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.
Gervais Williams is manager of the CF Miton UK Smaller Companies Fund, a top performer over three years. He believes we’ve entered an era of low growth and deflation caused by too much debt.
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.”
A long-standing star among smaller company managers is Harry Nimmo, who manages the Standard Life Investments UK Smaller Companies fund and its sister investment trust.
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%.