- Smaller companies can deliver more growth than larger companies over the long term
- UK small caps look cheap but could experience volatility
- Many UK smaller companies funds are run by experienced teams
A problem with many of the 'bargain' investments that emerged in 2022 is that their de-rating looked pretty justified at the time. Bonds were facing a daunting series of interest rate hikes after years of looking expensive, while highly-valued favourites such as tech stocks had to answer pressing questions about their future prospects. And things are still uncertain: bargain hunters who want to buy now may have to buckle up for further volatility and stay focused on the promise of good long-term performance coming through.
Such a mindset is useful for investors eyeing up domestic companies further down the market cap spectrum. UK mid caps took a big hit last year, with the FTSE 250 index shedding 17 per cent. The FTSE Small Cap index was down by 13.5 per cent, a stark contrast with the 4.7 per cent gain for the FTSE 100.
But cheap as small and mid caps now look, there are problems that cannot be ignored. Such companies tend to have a notable growth bias, which has left them exposed to that investment style’s fall from grace and the effect of rising interest rates on valuations. Even if interest rate rises are near an end the UK still runs the risk of plunging into recession, or simply seeing growth flatline, causing problems for smaller companies which tend to rely more heavily on the health of the economy.
“[Recent events have created] a particularly unhappy cocktail of issues for smaller companies which tend to be more sensitive to both economic activity and borrowing costs compared with larger, more established businesses,” notes Charles Stanley chief analyst Rob Morgan. “In addition, smaller companies tend to be more orientated towards the domestic economy where there are concerns of a pronounced slowdown.”
This means that investors looking to buy smaller companies need to be able to tolerate volatility. Morgan notes that the average fund in the Investment Association UK Smaller Companies sector was down by around 4 per cent over the first quarter of 2023, having been up 6 per cent in the first month of the year.
Other big ups and downs could occur, although small caps can still offer big gains over the longer term. The FTSE Small Cap returned 116 per cent over the 10 years to 5 April, despite recent difficulties, putting it notably ahead of the FTSE 100.
The smaller companies universe is an area where a decent case can be made for backing stockpickers rather than investing via tracker funds, given that market inefficiencies can give rise to mispricings. But actively managed smaller companies funds can have very different investment approaches to one another.
Some important dividing lines
One key dividing line between smaller companies funds is whether they run their winners. Smaller companies funds can cling on to much bigger gains by sticking with businesses as they grow from small caps to mid caps, and benefit from their returns if things work out. But this is a problem if you want a dedicated small-cap fund, and a fund with a mixture of market cap segment exposures might create some overlap with your other holdings.
However, exposure to mid caps can at times make a fund less reliant on the domestic economy, which could be beneficial if the UK goes into a recession. A good number of funds take such a combined approach. BlackRock Throgmorton Trust (THRG), for example, backs a mixture of mid and small caps, and while it has struggled in the past year it has tended to outpace many of its small cap-focused rivals when the growth investment style was doing better. At the end of its last financial year on 30 November 2022, it had over half of its assets in the FTSE 250, a third in FTSE Aim and 6.9 per cent in FTSE Small Cap companies, on a net basis.
Another important consideration is how concentrated a portfolio a manager is running, especially with a dedicated small-cap fund. Some funds such as Odyssean Investment Trust (OIT) tend to have especially focused portfolios, and this trust's two largest holdings made up around a quarter of its assets at the end of February. The pros and cons are fairly clear: you have a simpler proposition with fewer holdings to consider, but the trust’s performance is much more heavily influenced by a few individual stocks.
Experience counts
Many smaller companies funds have experienced management teams. Morgan points to BlackRock Smaller Companies Trust (BRSC) because of its long-serving team and focus on quality companies. “The portfolio is built around companies with good management, strong market positions, sound balance sheets and a demonstrable ability to convert earnings into cash," he says. "In other words, it steers away from highly cyclical, excessively leveraged or blue-sky companies."
The trust has around 100 holdings which moderates stock specific risk and it was recently trading at a 13 per discount to its net asset value (NAV).
Some smaller companies funds have a degree of appeal for income investors, too. Morgan notes that BlackRock Smaller Companies Trust has a “surprisingly decent” yield of 2.7 per cent, while others specifically focus on payouts. Ben Yearsley, investment director at Shore Financial Planning, likes Montanaro UK Smaller Companies Investment Trust (MTU) because of its specialist team and focus on long-term quality growth. The trust pays a quarterly dividend equivalent to 1 per cent of its NAV a perk, although paying dividends out of capital can mean lower payouts in difficult markets.
Some analysts argue that a focus on dividend-paying stocks, which served investors well last year, can be as applicable further down the market cap spectrum as with bigger companies. Rory McPherson, chief investment officer at MFDM, has been shying away from “very exciting or hopeful stories of cheap growth stocks in the UK market and [turning to] those that pay good and growing dividends."
His team has backed Premier Miton UK Multi Cap Income (GB00B4M24M14) but also opted for more mainstream funds with a mid-cap allocation such as value play Fidelity Special Situations (GB00B88V3X40). “History has shown that inflationary periods can benefit the mid-cap companies as they have the ability to acquire smaller companies that struggle with debt burdens due to higher interest rates,” he adds.
