My Small Cap Dilemma

I have something in common with the England football team. I may have been made to look better than I really am by a favourable context only to be found out in the most testing conditions.

I’m referring to my until recently successful use of a variety of UK small and mid-cap funds since my accelerated journey to early retirement began in 2012. For the next three years progress was largely serene, indeed the Numis Smaller Companies Index reached an all-time high in June 2015. The diagram below from the 2016 Numis Annual Review  captures the long-term outperformance of UK smaller companies over sixty years:

However look carefully and you can see the down-squiggle of 2007-9 which was far more severe at the time than the graph’s scale expresses (many UK smaller company funds and shares fell 40-60% between late 2007 and spring 2009).

  

Could we be on the brink of another sharp decline in UK small cap fortunes?

Even before the EU referendum vote on June 23^rd there’d been some signs of a pull-back before the severe and sudden mark-down. The partial recovery in some funds and stock prices since early July 2016 still leaves many several percent down, as the prospect of more difficult times for UK-focused smaller firms and funds looms.

So what to do? 

About 10% of my hoped for retirement fund is in non-income bearing UK smaller company funds (e.g. Marlborough Special Situations, Fidelity UK Smaller Companies, River and Mercantile UK Smaller Companies) from which I’d been intending to switch into dividend-generating vehicles (possibly adding to existing holdings in Acorn Income and Small Companies Dividend Trust) either side of the April 5^th 2017 tax deadline (I aim to leave full-time work in late 2017).

One of the many lessons of June 2016 is the importance of geographical/currency diversification and the avoidance of excessive home bias. 

I’d begun to address this in my 2016/7 ISA and the improvement in a number of previously lagging overseas holdings in Newton Emerging Income, Guinness Asian Equity Income, Aberdeen Latin American, and the strong performance of Fidelity Global Dividend, provide some indication of the worldwide array of income-generating options at my disposal.

However, one strategy is becoming more appealing, particularly given the likelihood of my breaching the £5000 dividend taxation threshold in future years. Rather than switching all my capital into dividend paying instruments I will reserve a portion for pure growth investments, selling a small portion of the capital if and when required to supplement the core natural yield of the bulk of my holdings. 

In this vein I am likely to add to what has so far been a highly successful position in Fidelity Asian Smaller Companies. The fund manager Nitin Bajaj has an admirably candid approach as he outlines in this 15 minute Charles Stanley video and this fund (and the very similar Fidelity Asian Values investment trust) provide access to companies I’d be highly unlikely to have found myself.

With (hopefully) thirty years or more ahead of me (perhaps even more according to this book about The 100 Year Life) there has to be a place for growth in my portfolio, and given the rhetoric of the new UK Prime Minister we can’t assume that dividend tax rates and thresholds will be left untouched in the years ahead.

In this possibly higher-tax lower UK dividend environment the ability to realise up to £11,100 per annum free of capital gains tax, as well as natural yield, from globally diverse sources should not be overlooked.