Smaller companies have been a lucrative, albeit higher risk, area to invest over the long term. The Numis Smaller Companies Index has, since 1955, achieved an annual return of 15.8 per cent compared with 12 per cent for the broader UK stock market. Now, you might think that is taking long-term investing a bit too far, but even over ten years the smaller companies index has risen 258 per cent, while it is up 223 per cent over five years.
Smaller companies did have a poor time in the late 1990s when larger blue-chip companies were performing well. By 2000/01 blue chips were clearly overvalued though and it has been small caps that have once again made the best returns.
The past two years have been particularly good for smaller companies despite the economic problems the UK had to contend with. Many of the best performing stocks in the market over this period have been smaller companies.
Even within the equity income sector it has tended to be funds with significant exposure to smaller companies which have dominated performance tables. These include Unicorn UK Income and Marlborough Multi-Cap Income. The former also run a successful UK smaller companies fund – Unicorn UK Smaller Companies and what is interesting is it is only £50m in size. It is managed by Simon Moon and his co-manager John McClure, who also runs the Unicorn UK Income fund.
Size can count for a lot when running a smaller company fund. Once a fund’s size approaches £1bn it can become difficult to buy meaningful positions in favoured companies and invest in some of the smallest companies in the market. This is a genuine small cap fund and you won’t find a large weighting in medium-sized companies.
In addition, the smaller a fund is, the more nimble it is, meaning the manager can take advantage of opportunities quickly.
There is no great concentration in any particular sector and as I have said before in this column smaller company investing has changed almost beyond all recognition over the past 25 years. Many smaller businesses are far more globally focused and no longer dependent on conditions in their home economy. That said Unicorn UK Smaller Companies has made successful investments in domestically-focused companies in recent years, including broking firms such as Cenkos, Numis and Arden Partners.
There is no blue sky thinking in Unicorn’s philosophy and they want companies to be cash-generative and profitable with strong balance sheets at the point of investment. They are seeking unloved and under-owned companies which they can add to the portfolio while the shares are looking cheap. To Simon Moon the most important point is meeting the management so he can better understand their business philosophy.
While this is a fund that essentially focuses on the prospects for individual companies rather than the wider economic environment there are some themes running through it. These include smaller companies that can benefit from strong US economic growth, the reindustrialisation of America, and advanced manufacturing. The latter is something hardly ever talked about, but an area in which the UK excels.
Given the strong returns from smaller companies over the past couple of years I asked Simon Moon what he thought of the current flow of companies listing on the stock market.
Usually deterioration in the standard of companies listing is an excellent early warning sign of the top of the smaller companies market. Interestingly, though he reports that the financial crisis delayed many listings and companies used the time to consolidate and become even stronger. He therefore believes the quality of companies coming to the market is strong.
The fund holds approximately 50 companies with a low portfolio turnover rate. At present exposure to the AIM market is constrained to 20 per cent, but Simon Moon is looking to increase this to 40 to 50 pr cent to capitalise on the opportunities he is seeing.
Smaller companies will always be vulnerable to short-term shocks but here we have a small fund with an experienced team in an area that has historically delivered strong long-term returns. This is a potent mix in my view.
Mark Dampier is head of research at Hargreaves Lansdown