How to spot smaller companies winners

Funds that focus on smaller companies tend to outperform their benchmark indices by a greater proportion than their large-cap peers over time. The average share price and net asset value (NAV) total returns of UK smaller companies investment trusts increased by 99 per cent and 68 per cent, respectively, over the five years to 19 March, according to broker Winterflood. By contrast, the Numis Smaller Companies Index ex investment companies index has increased 51 per cent over the same period. 

Compare this with investment trusts focused on larger UK companies, for which the average share price and NAV total returns were 54 per cent and 46 per cent, respectively, over five years to 19 March. The FTSE All-Share index, which includes the largest UK-listed companies, increased 35 per cent over this period. 

Not only have the smaller companies performed better, they have also beaten their benchmark by a more significant margin. This trend is well known and expected, as smaller companies are less well researched so there are more mispriced assets for managers to spot. 

Global equities investment trusts focused on larger companies, meanwhile, on average made respective share price and NAV total returns of 122 per cent and 115 per cent over five years, while FTSE World index returned 100 per cent. But global investment trusts focused on smaller companies, on average, made respective share price and NAV total returns of 192 and 183 per cent, compared with 103 per cent for MSCI World Small Companies index. Admittedly the success of global smaller companies investments trusts is thanks to one fund – Edinburgh Worldwide Investment Trust (EWI) – run by Baillie Gifford.      

But in the US, the S&P 500 and the Russell 2000 indices have risen by 120 per cent and 117 per cent, respectively, over five years. And in Japan, the first section of the Tokyo Stock Exchange has made a total return of 79 per cent over five years compared with 73 per cent for MSCI Japan Small Cap index. In emerging markets, large caps have also tended to outperform small caps in recent years.  

Analysts think smaller companies are poised to outperform their peers as economies recover from the pandemic. While recent strong performance suggests a degree of good news is priced into the UK, James Carthew, head of investment company research at QuotedData, says: "On a relative basis, the performance of UK equities may be perking up, which should attract attention from a wider pool of investors.” Smaller companies are more geared to domestic economies so are more likely to do well as economies pick up. 

Priyesh Parmar, associate at Numis Securities, says that it is a compelling time to invest in US smaller companies owing to a recovering domestic economy and attractive relative value versus large caps. Carthew adds that global small companies should continue to do well. The pace of innovation is not slowing and growth in areas such as cloud computing is making it easier for smaller companies to access customers.

Looking under the bonnet

When you buy a smaller companies fund it is worth looking at the size of the positions within it to see how much liquidity risk it has. If an asset management company holds a large proportion of the shares in the companies its funds hold, it could be harder for them to sell these shares. This is particularly notable at large fund houses, such as Aberdeen Standard Investments, which has many funds investing in the same smaller companies stocks. 

Given the risk of having any one position too large, you also want to look at a fund's top holdings to see what proportion of it they make up. Having large positions in some stocks can be a double-edged sword: while stock-specific risk increases, it can also be because the fund's manager runs the winners, which should lead to better performance over time. 

Edinburgh Worldwide Investment Trust, for example, holds on to investments as they increase in size and Tesla (US:TSLA) was its second-largest holding at the end of February. This trust's managers typically invest in companies with a market capitalisation of less than $5bn (£3.6bn) at time of initial investment and expect to own them for at least five years – regardless of their size. 

Smaller companies funds have different policies on the size of companies they hold, which they set out in their annual reports. Henderson Smaller Companies Investment Trust (HSL), for example, sells a holding within six months if it becomes so large that it enters the FTSE 100. And  BlackRock Smaller Companies Trust (BRSC) stipulates that new holdings must have a market cap beneath £2bn and any stock that enters the FTSE 100 will be sold within 30 days of entry.  

Three investment trusts focus on very small companies of which River and Mercantile UK Micro Cap Investment Company (RMMC) has been the standout performer over the past five years. Its managers invest in companies with a market capitalisation of less than £100m. The trust has a policy that no holding will exceed 10 per cent of its net assets at time of investment and it “would not normally intend” to hold more than 25 per cent of the capital of a single company at time of investment.

An expected increase in mergers and acquisitions this year could play a significant role in the performance of smaller companies funds. Generally, fund managers welcome acquisitions of their holdings as they are usually at an attractive premium to the share prices. However, Ryan Hughes, head of active portfolios at AJ Bell, points out that it can often be a source of frustration for smaller companies fund managers as one of their great hopes for the future may be taken out.

Hughes says: “This is essentially an occupational hazard for smaller companies managers. The key is to put the proceeds of that takeover back to work in new ideas. This isn’t too much of a problem given smaller companies funds often run pretty diversified portfolios, so often these proceeds can be used to top up existing holdings or introduce new ones.”

He adds that the likelihood of a cash drag scenario – when managers take time to reinvest excess cash – is very low.  

Closed-ended versus open-ended

Because of enhanced liquidity issues with smaller companies, investment trusts may be more appropriate for investing in them. However, because investment trusts use gearing (take on debt), and can swing from premiums to discounts to NAV, they can also be more volatile. So be wary of buying them at premiums. But as of 19 March, only one out of 15 UK smaller companies investment trusts listed by Winterflood – BlackRock Throgmorton Trust (THRG) – was trading at a premium. 

Carthew says: “The relative illiquidity of smaller companies means that they are much better suited to being held in a closed-end portfolio where there is no need to keep substantial cash on hand to fund potential redemptions. Managers of trusts are also better able to take a long-term view.”

However, Darius McDermott, managing director of research company FundCalibre, argues that there are equally creditable open-ended funds. Because managing liquidity is more pressing with an open-ended fund, McDermott expects their managers to say how much money they think they can manage and would expect them to soft close to new investment if they exceed that amount. 

The maximum position that open-ended funds can have in one company is 10 per cent – a rule that provides more discipline, but means their managers have less flexibility than those of investment trusts. And investment trusts in the Association of Investment Companies (AIC) UK Smaller Companies sector hold companies with an average market capitalisation of £642m, but open-ended funds in the Morningstar UK Smaller Companies category have holdings with an average market cap of £903m.

McDermott highlights LF Gresham House UK Micro Cap (GB00BV9FYS80) and TB Amati UK Smaller Companies (GB00B2NG4R39) as lesser known funds with good managers and track records. The former is a high conviction fund with 45 holdings, a 47 per cent turnover rate and assets worth £283.9m.

TB Amati UK Smaller Companies was launched in 1998, has 73 holdings and assets worth £631m.  

Hughes likes TM Tellworth UK Smaller Companies (GB00BDTM8C53) as he particularly rates its managers, Paul Marriage and John Warren. Marriage set up Tellworth in 2018 after working at Schroders (SDR) because he “wanted freedom over how much money he managed rather than being an asset gatherer”, says Hughes. The fund has assets worth around £360m and invests in the smaller end of the market, with 70 per cent in companies that have a market cap of less than £500m. 

When deciding between an open-ended fund and an investment trust, also consider the charges of the investment platform you use. If you invest with a platform that caps holding charges for listed securities but not open-ended funds, such as Hargreaves Lansdown, Fidelity and AJ Bell, it could be cheaper to hold investment trusts. But these platforms' dealing fees for listed securities are higher.