This article is part of Morningstar’s Guide to Investment Trusts, highlighting the benefits of these unique investment vehicles – busting the investment trust jargon, revealing potential pitfalls and celebrating those experienced managers who have earned the top ranking from Morningstar fund analysts.
Emma Wall: Hello and welcome to the Morningstar series, 'Why Should I Invest with you?' I am Emma Wall and here with me today is Mike Prentis, Manager of the BlackRock Smaller Companies Trust.
Mike Prentis: Hello Emma.
Wall: Hi Mike. So, we're running an Investment Trust Special this week and your investment trust is Gold-rated by Morningstar analysts. So, you should be best placed to explain to us exactly how to run an investment trust. I believe there is sort of five-tiered process that you go through before picking companies. Perhaps you could explain that to us?
Prentis: Yes. I mean, when you are investing in smaller companies, it is very important to have a really robust process to choose companies and it won't surprise you to know that actually one of the key things for us is actually meeting management and forming a view that they are competent and are able to drive their businesses forward, preferably organically, motivate their work forces and without an excessive optimism, let's say. So, we like very realistic management teams with a good record. I mean, that's just sort of the starting point really for any investment.
The second, obviously, is we got to like the business that they are running. So, we look for differentiated businesses, businesses that are quite special in some way, they might have some intellectual property or brand or distribution network, something which gives them a sustainable barrier to entry effectively to keep others away. So, that's the second.
The third is, they use this great management and business to generate cash and profits, both really. I mean, we like to see profits that have been developed over a period of time and preferably are not sort of too cyclically dependent, so structural growth and see those profits converted well into cash, and that should mean effectively that the company has a good strong balance sheet. So, we like all of those criteria.
And our large holding, our core holdings do meet all of those criteria. But of course, when we initially make a new investment, it wouldn't necessarily meet all of those criteria. We'll see the potential for it to meet those criteria in time and we hope that our confidence builds up in that company, we will add to that company and we might start off an investment, do they need 25 or 50 basis points, but over time build it up if we like what we see and if we don't like what we see, of course, we sell.
Wall: Of course, ideally returns to investors will be driven solely by these stocks outperforming their peers. But one thing that is unique to an investment trust manager is you can use gearing to boost returns. Of course, gearing can also mean that greater losses if a stock doesn't do very well. How do you use that?
Prentis: Yes, you are right. We've had gearing in the trust since – well, over the long term, but it's been a round about 9% to 10% of net assets since 2014. So, in fact, we went through the last recession with gearing which is perhaps not ideal, but we took some comfort from the fact that the companies that we had invested in were generally cash-rich. So, in fact, the gearing almost neutralizes the cash that these companies had on their balance sheets. So, in fact, we outperformed during the recession – in fact, we've outperformed every year for the last 11 years. We're about to complete our 12th year we hope of outperformance this year given nothing too dire happens for the rest of this month.
Wall: Looking then at the smaller companies sector, what are the challenges facing those are unique to this time? One thing that perhaps most bring to mind is auto enrollment. For the first time some of these companies might be having to provide a pension for their employees. Is that sort of macro thing a concern for you?
Prentis: That's the sort of thing which can affect larger companies on the whole. It's not something which tends to affect the bottom line to any great extent and the sorts of companies we're investing in. The issues really are all of the ones you'd be familiar with, obviously the company-specific ones and then the macro ones.
So, in the U.K. some of our companies are particularly dependent on the U.K. economy, not all of them by any means. Coming up to the election what impact is that going to have on their businesses. In the U.S., I mean, a lot of our companies actually do have U.S. revenues, actually the headwinds aren't quite so obvious, although maybe one possible headwind is earlier than expected increase in interest rates. Then in Europe, well, there are all sorts of challenges, but on the whole the companies haven't been re-rated to recognize the opportunity ahead and some of the companies that get a lot of their revenues there are – they are just starting to see a bit of a pickup. So, there are opportunities everywhere and challenges everywhere and we have to sort of find our way through the minefield. I think this means you have to be well-diversified, but fundamentally invested in really good companies.
Wall: Mike, thank you very much.
Prentis: Thank you, Emma.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
