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Each-way bets with small stakes

As most fund managers have moved up the market cap scale, UK smaller companies have gone out of vogue. Bigger companies generally have better valuations and a more difficult economic situation suggests a better picture for them.

However, while asset allocation can explain most of the profits from an investment, it can also explain most of the losses. The nature of small caps has changed for the better and they remain under-researched compared with their bigger counterparts.

Where some investors may be going wrong is in moving out of the sector lock, stock and barrel. This is not what most professionals do because they know there are always some opportunities to be found in smaller companies. If you can identify the top managers, then it is worth sticking with them. In my opinion, Harry Nimmo at Standard Life is one of the very best.

It often surprises me that few investors have much exposure to UK smaller companies. It is the area in the stockmarket where the most price anomalies and under-researched companies can be found. This can offer superb opportunities for talented investors to outperform.

For example, if you look at the FTSE 100, just 10 companies account for more than half the index. Their accounts are poured over by hundreds if not thousands of analysts around the world, which tends to make it quite an efficient market and one where it is hard to make excess returns.

Nimmo’s maxim is that he is buying tomorrow’s bigger companies today. He is looking for proven business models with reliable revenue streams. He does not look for esoteric companies that are marketing some fancy new technology simply because most of those end up going bust.

Nimmo often refers to his fund as an each-way bet, by which he means that it does not tend to lose out by too much if bigger companies make most of the running. This is born out by the fact that even though the FTSE All Share has performed better than the FTSE Small Cap index this year, Nimmo’s fund has actually done better than an average broadly-based UK fund. This reinforces my belief that making moves just for asset allocation purposes can often turn out to be wrong.

There are a vast number of smaller companies out there so it can be a tough universe to keep track of but Standard Life has a great starting point. It has developed a system it calls the matrix, which allows it to rank hundreds of companies against many different criteria and helps sieve out some of the dross. In this way, it can focus its in-depth research on some of the more promising companies.

Nimmo is supported by an experienced team of three other fund managers, each specialising in specific areas, so together they have a high level of expertise across the market.

Smaller companies are very different today than when I started in the investment industry in the early 1980s. In those early days, they tended to be highly cyclical and domestically-oriented industrial companies. In effect, this meant they went through especially exaggerated periods of boom and bust.

There are still plenty of domestic UK companies around but more of them have strong revenues and sound business models. For example, in Nimmo’s portfolio you will find Dignity, the funeral home operator. However, these days, far more small UK companies derive a lot of their earnings from overseas. These include firms such as Chloride Chemring Group, First Quantum Minerals and Salamander Energy.

The three biggest holdings in the portfolio are Asos, which is very successful in online clothing, bookmarker Paddy Power and engineering software designer Aveva. There is plenty of diversification among that lot.

I believe that despite recent market falls, some small-cap exposure is worthwhile, particularly if you can find a consistently good fund manager.

I believe you have all that with the Standard Life UK smaller companies fund.

Mark Dampier is head of research at Hargreaves Lansdown

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