Small caps are often regarded as risky, volatile and illiquid. But by playing the market rather than fighting it, you can invest more effectively. Here are some ideas on how to do so:
Investment trusts
If you believe that small caps represent an excellent opportunity what are the best strategies to profit from a recovery? One suitable way would be to buy an established OEIC with a strong long-term track record. However for more adventurous investors there other ways to benefit from a rally in small caps. One such way is to buy a smaller companies investment trust. Discounts on smaller company investment trusts as a group currently stand at 22 per cent to net asset value (having reached 25 per cent in November). If an investor believes that small caps will come back into favour buying an investment trust on a discount will provide the double kicker of a increase in nav and a closing of the discount. In the current climate it would be best to choose a manager with a value orientated approach. Such value stocks – which have been hit hard in the downturn – could rebound strongly. However, one word of warning – it works both ways. If small caps as an asset class slump further you could be hit by the double whammy of a falling nav and a widening discount.
Profiting from index changes
It is no exaggeration to say that the activities of index tracking funds can wreak havoc on small cap stocks at present. This is not the fault of the index trackers – their job is to simply buy constituents of each index albeit with as little market impact as possible. However buying and selling significant volumes of small cap stocks is likely to have significant market impact even when markets are liquid. And markets are far from liquid at present.
The negative impact of index changes on small cap stocks was particularly noticeable at the end of 2008 when several solid small cap companies were ejected from the All-Share not because they were too small but for liquidity reasons (any company that did not see 0.015 per cent of its outstanding shares trade on a median day during the year was ejected). Perversely this rule penalised solid companies with loyal shareholder bases. The share prices of companies such as Huntsworth, Pinewood Shepperton and VP (none of them basket cases) were hit hard as a result of index trackers selling their holdings into a market fully aware of what was coming. During the first few weeks of December, for example, the share price of Hunstworth slumped from 35p to 19.5p. The directors of Huntsworth certainly appreciated the undervaluation of their company. They bought around 3.5m shares at prices between 19p and 24p.
Aside from moves out of the FTSE All-Share index investors can requently profit from other index changes. Moves from fledging index to the full All-share index, for example, can be extremely beneficial as FTSE All-share index trackers buy. Moves from Aim to the main market will also usually drive a share price higher – but watch out for IHT funds on the shareholder register as these will have to sell out as they cannot get tax breaks on main market stocks. In contrast a move from the FTSE Small Cap to the FTSE 250 index is usually a marginal negative as the company will probably be a smaller component of the FTSE 250 than the Small Cap Index. This means selling by Small Cap benchmarked funds is unlikely to be mitigated by buying from FTSE 250 funds.
The Hoare Govett Smaller Companies Index
The Hoare Govett Smaller Companies index, which is recalculated annually, accounts for the bottom 10 per cent of the UK market. The index, which has data running back to 1955, is the most widely used benchmark amongst small cap fund managers. You might be surprised that this index now includes all but the largest 41 companies of the FTSE 250 index. This reflects the increasing polarisation of the UK market into large, mega cap companies "and the rest". In 2008 the total return on the index was -39.6 per cent, an underperformance compared to the All-share of 9.6 percentage points. The HGSC consists of 907 companies, or 495 if investment companies are excluded.
