It has been a challenging year for UK smaller company investment trusts. In the first six months widening discounts turned an average 8 per cent fall in their net asset values (NAV) per share into an average 17 per cent fall in share prices.
The end of the period was particularly harsh, with the vote for Brexit followed by the slump in sterling.
This boosted multinational companies in the FTSE 100 index, whereas UK smaller companies were almost indiscriminately marked down on the assumption that they are more domestically oriented, and therefore vulnerable to a sharp economic slowdown.
In the event, the post-Brexit panic created a great buying opportunity for investors who recognised that the large and diverse universe of UK medium to smaller companies includes a great many international businesses.
It also includes a growing number of innovative niche companies, many of them quoted on the Alternative Investment Market (Aim), which can make headway even in hard times by stealing market share from their larger rivals.
Their post-referendum bounce helped a number of UK smaller companies trusts achieve sparkling NAV recoveries in July and August, as did the realisation that Brexit will take time and that the economy could prove reasonably resilient, at least over the next year or so.
As a result several investment trust managers are cautiously optimistic on their prospects.
One of them is Gervais Williams, whose Diverse Income trust has achieved the best NAV returns in the UK equity income sector over the five years since it was launched in October 2011.
Much of that outperformance has come from its persistently high smaller company exposure: two thirds of the portfolio is invested in companies too small for inclusion in the FTSE 350 index.
Williams suggests such companies remain an attractive hunting ground for the short as well as the long term, because their 'vibrancy' is even more important in times when economic growth is subdued.
He adds that with world growth slowing, a growing number of larger UK companies, including supermarkets, banks, major engineering companies and resources specialists have been forced to cut their dividends.
Smaller companies, on the other hand, generally have superior dividend cover (the ratio of earnings to payouts).
Coupled with their greater ability to buck the economic trend, this means they look better placed to hold or even raise their dividends, which Williams expects to contribute to better long-term total returns.
The relatively high and growing yield available from UK smaller companies is one reason why Jonathan Brown, who manages Invesco Perpetual UK Smaller Companies (IPU), remains upbeat.
'The Bank of England's decision to cut interest rates means the return on gilts is very low or negative. That makes the 3.7 per cent yield on our Numis Smaller Companies index benchmark look attractive, especially as you can find reliable businesses where the dividend should continue to grow,' he says.
'The arguable disadvantage of mid to smaller-sized companies is that they are more domestically oriented than larger ones, but there is a much wider choice of companies and if you pick carefully there are attractive ones even in apparently beleaguered sectors.'
One such sector is retailing, which looks vulnerable to a fall in consumer confidence, a rise in costs from the minimum wage, and the fall in sterling.
'But we have done well from boohoo.com, which has recovered strongly from its early setback, and from JD Sports, which is benefiting from the problems of Sports Direct and from European expansion,' says Brown.
'On a more positive note, we think the government will have to step up infrastructure spend to help stimulate the economy, and that should benefit smaller companies like Hill & Smith, which makes products such as temporary crash barriers, and Severhead, which makes bridges for road and rail.
'Additionally, companies like Kainos Group, which is a well-run little Belfast-based business, are benefiting from the government's keenness to use smaller software companies rather than the big international ones which have let it down in the past.'
The trust's shares have performed even better, as the discount halved following the board's 2015 decision to start paying a 4 per cent yield (funded partly from capital) plus a commitment to offer an exit at close to NAV in 2017.
Brown must continue to do well to encourage investors to stay loyal thereafter.
'We look for smaller companies with very strong positions in niche markets,' he says, citing as an example James Fisher, which is a world leader in marine services.
Like other exporters, it should benefit directly from weaker sterling, but Brown believes some UK-oriented companies will also benefit, albeit indirectly.
'For instance he expects Johnson Services, which is the UK leader in linen hire, to do well from more Britons holidaying at home and more overseas visitors coming to the UK.
Brown approached the Brexit vote with 5 per cent cash, hoping it might create buying opportunities, and has reduced it to 3 per cent. This is a gesture of confidence for a trust which seldom gears - as is Brown's decision to increase his personal stake in the trust.
Mike Prentis, who has steered BlackRock Smaller Companies (BRSC) to among the top performers since he became manager in 2002, initially reacted to the Brexit vote by selling some lower-conviction holdings.
Although he has reinvested some of the cash raised, he has kept gearing below its 'neutral' level of 10 per cent. 'Most of our companies have not seen any significant impact from the vote, and are reasonably positive, so our initial worries have been put on hold, but they have not gone away,' he says.
Worries about Brexit prompted Prentis to start increasing BRSC's exposure to companies with overseas interests as early as March. As a result half the portfolio's revenues are now earned outside the UK.
He is particularly keen on companies with US or emerging market exposure, such as City of London Investment Group and Ocean Wilsons, both of which have been performing strongly.
The companies Prentis backs are almost invariably profitable by the time he takes a stake in them. He warns investors to be wary about overpaying for companies making their debut on Aim, particularly those that have benefited from investments via enterprise investment schemes or venture capital trusts.
Small companies can go spectacularly wrong as well as right, even if they are selected and closely monitored by experts.
Prentis mitigates that risk by holding stakes in around 150 companies, by restricting almost all those stakes to less than 2 per cent, by keeping in close touch with all his holdings, and by only investing in quality companies.
'We try to make sure we own very good companies, which are leaders in their sector, with real immediate and longer-term growth potential and pricing power.
