• Smaller companies have been seen as more exposed to any potential deterioration in the UK economy
• They are also seen as more risky in an environment where investors are nervous
• The reality for smaller companies is quite different and investors should take note

The UK stock market has been dented by the uncertainty over Brexit with smaller companies in the eye of the storm. They are considered particularly vulnerable to any weakening of the UK economy should the Brexit outcome be damaging. However, this is a one-dimensional view of UK small companies, which – on closer inspection – have real diversity when investors look closer.

While the UK market as a whole has been widely overlooked by investors as the sentiment has ebbed and flowed over Brexit, this problem has been less evident in larger, more internationally-focused companies. In contrast, smaller companies have been seen as more domestic in focus, more exposed to any potential deterioration in the UK economy and, as a result, have been neglected by investors.

To our mind, this central assumption is flawed. In many cases, when we look under the bonnet, UK smaller companies have plenty of international exposure. This makes intuitive sense: smaller companies tend to be higher growth companies and will look for growth wherever that can be found. That is likely to be in fast-growing markets abroad as well as in the UK.

This is particularly true in the companies we analyse for the Aberdeen Smaller Companies Income Trust. We aim to target those companies that also generate an income. This tends to lead us to the more mature end of the smaller companies sector, where companies will have expanded into new markets. This might be companies such as Dechra Pharmaceuticals, which sells specialist veterinary pharmaceuticals across the globe from Europe, to Mexico to the US to Australia.

At the same time, smaller companies have suffered from a perception that they are inherently more risky than larger companies. These are uncertain times, and investors’ instinct at difficult moments is to move away from any ‘risky’ areas. Smaller companies have been struggling against this natural inclination to pull away as volatility increases.

It is true that larger companies are more diversified and therefore less vulnerable to problems in a single business line. However, the prospects for smaller companies are not more challenged simply because they are small. There are circumstances where larger companies prove more vulnerable in a downturn. The UK High Street would be a good example, where larger companies with long inflexible leases have struggled, while smaller retailers have been able to be more nimble, or have occupied specific areas. Hollywood Bowl, for example, has exposure to consumer spending, but has proved more resilient than many of the major high street names.

At the same time, smaller companies will often be in niche markets. Here, the pie is smaller, so doesn’t attract interest from larger companies, but can have plenty of growth potential for a single player. When all your eggs in one basket, you tend to care for that basket very well and we see this a lot among smaller companies. We find plenty of companies with strong balance sheets, good cash generation, low debt and dependable management teams. In rooting out these companies, our ‘quality’ screen helps.

As part of the deal between Aberdeen and Standard Life, the management of the trust has passed to the dedicated UK smaller companies team at Standard Life under Harry Nimmo and Abby Glennie. That transition has involved some restructuring, which is now largely complete. The market volatility has made this restructuring more difficult at times, but it has also seen some good companies sold off alongside far weaker companies. In this way, the gap between perception and reality on smaller companies has created some real opportunities. This includes companies such as Midwich, a specialist distributor of audio-visual equipment, which was new to the market in 2016. More recently we participated in the AJ Bell IPO. This is the type of founder-owned business that we like.

The team runs around £3bn in smaller companies mandates and has built a good relationship with companies and brokers over time. Companies understand that Aberdeen Standard will be long-term, committed shareholders. This brings good access to management teams and better insight into the companies themselves.

The fund currently yields over 3%. The yield is supported by preference shares. This gives some flexibility on where the trust is invested. It means not every companies in the trust has to pay an income, enabling the team to invest in those companies that are earlier stage, where the investment case merits it, or may pay an income in future.

It is possible that sentiment doesn’t shift until there is some clarity on Brexit, but at some point investors will recognise that there is inherent value in the UK stock market, and in smaller companies in particular. The misperception about the risks involved in smaller companies and their vulnerability to a slowdown is creating some opportunities for long-term investors.

Important information

Aberdeen Standard Investments is a brand of the investment businesses of Aberdeen Asset Management and Standard Life Investments.

Risk factors you should consider prior to investing:

• The value of investments and the income from them can fall and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• The Company invests in the securities of smaller companies which are likely to carry a higher degree of risk than larger companies.
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
• With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘subinvestment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
• Specialist funds which invest in small markets or sectors of industry are likely to be more volatile than more diversified trusts.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.

Other important information:
Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments.

Investors should review the relevant Key Information Document (KID) and brochure prior to making an investment decision. These can be obtained free of charge from www.invtrusts.co.uk or by writing to Aberdeen Fund Managers Limited, PO Box 9029, Chelmsford, CM99 2WJ. Aberdeen Standard Investments is a brand of the investment businesses of Aberdeen Asset Management and Standard Life Investments.

Find out more at: www.aberdeensmallercompanies.co.uk/