The UK’s smaller companies are misunderstood. That’s the view of a raft of fund managers looking for opportunities at the low end of the corporate size scale, and it’s easy to see why. Most investors won’t recognise the majority of the names on the Alternative Investment Market (AIM), or FTSE Small Cap Index and regulatory pressures on analysis costs aren’t helping. Fund management groups tackling rising research fees will most likely mean even less research at the bottom end of the market and so, even less of a grip on company fundamentals.
Then there is the common misconception that UK smaller companies are just too exposed to the UK economy. Nearly half of all sales in the FTSE UK Small Cap Index come from overseas. While the 2016 referendum broke what had been a relatively similar growth path for the UK smaller companies index and its global peer, the MSCI World Small Cap index, UK companies continued to report positive earnings results especially in healthcare and technology, waking investors up to the fact that even the small caps are internationally diversified when it comes to income streams.
The result of all of this is a wealth of opportunity out there for fund managers willing to look where no-one else does, and capitalise on mispriced opportunities when they see them.
Here are three of the most popular UK smaller companies funds on fidelity.co.uk this month.
While many active managers prioritise company research and sometimes deliberately filter out the macroeconomic ‘noise’, Merian’s Dan Nickols likes to draw from both approaches. He uses trends in gross domestic product (GDP), inflation, and interest rates and complements the ‘big picture’ with company research which emphasises both sustainability and the potential for change.
Nickols looks for firms which dominate their industries, a position which affords them greater profitability and faster earnings growth, and particularly likes finding good companies dismissed by the broader market. If, as Nickols predicts, the company posts good results, then its share price should appreciate as the pessimists re-evaluate their positions.
Nickols believes that facetime with company executives is vital when investing in smaller companies and so, holds over 300 company meetings each year, along with his team of analysts. For the manager it’s just as important for a company to court Nickols as it is to show that he is serious about making an investment. It is also slightly easier to derive unique insights into a smaller company than a large one through meetings because fewer competing analysts are actively following the same firm.
The fund’s top holdings include AIM darling Fever-Tree, ASOS competitor Boohoo and litigation finance provider Burford Capital - all strong performers in their own right over the past few years, with the fund providing further diversification across industries.
With research efforts concerning UK smaller companies often stretched, compelling stories, exciting products and headline services set for future growth can seem like easy wins for analyst teams.
This growth focus can lead to well-liked stocks being bid to high valuations – based more on hope and positive sentiment than a solid earnings base – leaving a large “reject bin” of under-researched companies. This is the starting point for co-portfolio managers Alex Wright and Jonathan Winton in running the Fidelity UK Smaller Companies Fund.
Among these unloved stocks, it is often possible to identify positive change that the market hasn’t yet recognised.
Like Nichols, the managers look for companies with the ability to buck lukewarm expectations however the Fidelity team pays close attention to limiting the downside, should companies not fulfil their potential. They look specifically for undervalued companies attracting negative market sentiment, judging that a poor outlook is already baked into the share price, limiting downside risk, and presenting good opportunity to significantly beat expectations.
“Investing against the weight of opinion in the market requires differentiated and rigorous analysis in order to build conviction and back each position,” says Winton, “Fundamental company research is therefore the cornerstone of my strategy.”
The managers tend to think about individual investments in three stages; building a position, waiting for the thesis to play out and a re-rating to occur and finally recycling proceeds into new opportunities. On average it takes around 18 months for a company to move through this cycle, but this can vary significantly depending on the speed of a company’s recovery.
The fund currently holds Irish drinks business C&C as well as global hotelier Millennium & Copthorne Hotels.
Seasoned smaller companies specialist Giles Hargreave is joined by co-manager Guy Feld at the helm of the Marlborough fund focused on the particularly small end of the market. Examining firms with a market cap less than £250 million, and often less than £150 million, the pair aim to find the gems where even fellow small cap managers stop looking.
Companies at the low end of the cap scale often carry a higher risk of failure - something the managers keep in mind and attempt to mitigate by holding a diversified portfolio of more than 250 names.
Supported by a large team, the managers are also well-positioned to analyse each company in detail, rarely investing without meeting company management face to face. The pair specifically look for businesses operating in niche markets, with reliable management, solid balance sheets and evidence of good free cash flow.
The ability of the smallest UK companies to grow quicker than their large cap peers means relatively few investments need to exhibit outsize performance to benefit the overall portfolio. Hargreave and Feld can therefore run their winners and cut the losers - a job made easier by compiling such a large portfolio of opportunities.
Current holdings include Future, the Bath-based magazine publisher on the FTSE Fledgling index, as well as Audio equipment manufacturer Focusrite, based in High Wycombe, and digital marketing firm Next Fifteen.
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. These funds invest more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.