able to add more traditional ‘growth’ small-caps to the portfolio at attractive valuation multiples following de-rating. “As painful as it was to watch mid- and small-caps underperform large-caps over the last year, the de-rating has presented us all with a much larger universe of potential companies,” adds Mackersie.
With UK equities having been broadly out of favour since the EU referendum in 2016, and smaller companies underperforming their larger brethren for much of that period, it is perhaps understandable that the directors of ASCI have run short on patience. However, it is to be hoped that whatever the outcome of their strategic review, it does not represent a capitulation just as the small-cap income space is turning a corner.
“Small and mid-caps historically have outperformed over extended periods,” says Mackersie. “Last year was different, but over time, the ability of some smaller companies to grow faster than large-caps while paying an above-market dividend is compelling.”
