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Harvests from small holdings

If you want to own UK equities, go for a smaller companies fund every time.

Consider the last five years. Despite similar performances from the FTSE All Share and FTSE Small Cap indices, 50 per cent of UK smaller company trusts outperformed the FTSE All Share index by between 2 and 132 per cent. In the UK general growth sector, only 40 per cent of funds outperformed the FTSE All Share by between 0.2 and 77 per cent.

The bottom-performing UK general growth fund was down by 71 per cent whereas the bottom smaller company fund was down by 46 per cent.

The statistics are compelling and I believe that smaller company funds will continue to outperform. There are about 2,000 smaller companies listed below the FTSE 250 index. A fund containing 70 smaller companies would represent only 3.5 per cent of the universe. This wide choice gives smaller company fund managers a major advantage.

Against a background of increased competition, finding companies that should be able to sustain their margins and profitability is difficult. Some companies are combating the pressure by exploiting their intangible assets. Often referred to as intellectual capital, these include customer relationships, repeat business, databases, distribution networks, intellectual property and organisational strengths such as procedures, formats and culture. These assets form a powerful barrier to competition because they can be difficult to copy.

For example, Radstone, a UK defence company, produces robust computers that can be used in extreme conditions. Through a regular spend on research and development, it has a growing market share in electronic warfare systems.

Bell Group produces sophisticated security software which is used by banks and a growing number of big organisations such as airports.

Datamonitor produces research into areas such as information technology and healthcare. It has strong repeat business and a growing database of research material.

Lawrence has developed a number of animal medicines that are similar to drugs that have come off patent. Medicines must go through rigorous registration procedures and the company has signed up significant distribution partners.

Numis is a stockbroker with a high level of employee equity ownership. It is winning market share from bigger brokers, many of which suffer from poor staff morale.

Intellectual capital is found across many sectors from media through to information technology, healthcare, professional support service companies and financial businesses. But a depth of intellectual capital is only found in a relatively small number of companies. This is not a problem for smaller company investors but does create a problem for investors who are skewed towards the FTSE 350 index.

Another advantage for smaller company investors is that significant numbers of their universe of stocks are heavily owned by management and employees. Equity ownership, particularly through fully listed shares, is a terrific way of motivating management and employees.

Studies in the US and UK have shown that employee equity ownership leads to better company performance and this translates into better share price performance in listed companies. The owner-manager culture also makes companies more conservative when it comes to acquisitions and financial gearing. Given that over 50 per cent of acquisitions go wrong and that many companies overgear, this conservatism is to be welcomed.

The sheer number of smaller companies allows an investor to find enough companies with intellectual capital and employee equity ownership.

Numerous small companies are exposed to new high-growth industries and their compound growth will be far higher than that achieved by bigger companies such as banks and oil companies, which represent over 30 per cent of the All Share.

With smaller companies, it is possible to create a portfolio of companies that should, through the various economic cycles, sustain profitability better than others in their sector and deliver good share price performance over the long term.

The downside with having so many smaller companies is that commentators slip into generalisations. First, they say smaller companies do not perform very well. The universe they quote is the FTSE Small Cap index. Over the last five years, this index has performed slightly better than the All Share. This is not compelling but the performance of over half of the unit trusts available is extremely compelling. The universe for these funds is not just the FTSE Small Cap but also the FTSE Fledgling and AIM markets. The size of this universe creates choice and the chance to materially increase or decrease sector weightings.

Second, there is a concern that smaller companies are illiquid. I never understand why this should worry an investor in a unit trust. The fund manager provides liquidity by holding a small percentage of the fund in cash. Smaller companies have always been illiquid and, incidentally, so are many FTSE 250 companies but this has not stopped the majority of smaller company funds from outperforming.

Third, there is a fear that smaller companies are risky. This may be true compared with a select few in the FTSE 100. However, a fund, if structured correctly, should diversify away risk. But risk is not confined to smaller companies. Over the last 12 months, 32 companies representing over 9 per cent of the FTSE 350 have more than halved.

Finally, there is a concern about the vulnerability of UK-centric smaller companies to an economic downturn. With an abundant choice of companies, a fund can reduce the impact of economic turmoil.

The effects of economic turmoil can be blunted through changing the balance between sectors. The rewards, in terms of FTSE All Share outperformance, from time spent carefully selecting your smaller company manager are very worthwhile. In essence, you have no excuse for not buying smaller company funds.

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