Small companies set to perform well
If you choose wisely and are patient, it’s possible to make good money from investing in small companies. As global growth slows, many experts believe that shares in UK smaller companies could be set to perform better than shares in larger UK companies that have
What is a small company?
Definitions vary widely as to what constitutes a small company. Adrian Lowcock, head of investing at Axa Wealth, says: “I would say they are anything that isn’t listed in the FTSE 100 Index or FTSE 250 Index.”
Between them, these two indexes represent the largest 350 companies listed on the London Stock Exchange.
The FTSE SmallCap Index consists of the 351st to the 619th largest-listed companies on the London Stock Exchange.
The ‘Cap’ part of the name refers to ‘market capitalisation’, just a fancy name for the market value of all the shares in a company. For example, Laura Ashley Holdings is a member of the FTSE SmallCap index and has 727.7 million shares. On 10 March 2016, each share in Laura Ashley was worth 24p so the company had a market capitalisation of £174.6 million.
These three indices together make up the FTSE All Share index of all companies listed on the main market of the London Stock Exchange.
Investors looking for smaller companies can also look to the Alternative Investment Market (Aim), a sub-market of the London Stock Exchange that has a more flexible regulatory system and is aimed at smaller companies. However, Mr Lowcock says: “Aim is a bit less clear, as large companies can list there as well.”
Andy Parsons, head of investment research at The Share Centre, defines a small company as “one that has a market capitalisation of around £350 million at the initial investment point”. However, some small- cap funds go down as low as £100 million, which he considers ‘micro cap’ or even lower, which he considers ‘nano cap’.
What are the risks?
Mr Parsons says smaller companies can have a number of risks associated with them such as:
- Dependency on a single product/service or customer
- Threats and pressure applied by their customers around pricing
- Regulatory change
- Financial risk in that while appearing to have a strong product/service offering, cash flow is poor compared to their liabilities.
Despite these risks, collectively small caps have performed very well compared to their bigger brethren. The Numis Smaller Companies Index (NSCI), which is made up of the smallest 10% of the companies quoted on the London Stock Exchange by value, has produced great returns: since 2000 it has increased by 206% against 75% for the FTSE All-Share (see graph).
The future is small
There are also strong reasons for believing that quality small caps will perform well in the future.
With the ending of the credit boom, things are about to get very tough and most large companies are going to struggle to grow and meet profit expectations. He says: “One of the new trends that is beginning to come through is the outperformance of the smallest quoted companies.”
It’s a thesis he has outlined in his fascinating book: The Future is Small. There he writes: “Now that world growth has slowed beyond the boom, the differences in the investment characteristics of smaller companies are becoming highly relevant.
The extra growth potential of smaller companies as well as their diversification benefits will become hugely desirable to institutions. UK portfolios containing both large and smaller companies are likely to deliver better and more sustainable returns, and there are literally hundreds and hundreds of smaller companies listed in the UK that together form a wide-ranging and diverse ecosystem.”
In particular, he favours the very smallest small caps, the so-called micro caps, whose market capitalisation is typically below £150 million. Unloved by institutions and rarely covered in much depth by brokers, the scope
for mispricing is large. “The sector is small and illiquid so, as new capital is invested, it will become something of a virtuous cycle,” he argues.
How to invest
The safest way to invest is via an experienced fund manager, with a good track record of stock picking. That way you should get a quality, diversified portfolio (see our pick of recommended funds to consider on page 65).
Unit trusts (open-ended funds) and investment trusts (closed-ended funds that can be bought and sold like shares) are two types of funds that you can invest in to gain exposure to small caps.
When choosing between unit trusts and investment trusts, the most important factor for any investor is without doubt performance, alongside costs.
Another way to gain exposure to the superior growth characteristics of small companies is to invest in a tracker fund or exchange traded fund (ETF) that passively tracks the performance of a small cap index. For investors wishing to do this for UK markets, Mr Parsons recommends the iShares MSCI UK Small Cap UCITS ETF.
But Mr Lowcock does not recommend a passive approach: “Small caps really need an expert to filter
hrough all the companies that are not good quality, going nowhere or just too risky. Stock selection is crucial and smaller companies is a great area for investors to add value to their portfolio.”
How active managers deal with risk
The team of Ken Hsia and Calum Joglekar manages the top performing Investec UK Smaller Companies Fund. They manage the risks inherent in smaller companies in two ways: “Firstly, constructing a balanced, high quality portfolio acts as an effective risk reduction method.
