Still set on small

Both portfolios have been overweight UK smaller companies from the start, on the basis that sentiment towards this sector is too negative. Small-cap exposure has helped them outperform their benchmarks. Fears of weak growth notwithstanding, I would do the same again if I were starting afresh today. Sentiment remains weak, yet the fundamentals are good, so it's a good time to add exposure.

It’s different this time!

When I was a fund manager, the conventional thinking was that investors should be overweight smaller companies during an economic up-swing but underweight as the economy contracted. This thinking is still prevalent today, but it needs to be challenged.

One reason is that, as I suggested last month (, 6 August 2010), globalisation means that portfolio diversification by means of geography will continue to decline. Instead, the hunt is on for those themes which will reward investors. By and large, in such an environment, the UK smaller companies sector has tended not to be on some investors’ radar screens because of the perception that the sector is heavily reliant on the domestic economy, particularly manufacturing and building.

But this perception is slowing changing. The sector today has much more overseas exposure and is therefore less exposed to the twists and turns of the UK economy. Many smaller companies now generate more than half of their earnings overseas, and have exposure to a much wider selection of sectors, at least in part because of the advance in technology. Those hunting global themes no longer automatically shun smaller companies. And at a time when economic growth in the UK and the West generally will be anaemic at best, the right global themes will produce superior returns for investors.

Another positive change for the sector is that, after the shock of BP and other large companies cutting their dividends, more investors are looking further down the market-cap spectrum for income. And the potential is huge. Although the majority of Aim shares don't pay dividends, many smaller companies on the main market now have stronger balance sheets and yield as much as their larger brethren.

Good opportunity

Yet despite these reasons to be positive, sector valuations are reasonable, if not exactly cheap. The FTSE small Cap Index is on an historic PE ratio of around 11 times, compared to over 13 times for the FTSE 250 – quite a differential by historical standards. This reflects investor concern about the outlook for the UK economy. Sentiment is poor and therein lays the opportunity. With many good quality smaller company investment trusts standing on discounts of 15 per cent or more, the investor is almost spoilt for choice. The sector is pregnant with opportunity.

There is a further point to be made here. Trusts are particularly well suited for smaller companies because their closed-end structure allows fund managers to buy what may be an illiquid stock without the fear of being forced to sell it early because of redemptions. The ability to gear and generally lower costs also add to their attractions compared to unit trusts.

My chosen trust for both portfolios is Standard Life UK Smaller Companies (SLS), run by the highly-regarded Harry Nimmo and his team. It is the top performer in its sector over the longer term and focuses on resilient companies with organic growth, visible earnings and exposure to international markets. The trust sticks with its chosen companies, with stocks held on average for around four years. Although standing at only a 10 per cent discount, its historical average, I consider it is worth paying up for given its quality and longer term performance.

Otherwise, there have been no changes to either portfolio during August. I am happy to retain a modestly defensive position for both portfolios relative to their respective benchmarks.

John Baron waives his fee for this column in lieu of a donation by IC to chairities of his choice.