Ignoring small-caps is a dangerous game – here are four worth considering

Smaller companies are expected to outperform their larger cap cousins over time – but this journey is rarely smooth as there are risks involved with moving down the market-cap scale.

The concept is to buy into growing businesses with the potential to deliver higher earnings than the market expects. These companies are less closely followed by stock market analysts, so there tends to be more scope for mispricing. But the reality is many of these firms are still in the growth stage of their development, which means their business can be more fragile and investors can lose their money. They are often involved in niche, specialist areas and can have liquidity issues when markets are extremely volatile.

But resilience is the word that also comes to mind for this segment of the market. Battered, bruised and beaten they always seem to pass any test with flying colours.

Here we take a look at a variety of funds that are involved with smaller companies in different parts of the world and how their managers are currently positioned.

M&A activity in the UK

Let’s start with our home market and the Liontrust UK Smaller Companies fund, which aims to deliver capital growth over time. This is classed as being at least five years.

The five-strong team looks for companies with durable competitive advantages enabling them to defy industry competition and sustain a higher than average level of profitability for longer than expected. They must also have a minimum of 3%* equity ownership by senior management. This quality is seen as important in motivating employees and delivering a better corporate performance.

According to a recent update, takeover activity has been a notable driver of this fund’s performance, with Ergomed a particular winner**. The company, which provides fully outsourced drug trials to specialist pharma and biotech clients, recommended a cash offer of 1,350p-a-share from private equity group Permira**.

“Ergomed also boasts one of the largest qualified teams of pharmacovigilance professionals globally, helping clients manage the risks around portfolios of approved drugs,” it added.

More broadly, the fund’s managers currently have 23% in the financials sector, 21% in technology, and 21% in industrials***. The largest individual holding, meanwhile, is the 2.9% in Yougov***, the internet-based market research and data analytics business. This company, which has operations around the world, recently reported a 9% increase in underlying revenue to £258.3m for the year ended 31 July 2023****.

Finding innovation in the US

There’s certainly no shortage of innovative businesses across the Atlantic and that’s the focus of the Artemis US Smaller Companies fund. This portfolio, which aims to grow capital over a five year period, is managed by Cormac Weldon.

Cormac uses plenty of information sources to not only generate ideas but validate and test companies to see if they’re worthy of inclusion.

This repeatable process has helped the fund deliver steady, consistent outperformance of both its sector peers and the broader benchmark. Although it has a potential universe of 2,000 stocks, the fund typically holds between 50 and 70 shares, and typically targets companies worth up to $10bn***.

Industrials has the largest sector representation of just under 34%, following by technology and consumer discretionary with 13 and 12 per cent respectively***.

Clean Harbors, a provider of environmental and industrial services, currently has the biggest individual stock weighting of 4.5%***. The next two largest holdings in the portfolio are Eagle Materials, which makes basic construction products, and Builders FirstSource, both of which account for 4.3% of assets under management***.

Finding potential in Europe

Investors are understandably reluctant to put money into smaller companies ahead of a recession as these firms are generally more reliant on economic expansion. However, this much-anticipated contraction is yet to arrive – and may not even go beyond a shallow technical recession, according to Rory Stokes and Ollie Beckett of Janus Henderson Investors.

In a recent fund update, the co-managers of the Janus Henderson European Smaller Companies fund noted that large parts of the stock market were being valued for a recession. “We think this offers an attractive entry point for those looking to benefit from the long-term growth potential of smaller companies,” they wrote**.

The aim of their fund is to provide capital growth over the long term (five years or more) and they are willing to invest in the smallest of companies. This approach enables them to find hidden gems that may have been overlooked by their peers, while being ‘style-agnostic’ means they’ll consider all areas of the market. This has resulted in strong, long-term performance, making it a strong consideration as a core holding for small-cap purists.

According to its fund factsheet, industrials is the largest sector allocation at almost 26%, followed by 14% in financials^. IPSOS, a multinational market research and consulting firm that’s headquartered in Paris, France, is the single biggest individual holding at 2.8%^.

Taking a global approach

If you want broader exposure then it may be worth considering a global smaller companies fund.

One portfolio we favour is the abrdn Global Smaller Companies fund, which aims to generate growth over the long term. As usual, this is classed as being at least five years. Central to this fund’s proposition is abrdn’s proprietary screening tool, Matrix, which looks at four key factors: quality, growth, momentum, and value. Fundamental research is carried out on the financial accounts of a potential holding, looking at the quality of its earnings to ensure business sustainability.

The team’s opinion on the investment case will then be checked – and, hopefully, verified – through meetings with the management team. We believe this fund can offer long-term exposure to an exciting asset class and consider its manager, Kirsty Desson, to be a safe pair of hands.

According to the most recent factsheet, the fund has a significant 44% weighting towards US companies, with other countries each accounting for less than 10% of assets^. These include Japan, Taiwan, Australia, Germany, Thailand, Italy, and France. Industrials, meanwhile, is the biggest sector exposure, at 29%^. As far as company names are concerned, two stocks share the top spot: Fabrinet and Asics Corp^. Fabrinet is involved in optical product manufacturing, while Asics produces sportswear, including running shoes, jackets, hoodies, and shirts.

*Source: Liontrust, October 2023
**Source: fund commentary, October 2023
***Source: fund factsheet, 31 August 2023
****Source: YouGov, full year results year ended 31 July 2023, 10 October 2023
*****Source: Artemis Funds, October 2023
^Source: fund factsheet, 30 September 2023

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.

Published on 20/10/2023