Secondly, we perform a consistent and regular review of the portfolio to identify those shareholdings which are no longer satisfying our investment requirements.”
In particular, they focus exclusively on companies that they believe are high-quality, attractively valued, with improving operating performance that are receiving increasing investor attention.
Sophos, a security software company, is a recent purchase. “Sophos has built a strong position in the small and medium enterprise (SME) internet security market by offering straightforward solutions that fit the requirements of SME customers,” they say.
“The demand for internet security is likely to remain strong as the business risk of a security compromise can be life-threatening to a company. With a well-established reseller sales channel, it is likely that the company will continue its strong sales and profitability growth.”
There is an 80% overlap between the two, with the trust going into slightly smaller stocks than the fund, down to a £50 million market cap. He looks for growth companies that have strong balance sheets and have a good idea of what their future earnings might be. He also looks for companies whose forecast earnings are being upgraded by analysts.
He says: “Over the long run, research shows that investing in smaller companies has resulted in premium returns compared with those achieved by large caps.
“Over the past 20 years, investing in mega caps has often proved riskier than a well-structured fund investing in more dependable small caps. For example, the banks, Marconi, Glencore, Tesco have all disappointed despite their supposed merits.”
Mr Nimmo prefers companies such as Ted Baker, a clothing and accessories designer, and EMIS Group, a healthcare software and services provider.
Five UK smaller company funds to consider
The fund invests primarily in the shares of UK smaller companies and in related derivatives (financial contracts whose value is linked to the price of an underlying asset). It invests in companies that are included in the Numis Smaller Companies plus Aim (excluding Investment Companies) Index.
Performance: Over the 15 years to 31 January 2016, it delivered a total return of 523% according to Thomson Reuters Lipper.
Number of holdings: 77
Fund size: £431.9 million Launch date: July 1982
Annual ongoing charge: 0.84%.
The fund aims to provide long- term growth by investing mainly in the shares of smaller companies listed on the UK stock market. It has more than half of the portfolio invested in the FTSE 250 index. Smaller companies expert Harry Nimmo has managed the fund since its launch in 1997.
Performance: Over the 10 years to 31 January 2016, it delivered a total return of 333% according to Thomson Reuters Lipper.
Number of holdings: 57
Fund size: £1248.8 million
Launch date: January 1997 Annual ongoing charge: 0.85%.
It aims to provide capital growth and income in excess of that achieved by the FTSE Small
Cap Index (excluding investment companies). Small companies expert Giles Hargreave has managed the fund for 11 years.
Performance: Over the 10 years to 31 January 2016, it delivered a total return of 242% according to Thomson Reuters Lipper.
Number of holdings: 254
Fund size: £504.7 million
Launch date: October 2004 Annual ongoing charge: 0.79%
It aims to achieve long-term total returns by investing primarily in UK quoted smaller companies. Manager Gervais Williams has 30 years’ investment experience, including 17 years as head of UK small companies investing at Gartmore Group.Performance: It has delivered a cumulative return of 75% since launch in December 2012 to 31 January 2016.
Number of holdings: 97
Fund size: £138.6 million
Launch date: December 2012
Annual ongoing charge: 0.85%.
iShares MSCI Small Cap UCITS EFT
If you really have to choose a small cap tracker, this is the best of a rather average bunch.This aims to replicate performance of the MSCI UK Small Cap index and gives exposure to 239 UK smaller companies. Performance: It returned 65% over the past 5 years (31/1/2011 to 31/1/2016).
Since inception on 1 July 2009 to 29 February 2016, it has delivered annualised performance (the average amount of money earned each year) of 15.9% compared to 16.6% from the MSCI UK Small Cap Index.
Number of holdings: 239
Fund size: £64.2 million
Launch date: July 2009
Annual ongoing charge: 0.58%.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
A way of valuing a company by the total value of its issued shares and calculated by multiplying the number of shares in issues by the market price. This means the market capitalisation fluctuates continually as the value of the shares change in the market. For example, HSBC has 17.82bn shares in issue at a price of 646.2p making a market capitalisation of £115.15bn.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
Alternative Investment Market
AIM is the London Stock Exchange’s international market for smaller companies. Since its launch in 1995, 2,200 companies have raised almost £24 billion listing on AIM. The market has a more flexible regulatory system than the main market and can offer tax advantages to investors but its constituents are a riskier investment than bigger companies listed on the main market.