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Why small-cap investing can be beautiful

Monaghan, John_700x450

Exposure to the UK small-cap market can provide investors with additional spice to their wider portfolios. Like any good chef, however, fund managers have to consider a broad range of ingredients in order to make the end result a tolerable experience. Providing investors with a dish that could leave them with heartburn would not be a particularly pleasant outcome.

By their very definition these companies are small and therefore, arguably, far easier to analyse than a multi-national organisation with a large number of business interests. Saying that, small cap investors will need to consider a number of factors when looking at this area of the market. They may sound somewhat obvious but as Lord of The Flies author William Goulding once said: “The greatest ideas are the simplest.”

When assessing fund managers in this space, ensuring they have a firm handle on areas, including liquidity, concentration of ownership, how much capacity they are prepared to allow, diversification and their own investment horizon, are very important. This is not an exhaustive list and quite often this handful of examples are intertwined. For instance, managers may prefer to invest in companies whose principles are meaningful shareholders in the business. This confirms there is a clear alignment of interests between company management and external shareholders.

If we consider the product providing exposure is open-ended, investors should expect to be able to redeem their holdings through daily liquidity. With this in mind, the underlying stocks held need to be sufficiently tradable in order to meet any redemptions. If the fund is such a sizeable holder in a company that selling its stock has an adverse effect on the share price, one could reasonably question whether the manager’s philosophy and process has become compromised through taking on too great a body of assets. In order to mitigate against this, many of the more successful funds have closed to subscriptions from new investors or removed the ability to invest  new monies completely.

When completing analysis on small-cap funds, the latter point requires careful consideration. The potential rush of further new money by being placed on a buy list or within a model portfolio can do more harm than good. For fund groups, it could be a case of “be careful of what you wish for”. There is currently just shy of 50 funds in the IA UK Smaller Companies sector, with assets in the region of £13bn. By size, the top five account for over a third of the total assets. That said, of those funds, three are either currently soft-closed or have been in the past.

Fund picks 

The largest fund in the sector, Standard Life Investments UK Smaller Companies, is one that has taken steps to temper flows. It is also a fund we rate highly. Manager Harry Nimmo has been at the helm since it launched in January 1997 and has experienced a number of market cycles and varying market conditions.

The return profile can lead to more variable returns over short timeframes but this is due to the strict adherence to the investment process that underpins the strategy. We acknowledge that, as the strategy has grown, there has been a natural shift up the market-cap scale but the emphasis on investing in higher quality companies over the long term should prove beneficial to unitholders.

A second fund we hold in high regard is Alex Wright’s Fidelity UK Smaller Companies. This strategy has been soft-closed, re-opened and only very recently soft-closed again. Wright’s other mandates (Fidelity UK Special Situations and Fidelity Special Values) can also invest into small caps, so although the fund in question has less than £400m in assets, the manager has clearly considered the total asset base he is responsible for.

This fund operates further down the market-cap scale than Nimmo’s. Wright is a contrarian investor, so it can also experience short-term volatility as he is likely to be buying companies that are out of favour.

This cheaper entry point and subsequent recovery in the share price should prove bountiful over the long term. In both cases we see the stemming of flows as careful stewardship of investors’ capital.

The small-cap market can be highly profitable but it is not without its risks. Some of these can be mitigated through careful consideration by fund groups, managers and selectors alike.

John Monaghan is senior investment research analyst at Square Mile Investment Consulting and Research

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Comments

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  1. Graham Bentley 11th May 2016 at 6:50 pm

    Not surprised to see the capacity issue raised re small cap funds. However, I find it remarkable that researchers quantify capacity simply by fund size. Those larger funds tempering flows do so because they are concentrated – Harry’s £1.2bn fund has less than 60 stocks in it. Alex’s is more diversified, with more than 120 positions, yet only a third of the assets, and is still closed.

    Mean while Marlborough Special Sits is a £1bn+ fund, has exceptional long-term performance (17 years) despite being diversified across over 200 small-cap holdings.

    To my knowledge it has never closed. And gets little if any research attention.

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