Can these seven small-cap stocks buck the trend?

According to billionaire money manager Ray Dalio, smart investing is all about diversification. He says the ‘Holy Grail’ of portfolio construction is to find at least 15 assets with a good probability of making money and whose returns are uncorrelated. As he tells it, the point is not to find the very best investments (although bully for you if you do) but instead to improve the portfolio’s expected return relative to its risk.

That’s the theory at least. Finding assets that are genuinely uncorrelated is difficult, as anyone who has lived through a liquidity crisis (or owns bitcoin) can attest.

A good chunk of the investment world is in Dalio’s camp. Modern portfolio theory states that up to a point, more assets can improve a portfolio’s overall returns without adding risk. Diversification is also a guiding principle behind index funds, even if buying the market technically involves an automated, rather than a selective, approach to investing.

Others aren’t so sure. According to billionaire money manager Charlie Munger, smart investing has nothing to do with diversification.

“The idea that very smart people with investment skills should have hugely diversified portfolios is madness,” he told the annual gathering of Berkshire Hathaway (US:BRK.B) shareholders in 1994. “It’s a very conventional madness. And it’s taught in all the business schools. But they’re wrong.”

To Munger, diversification is a way of masking ignorance. To not possess a concentrated portfolio is to show a lack of conviction in your investment ideas, while the notion of looking for 15 ‘good’ ideas, as opposed to five excellent ones, is an inevitable road to diluting your returns.

The parallels with passive investing back this up: if you want average returns, you should by definition buy the market. Granted, this isn’t diversification as Dalio tells it. The FTSE 100 index, although it provides exposure to a diverse array of industries and economic drivers, is still a collection of equities. And over a short enough time horizon, share prices have a habit of correlating.

To these two billionaires’ credit, both practice what they preach. In the case of Munger and his better-known partner, Warren Buffett, this can be seen in Berkshire’s latest holdings. Aside from a cash pile – at $147bn and still growing – the conglomerate’s equity portfolio is as concentrated as you’re likely to see. Almost half is in Apple (US:AAPL), and another 32.3 per cent is split across just five more stocks – neatly chiming with Buffett’s view that “six wonderful businesses” is all the diversification that anyone needs.

If anything, Munger has taken this logic to greater extremes. Under his chairmanship, the investment portfolio of the Los Angeles-based publisher Daily Journal Corporation owned just four stocks as of this year: Bank of America (US:BAC), Wells Fargo (US:WFC), Alibaba (US:BABA) and US Bancorp (US:USB). Not only does this portfolio lack absolute diversification, but three of its four holdings are American banks.

This week’s screen, which looks for High-Quality Small Caps, has little to do with American blue-chip financials. But in searching for companies that tick a wide range of positive corporate attributes, its methodology has resulted in dispensing with diversification and taking a high-conviction approach to great companies.

Granted, this is by accident more than design. In each of the past two years, it has been unable to scrape together more than five companies that match its tests. In 2022, the screen yielded just four companies. And although this served up one bona fide winner in housing maintenance group Sureserve (SUR) – which was acquired by private equity firm Cap10 last month – the utter collapse in another pick, streaming device group Aferian (AFRN), meant another year of very poor performance.

If we wanted, we could try to unpick some of the reasons why this particularly high-conviction approach appears to be breaking down. Perhaps small caps, by their nature, are more liable to crises than their larger, and normally more experienced and better-resourced peers. Or maybe there is more wisdom in Dalio’s approach when markets struggle to adjust to a new paradigm. After all, while Berkshire Hathaway appears to be doing well, the Daily Journal’s four stocks have posted an average negative total return of 4 per cent this year, compared with a 15 per cent rise in the S&P 500 (the product, somewhat paradoxically, of a very narrow rally in a handful of companies).

However, it may simply be that the pool in which the screen fishes – Aim and FTSE Small Cap stocks with a market capitalisation of between £20mn and £1bn – has been stagnant of late. Last year’s four picks may have fallen 16.6 per cent, but the index from which three stocks were drawn – the Aim All-Share – was very nearly as bad.

This result dragged down the screen’s all-time total return to 130 per cent over the 11 years we have been following it. That’s a lot better than a rather horrible 26 per cent from Aim, but some way behind the 174 per cent return from the FTSE Small Cap index.

One snag with small-cap investing is the matter of trading costs, which are exacerbated in a portfolio that moves in and out of positions every year. The big reason for this is liquidity and the difference between the market price at which shares can be bought and sold, which tends to be wider the smaller the company.

To illustrate this expense, the addition of a 2 per cent notional annual dealing charge to the screen pares back the all-time total return to 84 per cent and below a 50-50 split of the Aim All-Share and FTSE Small. While factoring in frictional trading costs helps show the real-world impact of trading on a portfolio, like most of the screens run in this column, the intention is to produce ideas for further research rather than an off-the-shelf portfolio.

Historically, the high-quality screen has taken a bit of a have-it-all approach. While it primarily looked for stocks with signs of operational excellence across the balance sheet, cash flow and income statements – including a track record of solid and growing returns on equity and operating margins, manageable borrowings and good cash management – it also sought to balance this with a couple of value tests.

This year, in a bid to broaden the selections and better reflect the data outputs FactSet gives me, I have binned the requirement for a top-quartile genuine value ratio (which is essentially a price/earnings growth (PEG) ratio that factors in a company’s debt and dividends).

This year, five Aim stocks make the cut alongside FTSE Small constituents Macfarlane (MACF) and Porvair (PRV). Whether this broader diversification successfully reduces the apparently high ongoing risks of investing at the junior end of the stock market is a question whose answer we will know in a year’s time.