Investors looking for above-average long-term returns will, understandably, focus on those companies that can generate growth. And it stands to reason that the smaller a company is when you buy into it, the greater growth potential it will have.

Of course, making money from small-caps is not as simple as that. There are thousands of small-cap companies out there and comparatively few of them grow up to be big blue-chips. But then the point about small-cap investing is that they don’t have to. The small-cap end of the market is extremely dynamic, the natural territory for mergers and acquisitions and the home to companies that often display quite dramatic rates of organic growth.

A volatile area

Investing in smaller companies can be a volatile exercise. As the charts illustrate, periods of outperformance from the small-cap end of the market, usually when the stock market is generally going through a bull phase, are often followed by periods of dramatic underperformance, as small-cap values tend to fall more quickly than the market average when the bears return.

Last year was undoubtedly one of those periods when small-caps excelled. A key benchmark for the small-cap sector is the Hoare Govett Smaller Companies (HGSC) Index, which comprises the stock market’s smallest companies, whose collective market capitalisation makes up roughly the bottom ten per cent of the entire market’s value. Given the imbalances within the UK stock market these days, this means that it includes the vast majority of UK listed companies and that the term ‘smaller company' can refer to some substantial enterprises, even those up to £1,104 million in size.

Each year ABN AMRO, which calculates the HGSC, publishes a report on its performance in conjunction with the London Business School (LBS). In the most recent edition, two LBS academics, Elroy Dimson, professor of investment management, and Paul Marsh, emeritus professor of finance, noted that ‘For the fourth year running, small-caps outperformed large-caps, with the HGSC Index giving a return of 25.1 per cent in 2006, 8.4 per cent above the FTSE All Share. Over the past four years, the HGSC’s worst annual return was 20.3 per cent, in 2004, and its worst return relative to the All Share was 6.6 per cent, in 2005.’

A strong run

Small-caps have had a very strong run, even if, more recently, they have been overtaken by returns from mid-caps (see chart page 19). Of course, this follows a period during the most recent bear market (see chart page 19), where small-caps generally fared much worse than the rest of the market.

But, as Dimson and Marsh point out, ‘Small-cap investors have long since recouped their losses from the 2000-03 bear market. From the bottom of the market in March 2003, to the end of 2006, an investment in the HGSC trebled in value. Over the past eight years, the HGSC has returned 172 per cent, beating the FTSE All Share by 119 per cent.’

However, they also point out that ‘Since the HGSC went live 20 years ago, we have never seen four years in succession with index returns above 20 per cent in every year. This is an unprecedented period for small-cap investors.’

The evidence of the past eight months has been that mid-caps have been the place to be and that those small-cap investors who have enjoyed the recent run should be taking some profits. Although all sections of the UK stock market have suffered in the correction over the summer, the mid-cap index remains well ahead of the small-caps and the blue-chips.

A question of valuation

Indeed, when the small-cap specialist investment trust Standard Life UK Smaller Companies recently announced its annual results, its chairman, Donald MacDonald, observed that ‘While valuations for smaller companies are not as compelling as they were a few years ago, the long-term investment prospects remain attractive.’

Indeed, the key to investing in these companies as the fact that the most successful small-caps will be growing their earnings at rates that larger companies can only dream of.

The LBS report also noted the effect of merger and acquisition activity on overall returns, but argued that ‘too much emphasis has been placed on this’. In fact, takeovers contributed only 0.86 per cent to the overall 20.7 per cent return from the wider HGSC plus AIM index in 2006.

Perhaps more surprising was the emphasis on momentum. The report found that, if an investor had done nothing with a portfolio that had been successful during 2005, it is very likely that the portfolio would have continued to beat the index during 2006. Successful small-caps are very much long-term holdings.

Value management

This introduces another theme that often characterises small-cap investing – a preoccupation with value. Many of the most attractive small-caps will be classed as ‘value situations’ simply because their future growth potential has not yet been appreciated by the wider market.

Dimson and Marsh observed that ‘Value stocks did not do as well in 2006 as in earlier years. Previously, stocks with a high dividend have given better returns than stocks with a lower dividend yield. In 2006, value stocks delivered somewhat worse returns to investors. Over the longer term, however, value stocks have performed remarkably well. In both the main market and on AIM, small-cap value-oriented stocks had higher returns than large-cap growth-oriented stocks.’

