Key insights
Smaller company stocks are priced at the type of low valuations that only come along every 20-30 years
- Additionally, The Global Smaller Companies Trust trades at a discount of about 10% to the net value of its underlying portfolio[1]
- Together, this means it’s an inexpensive time to invest for easy access to the growth potential of the world’s most exciting smaller companies
For many years smaller company stocks have been thought one of the best ways to reap investment returns for the long run. The logic is that the smaller a company, the greater its scope for growth. Yet since the pandemic, with interest rates high across much of the world, that simply hasn’t held true—instead the biggest companies have outperformed.
After four years of underperformance, smaller company stocks are priced at a significant discount to large companies on the world’s stock markets. Indeed, discounts of this size have only come along every 20-30 years.
What’s even more unusual is that smaller company investment trusts such as The Global Smaller Companies Trust are also tending to trade at discounts to the net asset values (NAVs) of their underlying investment portfolios. That puts the trust on a double discount of the sort normally seen in sales. When anomalies like this appear in the investment world, they too often represent a bargain.
By way of explaining what investment trust discounts are, these trusts trade at discounts to their NAV when their stock market capitalizations are less than the valuations of their underlying portfolios. In the two years since interest rates spiked higher in the US, UK and Europe in 2022, many trusts have slid to discounts that are higher than normal.
Exceptionally low valuations
These discounts reflect lower demand for investment trusts in a world of higher interest rates, which has also driven down smaller company stock valuations. In the United States, the commonly used price/earnings ratio valuation measure for the US S&P 500 index of large stocks is about 20, considerably more than 15 for the S&P Small Cap 400 index. In the UK there’s a similar dichotomy: the FTSE 100 index of large companies has a p/e ratio of about 12, far richer than the FTSE Small Cap index’s 10[2]. In continental Europe the picture is similar.
Valuations this cheap have typically been the low point for smaller companies. Returning to the US stock market, on average the value of all smaller companies has historically represented about 7-8% of the entire market. Yet currently they account for only about 4%, which has tended to be their low point, after which their share prices have rallied[3].
Quite simply, there’s considerable room for smaller companies to close the valuation gap against larger companies. They have only sunk this low twice in the past 50 years. The first time was during the era of the Nifty Fifty stocks in the early 1970s, after which smaller companies subsequently outperformed the stock market for 10 years . The second was the dotcom boom of the late 1990s, when smaller companies spent the following eight years outperforming.
Turning to The Global Smaller Companies Trust itself and the second part of the double discount, at the time of writing the trust’s discount is about 8% of NAV. The manager has a target of closing the discount to 5% or less, which it’s actively pursuing by buying back the trust’s shares.
Doing so would result in a small rise in the share price, assuming the NAV of the underlying portfolio remained stable. But at the very least the trust’s discount to NAV provides a cushion against its share price falling in the event of stock market volatility.
Why now?
But why should smaller companies close the valuation gap with big company stocks after years of being overshadowed? There are several reasons, but perhaps the most significant is that interest rates are starting to fall. At the time of writing, central banks have made their first cuts in Europe and Canada.
Smaller companies are highly sensitive to the level of interest rates. They have less access to debt finance than larger companies and often borrow at variable rates of interest. In the 12 months following central banks starting to cut interest rates, smaller company stocks have historically outperformed the rest of the stock market by as much as 10%[4].
In summary, double discounts of this size are anomalies that don’t often come along—and may be followed by rallies lasting several years. For investors considering The Global Smaller Companies Trust, logically now seems a good time to access the growth potential of the world’s most exciting smaller companies.
Of course, there are no guarantees that the double discount will close. But the investment world often depends on shrewdly exploiting rare anomalies or opportunities such as these before they disappear.
Investment risks
The value of your investments and any income from them can go down as well as up and you may not get back the original amount invested. Gearing is used for investment purposes to obtain, increase or reduce exposure to an asset, index or investment. The use of gearing can enhance returns to investors in a rising market, but if the market falls the losses may be greater.
Issued by Columbia Threadneedle Management Limited and approved for distribution 07/10/24.
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