This week, we publish our list of top fund managers’ favourite UK small caps. This is a particularly interesting part of the market for private investors. That’s because many believe it is one of the only areas where individuals can hope to gain a genuine “information advantage”.
An information advantage refers to the ability to profit from knowing things that the majority of other investors do not. With advances in data analysis, coupled with the huge amounts institutions pay for the smartest research minds, many feel most professional investors are flogging a dead horse if they think they can get an information edge over competitors; never mind the chances of private investors.
However, it is rarely worth the time of big institutions, brokers and hedge funds to put in the hours with small caps.
It’s easy to see why small caps are low on the agenda of pros. It is difficult for very large funds to build meaningful positions in smaller company shares. Especially so considering the time required to really understand any company.
There is an illuminating illustration of the time cost of research in the soon-to-be published book 'The Smart Money Method' written by Steve Clapham, a former top hedge fund analyst and founder of training and research firm Behind the Balance Sheet. Mr Clapham puts the hours needed to really get to know a company at about 100 plus. He then breaks down the hours a professional analyst needs to monitor routine announcements during a year, getting to a total of 16 for European stocks (eight for the annual report, four hours for interim results, and two trading updates requiring two hours each).
Given the amount professional investors are paid as well as the amount of money they need to deploy, it is little wonder smaller companies are not seen as a profitable quarry. That’s despite the fact that returns from small caps can sometimes be exceptional.
Indeed, the relative ease at which investors can gain an information advantage in this field is arguably reflected in the fact that the majority of smaller companies investment trusts tend to outperform their benchmarks.
However, as well as the potential for reward, the lack of scrutiny of small caps also increases risk. A look under the bonnet of smaller companies can often reveal hopeless businesses trying to masquerade as something else through “headline” numbers and aggressive accounting techniques.
Meanwhile, small cap share prices can be very volatile. This means anyone holding a smaller company’s shares who is not totally sure why they are doing so, is highly likely to be panicked out of their position by price falls. Given the time it takes to properly understand a company (especially based on Mr Clapham’s workload), a private investor is unlikely to have the hours to bridge an information gap when a share price tanks. The “smart money” prepares for this through research ahead of time.
The importance to investors of knowing why something is held applies to any investment, not just small caps. This is because investors need to be sure of the rationale behind their holdings to have any chance of exploiting what many believe is the most readily available advantage to anyone in the market - behavioural advantage. This idea essentially boils down to one’s the ability to stay cool under pressure, stick with a predetermined plan, and above all, not do anything stupid.
We hope our new longer-form tips format can help bring readers closer to the level of understanding needed to make calm assessments of their investments when things are going wrong, as well as to aid decision-making in the first place. However, for all investors, doing one's own research and taking ownership of ideas has always been, and will always be, essential.