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Investment view – Brian Tora

Smaller companies may be at the riskier end of the invest-ment spectrum but I am still a fan.

By putting together an article for a sister publication of this august journal, I found myself examining, not for the first time, the relationship between smaller companies and the market leaders.

Smaller companies is a segment in the marketplace on which I have waxed lyrical on a number of occasions. They have delivered superior returns for investors over recent years. The purpose of the particular piece of introspection on which I was engaged was to determine whether or not they would continue to serve investors well in the future.

In the investment world, we do, of course, operate in an uncertain environment. To me, the joy of this is that you are looking at a future which will be formed by events which have not yet taken place. The crystal ball is always clouded and, of course, the problem for all investment managers is that you always know what you should have done after the event. Your mistakes are spelt out in pounds and pence.

Needless to say, the conclusions over whether or not small caps will continue to outperform was far from clear. On valuation grounds, there seems reason to be more tempered in enthusiasm for the minnows. Certainly, Gerrard’s in-house research people have pulled back on a previous (and most well timed) recommendation to maintain an over-weight position in the smaller end of the market.Today, their stance is neutral in recognition of the fact that the discount between small cap and large cap has all but disappeared.

But economic indicators are doing nothing to make investors fearful that the bull market in smaller companies is coming to an end. Indeed, last week’s Bank of England inflation report confirmed a generally rosy outlook.

The indications are that the domestic economy is continuing to grow at an above trend rate and so inflation could pose a threat at some stage. This, of course, is not good news but it does not necessarily mean that we are in for economic armageddon. What is more likely is that we will see a further rise in the cost of money before this particular interest rate cycle draws to a close.

Macro considerations aside, the main concern over the smaller cap end of the market must be risk. The outperformance achieved by the best managers over recent years has been stunning but performance of this nature is not usually gained without taking a few bets. Gauging the extent to which this contributes to fund performance is not always easy but, increasingly, it is part of the research process adopted by multi-managers.

Performance itself may not be sufficient to guarantee inclusion if the only way it is achieved is to leave yourself a hostage to fortune if the unforeseeable turns out to be less benign than hoped. Risk, of course, is assuming an ever greater place in portfolio management these days.

Investors are entitled to be told what risk they are running when they buy a particular fund or invest in a certain way. It is a far cry from the days when a client of mine, asked for the level of risk he wished to adopt, replied that he thought that was what he was paying me for.

You can, of course, cover off the riskier elements of a portfolio by simply limiting the money you devote to a likely volatile investment. This has worked for me in the past and, while you may have to live with the fact that you have not done as well as you could have if you had been prepared to take a gamble, at least you will know that your downside is protected to some extent. You can take comfort from the consistency of performance of a number of the managers at the smaller end of the capitalisation market.

In the end, I remain a fan of the smaller companies but recognise that they are at the riskier end of the investment spectrum. After all, the smaller companies section of the Financial Times All Share index may account for around 30 per cent of the number of shares included but it is worth just 3 per cent of the Index’s capital value. But it is the fun part of investing and the area where following the true professionals makes clear sense.

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