The sector may be home to trendy online retailers such as ASOS or EBTM, but smaller companies are decidedly out of fashion among investors at the moment. The dramatic fall in smaller company shares in 2007 is just one reason why the sector is about as appealing to most people as last season’s legwarmers.

But before any investor follows the trend away from smaller companies, it’s worth looking a little more closely at the potential they hold for your portfolio. The sector has been through some dramatic periods of growth, putting larger companies firmly in the shade. Between 1975 and 1988 smaller companies spectacularly outperformed large-caps, growing more than twice as much.

Riding the small-cap cycle
Tim Cockerill, head of research for adviser Rowan, says the past few years have seen small-caps prosper impressively. ‘Until June last year smaller companies did well. Often they are domestically focused so when the UK economy was booming they performed strongly,’ he points out.

So what, exactly, is a smaller company? Depending on the market you look at, smaller companies are generally defined as either the smallest ten per cent of the market by capitalisation, or the smallest 20 per cent. Within the UK, ten per cent is the traditional rule of thumb.

They have the advantage of being small, nimble and, therefore, able to respond quickly to market needs. They are not tied into structures and systems that stand in the way of market-leading developments, so they have the potential to grow phenomenally.

Indeed, far from being insignificant, the UK small-cap sector contains several niche market leaders, including payment services household name Paypoint, polymer technology world leader Fenner, and uninterrupted power supplier Chloride Group, all of which appear in the portfolios of many top-performing UK generalist funds.

Mark Dampier, head of research at adviser Hargreaves Lansdown, argues
‘If you have a long time horizon, smaller companies are under-researched, so a fund manager can find the anomalies and exploit them, whereas large-caps are well researched, so it’s hard to find an advantage. Most studies show that over the very long term smaller companies do better.’

Arguably, the advantages of the sector are growing as the market matures. Smaller companies used to be dominated by the manufacturing sector, which acted as something of a millstone around its neck. But that area of activity has fallen away to account for less than a tenth of the UK market in recent years, and more dynamic companies flourished in its place.

Broadening its coverage
The small-cap sector was formerly focused on cyclical businesses, but in recent decades it has expanded into a huge variety. Dampier says, ‘Smaller companies are different to how they used to be. