Investment Co. Briefing: Smaller companies offer opportunities, as well as risks

30 December 2015

They might still be struggling to achieve a presence for their products; they might face huge expansion costs; and they might not be generating enough revenue to survive longer-term.

For these and many other reasons, smaller companies offer risk challenges to the ordinary investor. But the flipside, of course, is that some small companies explode into growth, rapidly gaining market share for their products, overtaking bigger rivals, creating huge revenue streams and profit. If you back one of these, your gains can be great.

Investment trusts, like other collective funds, offer a less risky way of accessing these investment opportunities via smaller company trusts – and some top- performing trusts exist out there.

The UK Smaller Companies sector has outperformed the average investment company over one, three, five and 10 years.

Moreover, while the average investment company discount has widened in recent months, the UK Smaller Company sector has held up well and has moved in slightly from a double-digit discount of 10% at the end of July 2015 to 9% on 12 October 2015, according to trade body The Association of Investment Companies (AIC).

At a roundtable hosted by the AIC, several leading investment company managers discussed how the UK Smaller Companies sector might fare in future.

Stuart Widdowson, manager of Strategic Equity Capital, said future returns may not match past performance but that didn’t mean there weren’t strong gains to be made.

“Genuine smaller caps have performed well in recent years, and although returns may not quite match that for the next three to five years, there are plenty of reasons to be optimistic,” he began. “Value can be found if you are willing to look for it.

There also remain a few opportunities among higher-quality, higher-margin businesses, some of which have fallen out of favour, although valuations are not uniformly attractive.”

He believes low double-digit growth is possible, provided that earnings forecasts are achieved by companies.

Harry Nimmo, manager of Standard Life UK Smaller Companies, argued that the major academic studies on long-term smaller company performance (by those such as Ibbotson, Dimson & Marsh) are testament to the power of the ‘smaller company effect’ globally.

The studies indicate that, in a fast-changing world, smaller companies can adapt more quickly to new and disruptive ways of doing business. “What is more, these smaller companies are generally less well researched than their larger brethren, which itself provides opportunities for the diligent researcher,” argued Nimmo.

The best-performing smaller company investment trust of the last decade is Nimmo’s vehicle, turning £100 into £538 in the 10 years to 31 October 2015.

“Experience and a solid investment process, which has been tested through several economic cycles, does count in the world of smaller companies. Larger companies in their turn have been found wanting in terms of their ability to grow and adapt to changing market conditions.

“Going forward, smaller companies’ greater exposure to the comparative safe haven of the UK economy in an uncertain world feels right.Their greater prospects for profit and dividend growth suggests that the long-term outlook for smaller companies remains robust.”

If the best smaller company investment trusts perform as well in the next five years, investors could be in for some decent returns. In the five yearsto 31 October 2015, Strategic Equity Capital turned £100 into £333.37, followed closely by Henderson Smaller Companies (£267.58), Chelverton Growth Trust (£259.46), Invesco Perpetual UK Smaller Companies (£248.80), and BlackRock Smaller Companies (£233.04).

Even the worst-performing smaller companies vehicle generated a return of 33% in the past five years.

Jonathan Brown, manager at Invesco Perpetual UK Smaller Companies Investment Trust, said: “One of the major attractions of investing in UK smaller companies is that you can find companies that can continue to show good growth, largely irrespective of economic conditions.

“UK smaller companies have much greater exposure to the UK economy, with larger weightings to domestic- biased sectors including retailers, pubs and restaurants, and house builders.The UK economy has been one of the fastest growing global economies in 2015 with that growth helped by rising levels of employment, low inflation and rising wages. The UK consumer is feeling more confident, encouraged by rising household cash flow, which should continue to help drive economic growth in 2016.”


Henderson Smaller Companies

If you were 128 years old, you might be feeling a little tired in 2015 – but Henderson Smaller Companies shows no signs of slowing down.

At the end of last year, manager Neil Hermon – who has been at the helm since November 2002 – raised the dividend he pays shareholders by 23% to 13.5p, and in the past three years he has more than doubled investors’ money.

How has it done it? Henderson Smaller Companies swears by its research into the smaller company arena, targeting high-quality firms with strong growth potential. If a smaller company grows so fast that it enters the FTSE100 index, Hermon will sell it within six months of its inclusion.

In its last full financial year, the companies that drove its performance were housebuilders Bellway and Taylor Wimpey, the AA, Howden Joinery, e2v Technologies, Greggs, and Betfair, among others.

One look at that list and it’s clear that this vehicle is targeting well-established – if small – firms, rather than fledgling companies without much of a trading record. And it’s working.

In the year to 31 October, Henderson Smaller Companies turned £100 into £128, rising to £201.63 over three years, £267.58 over five years and £419,86 over 10 years.

It is worth pointing out that the vehicle doesn’t come cheap. There is a performance fee of 15% of any outperformance of its benchmark index (the Numis Smaller Companies Index), calculated on a total return basis over the trust’s financial year. Moreover, that fee was previously capped at £2 million but that cap has now been removed.

However, there is a new cap on the total amount payable by investors – including management and performance fees – of 0.9%.

So what does the future hold? At his last annual report, Hermon said: “Corporate profitability has proved robust but has not shown much growth in recent years. It is difficult to see the market making material progress from current levels without an increase in corporate earnings. However, given an improving economic backdrop, we are hopeful that the outlook for corporate profitability is improving. The small company market continues to throw up exciting growth opportunities, in which the company can invest.”