Portfolio Adviser • Portfolio Adviser February 2019 v2 • Fund Selector

UK smaller companies can offer knockout returns for active stockpickers willing to ride out shorter-term challenges

Economic theory would have us believe that investing in smaller companies is one way to unlock superior returns.

Many will be familiar with Eugene Fama and Kenneth French’s three-factor model that suggests equity returns have three characteristics: the market return; high book value-to-price companies outperform small book value-to-price ones (value outperforms growth); and small companies outperform large companies (see table below).

During both 10- and 20-year periods, smaller companies have significantly outperformed larger ones. The reasons for this are likely to include the higher growth potential of smaller companies. Being small, they simply have greater capacity for future growth. They are, however, also at greater risk of failing than larger companies, which together with lower liquidity means investors demand a higher risk premium.

Managers will argue that smaller companies are also under-researched compared with large ones and as such they can exploit pricing inefficiencies.

The historical return from UK smaller caps has been extraordinary. Over the past 20 years, while the broad UK equity market has lagged behind the US market by around 1.4% per annum (in sterling terms), as measured by the S&P 500, the average UK smaller companies fund, as measured by the IA UK Smaller Companies sector, has beaten the US market by a staggering 3.6% per annum.

It has also beaten the average US smaller company fund by 1.5% per annum. Even more impressive perhaps is that in the past 20 years, UK smaller companies have only been beaten by one other sector, IA China/ Greater China.

The long-term return potential has been proven to be very strong. But clearly small companies do carry extra risk. In 2008, UK small caps fell by more than 48%, significantly more severe than mid-caps (-38%) and large caps (-28%). It was a similar story in 2011 and 2018, though mid-caps fared worse than small caps last year.

When reviewing the performance of all 37 IA sectors in 2018, UK Smaller Companies was the sixth worst-performing. Both the European Smaller Companies and Japanese Smaller Companies sectors fared worse.

This is logical. During any severe market correction investors are likely to trade in their smaller company positions for larger, more stable, more cash-rich and higher dividend- paying companies or lower risk asset classes altogether.

Though short-term returns from smaller companies may cause concern for the more risk averse, the high-beta nature of the asset class means patient and risk-tolerant investors should be rewarded for the addition- al risk relative to large companies over the long term.

The period since the EU referendum has been a challenging one for smaller companies. Negative headlines and a perceived harmful impact from Brexit have pulled investors away from the UK. In addition, a drastically weaker sterling has benefited the translated overseas earnings generated by many of the larger companies, and they have outperformed as a result.

Smaller companies are naturally more domestically focused than their larger counterparts and this closer association with the UK economy has proved a headwind as Brexit concerns have intensified. Furthermore, smaller companies that import from overseas have faced the challenge of higher import prices as a result of weaker sterling.

However, the performance of smaller company funds has been rather strong. While at the index level large caps have outperformed since the EU referendum, at the sector level, the IA UK Smaller Companies sector has outperformed the broader IA UK All Companies sector.

This reflects the opportunity for stockpicking in the smaller company universe and we believe there is room for active managers to outperform this market, not just through the ability to pick winners but to avoid losers that can have such a destructive effect.

Though the headlines point to a difficult period for UK smaller companies, it is worth looking under the bonnet at the individual companies held within these funds. They may be less domestically exposed than expected. As such, while further political fallout might lead to indiscriminate selling across UK equities, particularly small cap UK equities, those companies with a greater global focus might offer some respite.

On the other hand, any positive Brexit outcome that leads to sterling appreciation should be positive for sentiment and smaller caps should respond well as a result.

Many smaller company funds invest in stocks listed on the Alternative Investment Market (Aim). A number of these compa-nies have significant global presence and are somewhat sheltered from the difficulties facing the UK at present.

For example, retailer JD Sports Fashion only receives around half of its revenue from the UK, according to its last report. Beverage company FeverTree stated in its last interim report that just over 50% of its revenue comes from the UK. Craneware, another Aim-listed stock, generates almost all revenue from the US.

It could be argued some of these stocks are pushing the boundary of what is actually a smaller company – JD Sports Fashion has a market cap of around £3.5bn – but they are all held within popular UK smaller company funds.

Capacity becomes an issue at a lower level of assets under management (AUM) within smaller company funds, and it is important to take note of the impact this can have.

