X

X

Small is Beautiful

ESG image

The Joy of Investing in Smaller Company Funds isn’t Just About Better Returns, Says Simon Cordery, Head of Investor Relations for Investment Trusts at F&C Asset Management

Investing in large, established, so-called ‘blue chip’ companies is a staple for most investors. Whether the goal is growth or income, the big is beautiful’ argument would appear difficult to beat.

But while owning a stake in companies that are part of our every day (think Tesco, BP, Microsoft etc) makes sense to most people, investing in less well known entities at the smaller end of the scale is somehow seen as being a more risky proposition. There are, nevertheless, some excellent investment opportunities to be found outside the blue chip realm – and there is good evidence that smaller companies outperform large companies over time (See Chart below).  What is more, the global nature of the pool of talent enables investors to build a highly diverse portfolio.

smallcap chart

Source: Bloomberg 09.04.14

Spoiled for Choice

The small company universe is both broad and deep. The global benchmark comprises over 4000 companies that operate in a diverse range of industries offering a wide choice of stocks from which skilled, active investors can profit, even in difficult markets. So what’s the magic formula and why should investors consider smaller companies as part of their portfolio?

Turning On A Sixpence

It boils down to the fact that well run, successful smaller companies exhibit faster growth potential than their larger peers. These are typically focused businesses, operated by nimble management teams who can steer the company through the economic cycle with great flexibility, deploying capital efficiently and shaping the enterprise to suit the prevailing conditions. By being able to adapt quickly to the changing economic environment, skilled management teams can protect their business when things are not going so well but then respond more rapidly when the recovery begins.  

Smaller companies are able to exploit market niches that are just not available to larger companies. The managers of blue chips often pass on these opportunities, because there is not the scale to make it worthwhile for them to participate. This is one of the reasons that large companies outsource to smaller specialists. Having a unique product or specialist service, one that is hard to replicate or one that can be adapted to find new markets, the ‘niche’ is often at the core of a smaller company – which is why its management team is so important.

Watching the Management

At F&C our smaller companies managers spent a lot of time meeting the management teams of companies that they are invested in or might invest in. Gaining a good understanding of their philosophy and plans for taking the business forward is a key part of the research process. We keep a close eye on cash flows and balance sheets and how effective the management is at deploying capital. These are some of the main drivers of earnings growth and hence the potential value of the business which helps protect the investments we make in this area.

In recent years we have noted a healthy demand for smaller companies, helped by rising stock markets following the financial crisis of 2008/09, increased fund flows into equities and a pick-up in investors’ appetite for risk. There has also been an increase in companies coming to the market via initial public offerings and an upturn in old fashioned merger and acquisitions activity. Bigger companies have been snapping up smaller ones and even smaller ones have been picking off weaker rivals or bolting on accretive and strategically sensitive deals.

Our fund managers don’t invest in smaller companies purely for their M&A potential, however – preferring to focus on the ability of each investment to develop organically. But it’s good to see that other investors see the same opportunities – and the resulting bid premium created by M&A speculation is useful to fund managers.

Defining Your Terms

What do F&C mean by smaller companies? Across the board, we have a market capitalisation range of between $200m and $9b at the point of investment, with a lower maximum size range for companies in the UK than the US reflecting the relative size of the economies. So in effect these are “smaller” rather than “small” companies, indeed some are substantial organisations that may employ thousands of people. We tend to be more cautious in investing at the very smallest end of the listed market capitalisation range as in microcaps our ability to move in and out of positions can be compromised.

Ideally when we invest in a smaller company, we are doing so on the basis that it possesses the ability to become a much larger one – and, as you’d expect, there will be cases when investments move up the market cap spectrum to a level above our normal small cap definition. If we still see strong investment upside at this point, we will not be compelled to sell,. But we do aim to ensure that our smaller company funds do not contain too many companies that have become too large.

Smaller company investing requires time, effort and focus, and arguably from the private investor’s point of view it makes sense to gain exposure via a specialist fund structure. This is because individual smaller companies will tend to have a higher level of stock specific risk than would be found in a typical blue chip.

The investment trust structure lends itself well to smaller companies for a number of reasons. The usual advantages of investment trusts, i.e. using gearing to enhance returns (although clearly this is not a one-way street), the potential to buy the portfolio at a discount to its current value (admittedly, discounts are narrower than for some time at the moment), the ability to “smooth” income by squirrelling away dividends and pay them out at a later stage and the fact that the independent board have a responsibility to investors are perhaps well known. The key advantage of the investment trust vehicle, though, is its closed-ended nature.

Freedom From The Liquidity Issue

As already mentioned, the fact that shares in smaller companies can be illiquid, or certainly less liquid than large cap stocks, can be an issue for the fund manager. However, because an investment trust has (outside of buy backs and share issuance) a fixed pool of capital to deploy, the manager can build a portfolio in the knowledge that they will not have to unpick it in order to meet redemptions – or, conversely, invest new capital – potentially at the wrong time. The manager can build a long-term portfolio, have the confidence to hold illiquid stocks and invest in companies that perhaps the manager of an open-ended fund manager would not be able to hold.

The closed-ended structure really comes in to its own during difficult markets. The manager is not forced to sell down the portfolio to meet redemptions as markets fall and investors withdraw their funds. With illiquid stock, the manager of an open-ended fund has to sell what can be sold. Often the best holdings have to go first, which leaves a far from optimal portfolio once this process is over. By contrast, the investment trust manager retains control over the portfolio, being able to hang on to the good stocks and even borrow money to buy more as prices are driven down, once the market turns and prices begin to rise. This can lead to an outperformance of many open-ended funds.

To summarise, investing in well managed, suitably financed smaller companies can generate attractive long-term capital gains. There is good evidence that they can outperform large companies over time and investing in them via an investment trust can enhance investors’ returns.

This Week’s Most Read

Latest IFA Magazine Podcast Episodes

Keep updated on the most important financial events 

Make sure you are an informed

wealth professional..

Adblock Blocker

We have detected that you are using

adblocking plugin in your browser. 

IFA Magazine