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This bargain fund offers investors a chance to own tomorrow’s winners

Investment fund
Investment fund

Last week Questor examined the woeful performance of the UK smaller companies investment trust sector in 2022 and why now could be an opportune time to gain exposure to it through the Aberforth Smaller Companies Trust, a value-based fund.

Continuing on this theme, Questor has picked another trust within the same sector, but this time with a growth focus, Montanaro UK Smaller Companies Trust.

For readers’ benefit, growth funds are generally geared towards picking “tomorrow’s winners”, whereas value funds have a bias towards selecting more established companies that are seen to be under-priced.

Against its peers, this Montanaro trust has suffered more than most this year, with falls in its shareprice and NAV each over 28pc and 24pc respectively.

There are two clear drivers behind this: first, its above sector average weighting to technology stocks, making up almost one third of the portfolio, which have been hit particularly hard by rising interest rates as much of their value has been tied-up in expectations of future profits.

This overweight position has largely been at the expense of mining and energy stocks, two areas that have underpinned the wider market’s flat performance this year.

The second is the relatively small size of the trust because in times of market stress, it is the smaller players that get hit hardest due to perceived liquidity risks; Montanaro UK Smaller Companies has net assets of just over £200 million as against a wider sector average of around £400 million.

But it’s important to take a step back and unpick further what has been happening. In very simple terms, a share price is made up of two elements: one is the expected earnings and the second is the valuation of those earnings, the multiple.

As we note, interest rate expectations have been rising in response to inflation and this has had a detrimental effect on how companies’ future earnings are valued.

However, what we are now seeing in America are tentative signs of inflation easing which would suggest that interest rates may have peaked there which would be a boon to growth stocks globally.

Although inflation looks likely to remain higher and for longer in the UK, where US monetary policy goes, other countries tend to follow. The impact of China slowly starting to ease its Covid lockdown restrictions should not be ignored
either and how this should help to reduce supply bottlenecks and inflation further.

The second element of a share price, besides its multiple, is of course its earnings. With the UK entering a recession, it would be unreasonable in the extreme to say there are no grounds for concern about earnings, but there are a number of important points to make here.

Number one, this trust focusses on selecting high quality growth companies. Montanaro defines high quality as those companies with superior predicted earnings growth underpinned by higher margins and returns on capital, occupying strong niche positions which lends them pricing power and the ability to pass on higher costs…valuable in a stagflationary environment.

The companies that this trust invests in tend to have a structural growth story and so are less tied to the economic cycle; it’s
interesting to note that less than 9% of the fund’s portfolio is exposed to consumer cyclical stocks.

Furthermore, the trust stays clear of those companies that are not yet profitable, so avoiding those more speculative stocks where a substantial part of their valuation has often been attributable to overly optimistic assumptions.

Secondly, the companies that Montanaro invests in tend to have strong balance sheets which not only enables them to withstand any downturns and higher financing more easily, but also to emerge stronger in the following recovery.

A third factor is the dividend yield: based on last year’s dividend, the trust is yielding 5.7pc, the highest in the sector by far. However, a caveat is this is part funded by capital, calculated by reference to the trust’s NAV.

With the NAV having fallen by over 24pc over the past 12 months, it would not be unreasonable to expect the dividend to fall by a similar amount, which would take the yield down to around 4.3pc; even so, this would still be one of the highest in the sector and should help to provide a floor to the current share price.

With this trust trading at around a 7pc discount, Questor sees this as an attractive entry point for those investors wishing to gain exposure to the smaller companies sector, an area that is often unfairly penalised and oversold off in terms of market weakness.

Questor says: buy

Ticker: MTU

Share price at close: 112.5p

Read the latest Questor column on every Sunday, Tuesday, Wednesday, Thursday and Friday from 6am.

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Nick Cox-Johnson is a former fund manager and financial communications advisor, now writes about investment trusts