Sector watch: your guide to investing in stocks and shares

You may not have heard of Advanced Medical Solutions, but its share price has rocketed over the past year, richly rewarding those investors who had the foresight to put their money in the company.

The Cheshire-based developer of wound-care products, which is listed on the Alternative Investments Market (AIM), has benefited from the interest of a potential suitor, positive news on its products and rising profits.

Such success stories illustrate the principal attraction of investing in smaller companies: the potential for a business to enjoy massive gains on the back of events such as the development of a new range or the signing of a major contract.

The fact that they are not as high-profile as corporate giants like Vodafone and BP also works in their favour. Because they fly under the radar of many investment analysts, they have far greater potential to surprise market observers on the upside.

The key, of course, is predicting which will flourish, and this is not an easy task. While some may progress to become the next Microsoft, many more will fail completely, warns Mark Dampier, head of research at independent financial adviser Hargreaves Lansdown.

"The world of smaller companies can appear from the outside to be a vast, untamed ocean, full of opportunities, yet fraught with danger," he says. "Smaller companies exhibit spectacular growth potential, but inevitably some will fail."

That makes investing in individual stock names a foolhardy strategy for all but the most risk-hungry private investors. The alternative is to invest in a fund sitting in the IMA UK Smaller Companies sector. Funds must invest at least 80% of their assets in the shares of UK companies that form the bottom 10% of the market in terms of their capitalisation (value).

The fund managers operating in this arena have certainly performed strongly over the past year: the average fund is up a solid 16%, according to Morningstar statistics (as of 15 October).

Only the IMA Global Emerging Markets, IMA Asia Pacific excluding Japan and IMA Asia Pacific including Japan sectors have turned in a better performance during this period, which has seen stockmarkets bounce back and confidence return.

Why have the smaller cap funds done so well - is it purely down to stockpicking? After all, the domestic economy has not exactly been charging ahead: many businesses are still struggling and anxiety is rising about the impact of the government's spending review and the prospect of a double-dip recession.

The answer is that many of these stocks were oversold in 2008 as panicky investors reacted to the credit crunch, says Patrick Connolly, spokesperson for AWD Chase de Vere. They paid the price for liquidity being poor and investor sentiment negative.

"This created fantastic buying opportunities for fund managers," he explains. "When combined with a more realistic perception of the effects of the credit crunch, it led to stocks bouncing back strongly."

Volatile market

However, while the sector has done superbly over the past two years, it is important to recognise that most funds are still showing a loss over three years. In fact, the average fund is down more than 6% since October 2007.

As a general rule, smaller companies tend to perform better than the market as a whole during the good times but worse during the bad ones. This can make them volatile investments, as we have seen in recent years. As the economy recovers, though, smaller companies have the potential to grow their profits, dividends and hopefully share price faster than their larger counterparts - although they will still come with a heightened risk of failure.

This inherent volatility can be seen in the data. The average fund may have delivered 16% over the past year, but this hides a huge disparity between those at the top and bottom of the performance tables.

Thus, while the Clerical Medical UK Smaller Companies Alpha fund has returned a whopping 44% over 12 months, the MFM Techinvest Special Situations fund has shed 6%, according to Morningstar. That is a staggering difference.

Geoff Penrice, an independent financial adviser with Honister Partners, argues this shows UK smaller companies is not a sector that will suit everyone, and that it's essential to take a cautious approach and do the homework. "This sector is for higher-risk investors who want the potential of a greater return than is likely from investing in large-cap funds," he says.

"Further, it's very important to select the right fund in this area of the market."

In fact most investors can benefit from investing in smaller companies, but the associated volatility means their exposure should in many cases be quite small, suggests Connolly. "Some investors may even get adequate exposure to this area through more broad-based equity funds, without the need to invest in specific smaller company funds."

So what should investors look for in a small cap manager? According to Andrew Merricks, head of research at Skerritt Consultants, they should opt for a manager with a consistent track record over a number of years.

"Don't go on short-term past performance because it can be misleading," he says. "A focused fund with relatively few holdings can enjoy years of massive outperformance and then similar periods of underperformance, so you need to look for consistency."

Consider this sector if...

  • you want greater diversity in your UK holdings
  • you believe that despite the difficult economic climate there's still potential for growth among the UK's smaller companies
  • you think small caps will outperform larger companies
  • you are prepared to accept higher risk in expectation of stronger returns over the long term

Fund to watch: Standard Life Investments UK Smaller Companies Fund

Harry Nimmo's Standard Life UK Smaller Companies fund has been one of the most consistently strong performers over the past decade, despite the huge levels of volatility experienced by the sector as a whole. It is also the winning fund in the Moneywise Fund Awards for the UK smaller companies sector.

It even boasts a return of almost 16% over the past three years, making it one of a relative handful to make it into positive territory, while anyone who has invested in it for five years will have virtually doubled their money.

The stated objective of the £784.7 million fund, run by Nimmo since its launch in January 1997 and boasting AAA ratings from both Standard & Poor's and Old Broad Street Research, is to provide long-term growth by investing in smaller companies.

Unsurprisingly, it is not short of support among advisers. Patrick Connolly, spokesperson for AWD Chase de Vere, points out that the fund has performed consistently well in comparison with its peer group since launch. "The investment team also has a strong focus on research and managing investment risk," he adds.

Mark Dampier, head of research at Hargreaves Lansdown, has gone as far as branding Nimmo the "Neil Woodford" of the smaller companies world, in light of his preference for resilient business models and predictable earnings.

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