Over the past three years Britain’s largest companies have delivered the best returns, but when it comes to recoveries, smaller companies reign supreme. Jenny Lowe meets the sector’s man of the moment.

Large-cap stocks offer additional protection to investors as they have traditionally been less volatile than their smaller peers. From 30 April 2007 to 30 April 2010 the FTSE 100 index outperformed both the mid-cap FTSE 250 index and the small-cap FTSE All-Small index, by 1.77 per cent and 15.15 per cent respectively.

Small companies are perceived as higher-risk investments than larger ‘blue-chip’ companies, due to their niche products and services and smaller financial clout. This means that in times of high volatility – such as recovery situations – they can be left behind, resulting in juicy opportunities for astute investors.

Those investors who opted to try their luck and invest in small-cap funds in 2009 certainly won’t have been disappointed, with the average fund delivering a return of 51 per cent.

Close Special Situations, however, topped the table, gaining 239.5 per cent over the year. Fund manager Deryck Noble-Nesbitt, puts this outperformance down to the contrarian approach adopted in selecting stocks for the fund.
‘As the bear market moved through sectors in the second half of 2008 and into the first quarter of 2009 the fund added to stocks that had fallen to long-term attractive levels, often with large quantities of cash or asset backing in the shares.

Close Special Situations is the best-performing UK Smaller Companies fund over one year and three years. The next-best fund in the sector is Beacon Investment, up 111 per cent over the past year – and it’s also run by Noble-Nesbitt.

Down to experience
Noble-Nesbitt joined Close in March 2005, having previously been a UK equity analyst at Govett Investments and spent more than six years working for Deloitte & Touche in London and New York as a chartered accountant.
The manager isn’t shy to confess that he has more or less built the fund from scratch since he took over managing it in August 2008 after the previous manager left and cornerstone investors took their money out.

Having recently carried off the award for best small-cap fund at the Growth Company Awards, Noble-Nesbitt contends that ‘people’s money has to go somewhere, and just now the alternatives to equities are not all that attractive’.

He describes his approach as ‘pragmatic, value driven and flexible’, and this means that nothing is ruled out, with each potential investment being assessed on its own merits.

He explains, ‘The emphasis in the approach is very much on value, based on what I believe the shares are worth and what price they are trading at in the market. I also consider a broad range of issues such as balance sheet strength, capital intensity, sales growth and margin potential.’

The fund is currently made up of around 35 stocks, of which Norseman Gold is one. Noble-Nesbitt notes, ‘In 1924, John Maynard Keynes wrote, “In truth, the gold standard is already a barbarous relic.” Here we are, 86 years later, in a world where countries compete to devalue currencies, and government-issued debt has lost a little of its perceived safety.

‘While that continues, the attraction of gold may persist. If you want exposure to gold you can buy the largest producer in the world – Barrick – a US company with a market cap of $35 billion, or you can buy a basket of smaller gold producers listed in the UK. The basket looks better value to me and Norseman is one such example.’
Small company, big gains

He also likes the look of pharmaceutical company Renovo. He explains, ‘There is a well-documented belief that global pharmaceutical companies face a “patent cliff” over the next five years, and yet biotech, a potential source of new drugs, remains out of favour because of its capital-intensive nature.

‘Renovo is well funded. Management’s interests are aligned with shareholders’ – deferred bonuses not vesting unless the drug trials are successful. Although this is not a typical holding, it certainly has its place in a diversified portfolio.’

Healthy prospects
Nestor Healthcare is another company that Noble-Nesbitt believes is a ‘simple growth stock’ and currently makes up the largest holding in the fund. It is the UK’s largest independent organisation dedicated to providing managed services to the UK health and social care market.

He adds, ‘The macro driver for the shares is nice and simple – ageing baby boomers should provide natural growth in the markets Nestor operates in. The company appears to have gradually overcome many of the legacy issues that have affected the shares over recent years.

‘Some still exist, including a pension deficit, onerous leases and losses on some interest rate derivative contracts. However, despite taking these negatives into account, and assuming only modest growth in the next five years, the shares appear significantly undervalued.’

It’s all in the research
There are more than 1,000 companies that could form part of a UK smaller company fund and, according to Noble-Nesbitt, each one has its own story.

He is a firm believer in looking at the individual stock, arguing that ‘each one is affected by the general economic climate in a different way and each one has its own valuation characteristics at any particular point in time’. Given the scale of choice available, it is likely that the variability of returns between funds will almost be as significant as the performance of the ‘asset class’ as a whole.

He concludes, ‘My own particular preference when thinking about the investment outlook is to continually ask the question: can I identify a group of equities that, blended together, form a portfolio with attractive investment characteristics? I believe that the answer to this remains “yes”, and so I remain cautiously optimistic for the long-term prospects for the fund.