Some UK investors are starting to see fresh opportunities in the small and mid-cap area of the market, which offer compelling fundamentals and long-term return potential, but the way in which investors are allocating to this asset class is diverse.
According to FE fundinfo data, the Deutsche Numis Smaller Companies Extended index (One of the common measures of UK small-cap performance) has risen 356.3%% over the past 20 years.
The mid-cap FTSE 250 is narrowly behind, up 346.3% over the same period. By contrast, larger FTSE 100 companies have not kept pace, as shown in the chart below.
However, while long-term return potential is exceptional, small caps are sometimes susceptible to less liquidity and more volatile share prices, which can lead to a divergence in approach among investors. Roland Arnold, manager of the BlackRock Smaller Companies Trust, favours a diversified approach to portfolio construction.
“The UK smaller companies market is a fertile hunting ground with a wide range of under-researched businesses, so we see little need to rely on a small number of positions to drive returns,” he said.
See also: Covered: The renaissance of the UK market
‘As soon as you need liquidity, it disappears’
Eustace Santa Barbara, manager of the IFSL Marlborough UK range, diversification and a broad book of holdings are particularly crucial.
He noted that in small caps, “liquidity is often one of those things that as soon as you need it, it’ll disappear”.
This is why he favours a large portfolio of around 150 holdings, as a way of recognising that the team “can get things wrong,” and ensuring they have the flexibility to respond.
Richard Bullas, portfolio manager at Clearbridge, added: “In a focused UK small and mid-cap portfolio, mistakes can have a larger impact, and liquidity can become more limited when sentiment or fundamentals deteriorate.”
Eustace Santa Barbara, manager of the IFSL Marlborough UK range
‘Liquidity is often one of those things that as soon as you need it, it’ll disappear’
Perhaps the easiest example of how liquidity in this asset class can dry up is the Neil Woodford scandal.
Part of his fall from grace was due to his shift towards smaller, less liquid companies, which forced the manager to sell his more liquid positions to meet redemptions when he underperformed.
See also: Downing Fox’s Evan-Cook: ‘We could see Woodford repeated on a market scale’
Richard Staveley, lead manager on the Rockwood Strategic Trust, said: “It makes sense to be more diversified in this market when you’re open-ended, because if you get an outflow, you may be forced to sell.
“That’s why the investment trust style is so well-suited to not only this style of investing, but also this specific market cap structure.”
Small caps and investment trusts
Ken Wotton, manager of the Gresham House range, said: “Inherently, smaller companies are riskier; you can’t get too many wrong, and the ones you do get wrong, you need to be comfortable you can get out of them.
“In the investment trust structure, it’s different, and because of the close-ended structure, you can take larger stakes and sacrifice some liquidity for the potential upside.”
This is why he runs a concentrated book in his trust, but 40-50 holdings in his OEIC, which he described as the “optimal level of concentration” for an open-ended small-cap strategy.
Stuart Widdowson, co-portfolio manager on the Odyssean Investment trust, pointed to another benefit of a more concentrated approach beyond being able to sacrifice some liquidity: the ability to engage with companies.
His own portfolio has just 17 companies and requires all holdings to pass at least four or five value creation pillars, based on strict frameworks and rigorous company analysis that would not be possible in a wider portfolio, he explained
“When you know a business deeply, after having spent many hours in due diligence, consulting sector specialists, and stress-testing the investment case, you should be willing to back your judgement with meaningful position sizes.”
This is particularly important in smaller companies, he said, where institutional and analyst coverage is often very thin, leaving room for deep diligence to make a difference.
Gresham House’s Wotton added that concentrated position sizes were particularly crucial for engaging with underperformers in their portfolio.
Stuart Widdowson, co-portfolio manager on the Odyssean Investment trust
‘When you know a business deeply, after having spent many hours in due diligence, consulting sector specialists, and stress-testing the investment case, you should be willing to back your judgement with meaningful position sizes’
“If we have a small position in a company that falls 50%, we can talk to boards and recommend changes, but they don’t have to listen to us at all,” he said. In a smaller position, the temptation would be to cut their losses and move on; that would crystallise a 50% loss, he explained.
With bigger positions, the team can engage with boards and find alternative ways to recover value and manage risks, he explained.
“I don’t think we can afford to have something we’re not high conviction in,” Wotton said.
That said, Wotton noted there were limits on exactly how concentrated he was willing to be.
“Something can always happen that you don’t expect in small-cap stocks, so you want to be high conviction in the things you own, but you don’t want to have unduly large positions.”
However, some managers disagreed that a high concentration position was needed.
Will Tamworth, who runs the Artemis UK Smaller Companies OEIC and the Artemis Future Leaders trust, said: “When you hear a company’s perspective, you’re usually getting the rose-tinted version of it, but you should be challenging that in as many ways as you can, such as by assessing if it’s consistent with what their customers or competitors are saying.”
This is easier to do when holding a much wider variety of positions, he explained, allowing his team to more easily “cross-reference” between holdings.
Marlborough’s Barbara added: “I think you can learn a lot from a diversified set of positions, by speaking to companies we can learn about competitors, about different elements that can attack the economic MOAT and so on.”
‘You can only ever lose 100%’
Similarly, while the ability to avoid redemptions does make it seem appealing to run more concentrated positions in an investment trust, not all trust managers agreed with Rockwood’s Staveley or Gresham House’s Wotton.
For example, Katen Patel, co-manager of the JP Morgan UK Small Cap Growth and Income trust.
“The UK small-cap market is a very broad and under-researched universe, spanning everything from AIM businesses to the lower end of the FTSE 250,” he said. “That breadth is part of the attraction.”
By following this approach, the trust has performed extremely well over the long term, rising 226.1% over the past decade.
Similarly, Artemis’ Tamworth, has roughly 70 positions in both his OEIC and his trust
See also: Artemis takes over Invesco UK Smaller Companies trust
“I think people tend to fall in love with their big holdings that have done well. That’s fine when it works, until it goes wrong and you almost start to trip yourself up,” he said.
On top of this, because the level of stock-specific risk is higher, there is an argument for having more holdings to achieve diversification, he explained.
Marlborough’s Barbara added: “You can do all the work in the world, but you never really know which of your holdings are going to perform.”
However, Rockwood’s Staveley argued that a more diversified approach could be riskier than expected.
“Quite frankly, the more diversified you are, the more you represent the asset class.
“When people ask what the catalyst is for a small-cap resurgence, in a diversified portfolio, it is much more important for performance that there is a good answer to that question,” he said.
“The concentrated approach does carry higher stock-specific risk, and we are transparent about that,” he conceded. “A material decline in one holding can have a significant impact on the overall portfolio.”
Staveley, however, reminded investors about the “asymmetric returns” you can achieve in a concentrated portfolio.
“The key in investing is you can only ever lose 100%,” he said. “Obviously, you don’t want to lose anything, but if you’re concentrating on companies that can make 100% and often go on to make more, that offsets the ones that go wrong.”
For example, Rockwood Strategic has the best total return in the UK market over the past 10 years, even though during that period, the team has lost 100% of their investment in two stocks, the manager admitted.
See also: Artemis, Rockwood and Dimensional: The best performing UK funds and trusts over five and 10 years