'As market leaders we expect them to cope better if things get choppy, to continue to invest in their businesses so as to increase their market share, to preserve their margins, and to emerge even more dominant.'
Harry Nimmo, who manages Standard Life UK Smaller Companies (SLS), prefers a much more concentrated portfolio of around 50 holdings. His trust's 10-year returns have bettered those of BRSC's, but the trajectory has been more erratic.
He is worried that 'the tortuous process of disengaging with Europe' will damage medium-term UK growth, but is relaxed about the next year or so.
'Theresa May seems in no hurry to engage with Europe, negotiations will take time, and recent results from our holdings have generally exceeded expectations,' he says.
He agrees with Gervais Williams that world growth is slowing regardless of Brexit, but expects his holdings to be able to continue to grow and to raise their dividends, thanks to his commitment to invest in quality growth businesses with earnings momentum and very little debt.
'They have helped to make the trust exceptionally resilient in past economic downturns, notably 2007 to 2008, and I am confident they will do so again.'
Having trounced the rest of its sector in the 10 years to 2013, SLS then suffered a dull patch, but picked up strongly in 2015. Nimmo says this was substantially due to investments in several rewarding new issues, and he is hopeful there are more to come.
WAVE OF DISRUPTION
'The trust did well between 2005 and 2013 thanks to a wave of disruptive new internet-based companies such as Paddy Power, Hargreaves Lansdown and Rightmove,' he says.
'Now a new wave is working its way through, including companies such as Sanne, Midwich, First Derivatives, CVS Group, Accesso Technologies, Motorpoint and Mattioli Woods.
'They cover a wide range of sectors, and they have started with clean sheets, so are not held back by [remnants of] the past such as underfunded pension funds, old business practices or outdated premises.'
Apart from Aim-listed shares, which account for a third of the SLS portfolio, Nimmo mainly holds smaller mid-cap shares that are constituents of the FTSE 250 index.
These may be more mature companies, but can still achieve exciting returns, as demonstrated by the continuing rapid growth of Dechra Pharmaceuticals.
Shares in the internationally diversified veterinary drugs company, which is also one of Prentis's favourites, have risen over a third since mid-June. Other top 10 holdings such as JD Sports Fashion and Ted Baker are also busy expanding overseas.
Nimmo claims he has not set out to raise the trust's overseas emphasis since the referendum, but many of his holdings are doing it for him. 'If small companies want to become large they have often got to expand internationally,' he explains.
Relative newcomers such as Fevertree, Accesso Technologies and NMC Healthcare were SLS's top performers last year.
But Nimmo says the real money has come from holding great companies such as Paddy Power and Abcam for extended periods, while taking sufficient profits to keep all holdings below 4 per cent of the portfolio.
'I remain passionate about smaller companies and the risks tend to be exaggerated,' says Nimmo. 'There are hundreds to choose from and we try to fill our portfolios with lower-risk companies.
'By that, I mean companies with less volatile businesses, strong cash flows, good balance sheets, predictable earnings growth and stable management teams.
'We are prepared to pay up for them [the portfolio has an average prospective price/earnings ratio to end 2016 of around 19] because you get what you pay for.'
In the three months to end September, the NAV total returns of the three trusts above rose by between 21 and 23 per cent, compared to a UK smaller companies sector average of 21 per cent, and a top performance of 26.7 per cent by Henderson Smaller Companies.
Their share price returns were mostly a little lower, because many investors are worried that smaller companies will be hard hit if weakening stock markets encourage a preference for larger, more liquid companies.
This is a valid concern for those with a short-term outlook, but longer-term investors should note that most UK smaller company trusts have achieved far better 10-year returns than the vast majority of UK equity income or UK all companies constituents.
Those who try to trade in and out of the sector can be badly wrong-footed - as were those who sold immediately after the Brexit vote.
It is also important to bear in mind that spotting and monitoring the winners in the UK smaller company universe requires constant hard work and good contacts. It is therefore a sector where it is especially sensible to let an experienced manager make the decisions.
Trusts are the most suitable investment vehicle because their closed-ended capital structure protects managers from having to try and sell in a hurry if markets turn sour.
Note: All the featured trusts except Invesco Perpetual UK Smaller Companies are Money Observer 2016 Rated Funds.
MANAGERS FINDING BIG WINNERS ON AIM
Under the management of Brown, Invesco Perpetual UK Smaller Companies' exposure to shares listed on Aim has topped 30 per cent for the first time. He attributes this to the number of attractive new businesses electing to list on the junior market.
'Good companies like CVS Group are attracted to Aim because it is much cheaper to list, and if they are growth companies it is much cheaper to issue new shares to fund that growth,' says Brown.
Aim-quoted shares are an even bigger feature of BRSC. Its Aim exposure has grown to over 40 per cent of its portfolio, thanks to the success of holdings such as Fevertree Drinks and GB Group, the identity management specialist.
Prentis says a lot of BRSC's fastest-growing holdings are Aim-quoted, partly because they often start smaller and can make acquisitions more cheaply.
Nimmo says the internet and globalisation allow smaller companies to reach critical mass and generate brand strength more quickly than in the past, adding that many are founder-led.
'These founder-led businesses normally have strong and stable corporate cultures, and often feature good customer service, product provenance and long-term brand development.'
Companies listed on the junior market currently account for over a third of SLS's portfolio, compared to a quarter two years ago.
'Abcam and Emis Group, which are among our top 10 holdings, are both Aim stocks. They are as good quality as anything else in the portfolio, but you have to be more careful when evaluating Aim companies,' Nimmo warns.