While some managers may decide to close their funds at lower AUM, others will be content to see assets rise. As a result, the number of holdings might increase as larger funds simply aren’t capable of taking sizeable stakes in small companies without compromising liquidity.

While this is not necessarily a problem, it is something to be acutely aware of as large inflows can easily disrupt the composition of a smaller company fund. What this does bring though is less conviction and, as a result, less chance of positive attribution from stock selection.

Instead, managers may decide to invest further up the market cap spectrum into companies some may argue are no longer small, the implication being that it is imperative to look closely at the companies held within smaller company funds.

Investors seeking pure exposure to the smallest UK companies may end up frustrated that many funds are in fact holding companies with market capitalisations that extend into the billions. Again, this is not necessarily wrong but certainly something to be aware of.

During the past three years, funds that have adopted more of a growth style have generally fared better. Stocks with significant exposure to markets outside the UK have also broadly done well relative to the more domestically focused businesses affected by Brexit concerns. Interestingly, those funds that have performed well have also had a greater allocation to micro caps.

The technology sector has driven returns over the past three years, and funds that have performed well have had a greater allocation to this market than poorer-performing funds. The technology names held within these funds may not be known to many and are very different from the large US names we hear so often.

On the other hand, poorly performing funds have had a larger allocation to industrials, a more economically sensitive sector plagued with ongoing Brexit fears.

Other factors include the inheritance tax exemption from investing in certain Aim shares, which has boosted popularity.

Two funds we have favoured in this space to date are Liontrust UK Smaller Companies and Merian UK Smaller Companies.

Liontrust UK Smaller Companies is managed by a team of four, though the most experienced and recognised are Anthony Cross and Julian Fosh. Their approach leads to a portfolio of companies with strong intangible qualities that display at least one of the following characteristics: intellectual property, strong distribution channels and strong recurring business.

Merian UK Smaller Companies has been managed by Daniel Nickols since 2004 and has typically been biased towards growth companies, though the process allows for the inclusion of stocks with greater value characteristics, too. Each company invested in also seeks to display at least one of the following characteristics: likely positive earnings surprise, re-rating potential and sustained above-average earning growth.

Overall, we believe the asset class is well suited for active stockpickers to outperform and that there is long-term merit in owning smaller companies as part of a diversified fund despite shorter-term challenges.

FUNDS TO WATCH 3-YR PERFORMANCE

● The Amati UK Smaller Companies Fund is managed by a team of three with a bias for seeking quality companies. Amati is a dedicated smaller companies manager, setting it apart from many in the peer group.

● Though Jupiter UK Smaller Companies manager James Zimmerman (pictured) has less experience than some managers in the sector, his performance has been exceptional, and assets have grown very quickly in this strategy as a result.

● Managers of Marlborough Nano Cap Growth seek exposure to the smallest UK companies with a market capitalisation of less than £100m. How the team manages inflows will be key in what is clearly a capacity constrained strategy. The number of holdings is large, at around 160.

FUNDS TO WATCH NEWCOMERS

● Liontrust UK Micro Cap is managed by the same team, including Julian Fosh (pictured), which owns a strong track record across a number of other UK equity funds. They adopt the same stock-selection approach across these funds and it will be interesting to see how well the approach applies to companies with a market capitalisation of less than £150m.

● Teviot UK Smaller Companies offers a value approach to UK smaller companies, which differentiates it from many funds in the sector. While it is early days for the strategy, performance has been strong and managers Andy Bamford and Barney Randle both have considerable experience in the asset class.

FUNDS TO WATCH ASSETS UNDER MANAGEMENT

● Standard Life UK Smaller Companies has been managed by Harry Nimmo (pictured) since 1997. The long-term returns have been strong but it is important to note there is significant exposure to mid- caps in the fund.

● The largest fund in the sector is Marlborough Special Situations and with around 190 holdings and top position sizes of less than 2%, it is a very diversified strategy. The fund benefits from one of the most experienced smaller company managers in Giles Hargreave (pictured) and has delivered very strong long-term returns.

● Invesco UK Smaller Companies Equity is managed by Jonathan Brown who adopts a bias for quality companies. Since his involvement in 2011, the fund has outperformed the sector in all but one calendar year.