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Brian Tora: Small companies risk and reward

Brian Tora MM blog side

It is a little while since last I commented on smaller companies. Mentioning them in October, with its history of upsets, looked too risky. Now that the autumn is well and truly upon us, perhaps it is time again to cast an eye over what remains, in my humble opinion, one of the more exciting investment areas. But despite the attractions, this remains a sector full of pitfalls.

When the TMT boom held sway, as the old millennium drew to a close, I well recall one of the highly regarded American technology analysts drawing up lists of what were known as potential “ten-baggers” – shares capable of rising tenfold and rewarding the early backer handsomely. I’ve had a few of them, but not – as it happens – in technology companies. But then this is the excitement of small companies – finding the next mighty oak from a humble acorn.

This is tougher than you might think. A glance at the performance records of smaller company funds will tell you that. Even well established and highly regarded managers have fallen from grace at times – and the past year has proved particularly difficult for some. In a way it is easier for the experienced private investor than for a professional fund manager. With a fund held by all manner of investors, trying to spread the risk is paramount.

One successful small cap investor of my acquaintance – admittedly a retired investment professional – felt the ideal portfolio was just one share. Either you held it or you didn’t, but at least you had the opportunity to understand the underlying company fully and make judgments accordingly. It didn’t do him any harm. He retired to a tax haven with the millions this strategy had delivered.

Life, of course, isn’t like that anymore. But there are themes that can be followed in smaller companies and, as any small cap manager will tell you, a dedicated follower of the sector has the advantage that it remains under-researched. So the odds appear stacked in favour of the smaller company fund manager, though the performance tables do not entirely support this contention.

Examining the IMA UK Smaller Companies sector for a sister publication recently, I was struck by how the leaders and laggards had changed since last I reviewed this group and how varied the performance was. Consistent returns had been achieved by a limited number of funds, but some of the earlier stars had clearly found the testing times present recently of a particular challenge.

All well and good, I hear you say, but why consider these funds now? Far be it for me to embrace a momentum approach to investing, but I could not help but notice that a five year underperformance of the small cap index against the FTSE 100 had recently come to an end. Perhaps this is just a blip, but trailing the large cap stocks since the beginning of 2007 until half way through this year strikes me as a trend ready to reverse.

Smaller company shares are less liquid than the market leaders, can be much more volatile and undoubtedly sit at the riskier end of the investment spectrum. But they can produce spectacular returns and, from my perspective, are firmly situated at the fun end of the market. And the managers that excel in this sector are not too difficult to identify.

They need to be approached with care and caution, though. Indeed, an ex-colleague of mine, who runs a small cap fund, once remarked that his research was concentrated on avoiding torpedo stocks. That is where the greatest danger lies – finding good picks undermined by a series of disasters. But there time will come – perhaps soon.

Brian Tora is an associate with investment managers JM Finn & Co

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