The lesson to be learned is that it does not make sense to slavishly follow one style of investing all the time, especially in an area as diverse and potentially volatile as smaller companies. Indeed, many fund managers specialising in this stress the importance of maintaining a flexible approach.

The mention of fund managers brings us to another key consideration. Should the private investor attempt to make their own small-cap investments, or entrust their small-cap exposure to a professional? The answer to this may well boil down to individual preference, but there are strong arguments for using a managed fund in this area (see Sector Leaders on page 58 for more details of the best-performing UK Smaller Companies funds).

Chief among these is the sheer scope of the small-cap universe. Small-cap investors are effectively covering the whole of the UK stock market outside the FTSE 350, even if they are not also covering AIM. Many of these companies are not well covered by institutional analysts, so the private investor is likely to find relevant information even harder to come by.

Information is the key

However, this lack of analyst coverage is one of the reasons why fund managers feel they can add value to investments in the sector. The argument goes that because relatively few institutions are looking at individual small-caps, there is more scope for fund managers to uncover hidden gems. However, in order to do this, they need to conduct their own research into companies, meeting their management and so on. Running a small-cap fund is a labour intensive business and many of the most successful small-cap managers are supported by teams of in-house analysts generating their own company research.

And even within the small-cap universe, there is differentiation, with some fund managers focusing on the upper end of the capitalisation scale, while others concentrate on the other end of the market – the so-called ‘microcaps’, many of which are quoted on the AIM market, and are generally even less likely to appear on the institutional analysts’ radars.

Gervais Williams manages an investment trust that focuses solely on microcaps – Gartmore Growth Opportunities. He argues that ‘This is the area of the market that represents the most attractive investment opportunity. We anticipated that microcaps would recover this year as valuations were mis-priced and were cheap relative to the rest of the market. We remain positive about microcaps, even in these unsettled markets and believe that there are many undervalued companies that should offer short- to medium-term growth.’

Reducing risk

Another argument in favour of using the managed fund approach is that it helps to reduce risk. An analysis of open-ended funds in the UK Smaller Companies sector by Trustnet found that average sector volatility was surprisingly low at 10.5 per cent, which is broadly in line with the FTSE Small Cap Index at 10.18 per cent. Trustnet’s conclusion was that ‘longer-term investors would not find this too painful to accommodate’.

However, the same survey also found that the risk/reward characteristics of individual funds vary significantly, as do their returns – the funds with the highest volatility do not always produce the highest returns.

The Trustnet survey also argues that ‘Fund managers’ skill in stockpicking is at a premium in this sector, and the difference that this can make is illustrated by the least volatile fund – at 8.7 per cent – which nonetheless outperformed the sector benchmark with a return of 86 per cent in three years.’

The survey concludes that ‘Investing in this sector will not necessarily be to everyone’s taste but, with care in fund selection, it is capable of delivering superior gains.’ In other words, selection of fund managers is as important as the selection of stocks.

How to approach small-caps

Harry Nimmo, manager of The Standard Life UK Smaller Companies Fund and the Standard Life UK Smaller Companies Investment Trust, adopts an earnings-driven approach to stock selection. He says, ‘The aim is to identify improving situations which are not fully recognised by the market. The starting point is that earnings growth generally drives share prices and we look for situations in which we believe the consensus opinion is wrong.’

He adds, ‘The dynamic environment of the stock market necessitates the use of a range of indicators. Smaller companies are less well researched, thus meeting company management and site visits are of particular importance.’

Specialist small-cap boutique Aberforth Partners adopts a value-led approach across all of its funds. But the team points out that ‘Our approach has been developed over time and does not use any one style or sub-set of value investing. We recognise that different types of businesses perform better than others, depending on the stage of the economic cycle and we incorporate this into our portfolios.’

It adds, ‘We undertake our own fundamental research and a key part of this is regular meetings and contacts with the management of small companies throughout the UK. This means that our funds have access to first hand information in what is a relatively under-researched area of the stock market.’

This article is from the October 2007 issue of What Investment.