Stripping out investment companies, the total return from the Numis Smaller Companies Index (NSCI XIC) increased to a stunning 36.9 per cent. We highlight five tricks to picking small-cap winners as revealed by data in the professors' 2014 annual review of small-cap shares.
1. Buy a basket of small-cap shares. Smaller companies are inherently more volatile than their larger counterparts and the risk of business failure is much greater. But NSCI historical data shows that smaller companies typically outperform over time, so we recommend reducing risk by buying a basket of small-cap shares. From 1955 to 2013, the NSCI would have provided an annualised return of 15.5 per cent, which is 3.5 per cent above the FTSE All-Share. Numis Securities offers several attractive funds tracking the small-cap sector, but we would highlight Simon Thompson's Bargain Shares Portfolio as a do-it-yourself alternative; his portfolios have beaten the FTSE All-Share index in 13 out of the 15 years in which time he has run them. And last year's portfolio has continued the strong recent performance, returning more than 37 per cent in the past 11 months and outperforming the FTSE All-Share, FTSE SmallCap and Aim indices handsomely.
2. Reduce exposure to resource shares. Natural resources equities performed terribly in 2013 and this heavily dragged down overall Aim performance; non-resource stocks on Aim had a return of 39.6 per cent (Aim All-Share: 21.3 per cent). Oil and gas and mining companies comprised 34 per cent of Aim shares in 2013, but we don't recommend investors take on that much exposure to the faltering resources sector in 2014. A significant chunk of the Numis index's outperformance was because its exposure to these sectors was much lower (NSCI XIC: 7.3 per cent). Not surprisingly, the three laggards in Simon Thompson's portfolio were all resources-related shares.
3. Small is beautiful. Smaller constituents of the NSCI XIC gave a return of 47.5 per cent in 2013, far better than the bigger companies in the index (33.7 per cent). These shares are often under-researched and can be a boon to investors in an up-market provided they're willing to put in the extra research and bear additional risk. But we caution that these shares tend to be illiquid and underperform in a falling market and there's a much higher chance of the company going completely bust. Indeed, since the inception of Aim, the NSCI has delivered an annualised total return of 9.4 per cent, while the Aim All-Share has delivered a total return of negative 0.7 per cent per year (before inflation).
4. Value can be more rewarding than growth. Value stocks in Numis' index provided a return of 46.6 per cent in 2013, far better than growth stocks (34.4 per cent). In a bull market, like the one we are in today, investors often over-pay for growth stocks. As investor Paul Scott advises on his small-cap value blog: "With the market for smaller caps generally quite expensive at the moment, there are going to be a lot of banana skins around this year, as those hefty PERs come down to earth with a bump for companies that fail to deliver strong earnings growth. [You] have to be very, very sure that a company is indeed going to perform well, before paying an expensive earnings multiple for the shares."
5. Run your winners and cut your losers. Over the course of 2013, the prior year's best performers turned £1 into £1.55. The prior year's worst performers turned £1 into 89p. Put another way, past winners outperformed past losers by 74 per cent. As the IC's resident economist, Chris Dillow, surmises: "The traditional advice to 'cut your losers and run your winners' is not always correct…[but] very often, it is a good rule. It encourages us to profit from momentum…and it tells us not to suffer from the disposition effect, our tendency to hold onto losing stocks in the hope that they'll return to the price at which we bought them."
