Markets go down and 'lost equity decades' occur, but anyone who has stuck with one of Harry Nimmo's small-cap funds will have experienced the opposite. So how does Mr Nimmo, head of smaller companies at Standard Life Investments, do it - and in a highly volatile area of the market?
Mr Nimmo's investment process "has not changed since January 1997 when the Standard Life Investments UK Smaller Companies fund was launched" - and has since been successfully applied to other funds, including the UK Smaller Companies investment trust, and more recently a global fund. The emphasis is on stock selection rather than sector allocation and he focuses on three areas: growth; business and share price momentum; and quality.
A lot of managers say they seek quality, so what does he mean by this? Cash flow and special dividends; good revenues, profits and dividends; longer-term contracts and customer relationships; and pricing power are among the attributes he considers a quality company to have.
He won't necessarily buy a share because it's cheap. "If you buy a cheap share, especially among smaller companies, you could be buying a heap of trouble," he says. "Shares are cheap for a reason - for example, there could be a profits warning in the post or a dividend cut around the corner."
Low price/earnings ratios (PEs) and high yields are also not reasons to own a stock. That said, Mr Nimmo prefers companies that pay dividends and commented in the investment trust's recent annual report: "Another encouraging trend is the good rate of dividend growth and the use of special dividends without compromising growth prospects."
Dividends aren't usually an attribute investors look for in small-caps, an area associated with growth, so why does he think it is important?
"Dividends keep management honest and remind them what it's all about," he explains. "They are a signal of what the management feels about the medium term, and the only tangible benefit to owning a share. However, it is better if they do not raise them too fast but smooth them over the long term, and don't pay uncovered dividends."
Mr Nimmo also doesn't set target prices as a sell trigger: "Run your winners," he says. "If the share price goes up I may buy more and if it goes down I may sell because things have changed."
He tends to hold shares for a long time, but he will sell if a company has grown too large, as he doesn't like one holding to account for more than 5 per cent of assets in one fund and, of course, the funds are focused on smaller companies.
Seven of his former portfolio holdings have reached the FTSE 100: Autonomy, Cairn, Shire, Stagecoach, First Group, Capita and Serco. Hargreaves Lansdown, meanwhile, is still a top 10 holding in the UK funds and Mr Nimmo would prefer not to move out of it if possible. "I think it is going to be a good deal bigger, but we may have to sell if it grows to more than 5 per cent in the funds.”
Another quality Mr Nimmo likes is management longevity. He says at least 10 of his holdings are still run by the founder, while 17 have had the chief executive officer or founder on the board for more than 10 years. "And almost none (with the exception of three) have previously been owned by private equity," he says. "Private equity is more about quick churn and it doesn't add much to long-term growth. If anything they subtract from it."
Lower risk
Smaller companies are generally considered to be a higher-risk investment, but Mr Nimmo says this does not have to be the case. "I don't agree that you need to take on more risk to get more returns," he says. "I buy lower-risk smaller companies and they do better than higher-risk smaller companies. Investors are poor at figuring out the risk/return trade-off and some get carried away with upside. There are some smaller companies described as high-risk businesses that I say are not businesses but an idea. For example, they have no profits or dividends and many fail. I tend not to invest in 'blue sky' ideas."
He says you find a lot of these in the oil, gas and mining sectors, hence the fund's low allocation to these areas, which only account for around 5 to 6 per cent of the UK funds' portfolios.
Exceptions include specialist oil services companies such as FTSE 250 listed Kentz, an engineering company, while the global fund holds US listed Oceaneering, a specialist in deepwater applications for the oil and gas industry.
Some are concerned that UK smaller companies, which have had a good run over the past few months, may have hit their peak. However Mr Nimmo argues that smaller and medium-sized companies are likely to outperform larger companies for another 10 years, in part due to the fact that many can build their business with new technologies, while older ones find it harder to adapt to the online world.
"Smaller companies tend to be in more specific niches and if those are growing so are the companies," he says. "Larger companies tend to be shackled by the straitjacket of world gross domestic product (GDP). Investors tend to talk of a lost decade for equities (2000 to 2010) but this was not the case for our funds."
