Fund Briefing: when to invest in smaller companies

Investing in smaller companies can be a terrific way to earn bumper returns by finding tomorrow’s winners at an early stage in their development

The idea is to buy shares in innovative businesses before everyone realises their potential and then sit back as your foresight is handsomely rewarded.

After all, even today’s corporate giants were once relatively modest start-ups struggling to attract attention and build a customer base.

Take Microsoft, for example. If you had invested $1,000 into the company when it floated on the stock market back in 1986, your holding would now be worth more than $1 million.

The fact is that smaller companies offer the potential for significant growth, according to Adrian Lowcock, head of personal investing at Willis Owen.

“They are often under-researched, so the opportunities are not recognised until they get much bigger,” he explains.

It is also much easier for a company to grow its profits by 20% when those profits are much smaller. Larger firms obviously struggle to match such growth rates.

“Smaller companies can also be more flexible, nimble and able to react quickly to changing events,” says Mr Lowcock. “They can also take advantages of niche opportunities.”

However, while it is tempting to look for the next Just Eat, these companies are not easy to spot. A combination of expertise, experience and resources is essential.

“Smaller companies are more volatile when markets go down”

For every success story, there are plenty of disasters. Some will grow rapidly, but many more will remain small or fail completely.

“Investing in smaller companies requires a huge amount of work,” adds Mr Lowcock. “It’s about avoiding the losers as much as it is about spotting potential winners.”

It is a point echoed by Patrick Connolly, a chartered financial planner at Chase de Vere, who believes smaller companies are most suitable for investors with a higher tolerance to risk.

“They are more volatile than larger companies and tend to fall further and faster when markets go down and investors avoid risk,” he explains.

This can also make them potentially susceptible to political risks, such as any fallout from the long-running Brexit negotiations.

“If there is a bad outcome, it is domestically-based UK names, such as smaller companies, which are likely to be hit hardest,” he adds.

Quick guide:

Are smaller companies funds right for me?

Consider investing if…

• You want to invest in the businesses of tomorrow
• You want exposure to companies with lots of potential
• You understand there are risks attached to these holdings

In addition, investments in small companies can be very volatile. The share price can swing dramatically and result in significant falls in the value of holdings.

“This means that it is not for the faint hearted and only for someone willing to take their time to invest,” adds Mr Connolly.

If you believe buying individual shares is too risky – and that is certainly a fair conclusion – the next best option is to buy a smaller companies investment fund.

These products are run by professional managers whose job it is to use pooled investors’ cash for buying a portfolio of smaller companies.

The type of companies owned – and the way such funds are run – will depend on their aims, according to Jonathon Curtis, an investment analyst at Hargreaves Lansdown.

“Look for managers who really understand how small companies work ”

“Some fund managers focus on medium-sized ones at the upper end of the size scale, while others invest at the smallest end of the spectrum, known as ‘micro-caps’,” he explains.

There will also be differences in the way they are managed.

“Some hold on to small companies as they grow bigger,” he says. “Others sell them once they reach a certain size and look for the next opportunity.”

It is very important to scrutinise smaller company funds as they will differ from one another, as opposed to larger company investments that hold many of the same shares.

The objective is finding a manager who can pick the winners from the losers, points out Mr Connolly at Chase de Vere.

“You need to look for managers who can really get under the skin of companies to understand how they work, as well as assessing their future plans and prospects,” he says.

Compared to giant sectors such as UK All Companies, the array of funds – and, subsequently, the number of investors in IA UK Smaller Companies is relatively small.

In fact, it has £14.3 billion of assets under management – with £29.9 million of net retail sales during January 2019, according to figures from the Investment Association.

Of course, you don’t have to stick to small firms listed in the UK. There are plenty of funds focusing on other areas of the world that might be worth considering.

There are even specialist sectors covering Europe, North America and Japan, in which billions of pounds have been invested.

However, whether or not putting your money into smaller businesses is a sensible option will largely depend on your investment goals and attitude to risk.

Franklin UK Smaller Companies

Value of £100 invested in the fund over five years

* The £100 was invested on 1 January 2014. Source: Moneywise.co.uk

Fund to watch: Franklin UK Smaller Companies

The fund aims to increase the value of its investments by more than the return of the Numis Smaller Companies ex-Investment Trusts index over the medium to long term.

The managers, who boast a combined 62 years with the firm, define this time period as between three to five years.

Almost 75% of the fund is in companies with market capitalisations of less than £1 billion, with around 24% in those of £1 billion to £2 billion.

Businesses within the industrial goods and services sector account for 38.84% of assets under management, followed by financial services with 11.69%.

Other sectors include real estate, construction and materials, technology, healthcare, chemicals, personal and household goods, and retail, according to the fund fact sheet.

The fund’s largest holding of 4% is in the Vitec Group, which supplies products to the ‘image capture and content creation’ market. These include camera supports, LED lights, mobile power, monitors, bags, smartphone accessories and noise reduction equipment.

The second largest is Discoverie Group, which is an international ensemble of businesses that design and manufacture components for electronic applications.

Adrian Lowcock, head of personal investing at Willis Owen, likes the fund’s balanced approach.

“The investment process focuses on quality companies that are attractively valued,” he says. “Quality is assessed via three pillars: business risk, management risk, and balance-sheet risk.”

ROB GRIFFIN writes for the Independent, Sunday Telegraph and Daily Express.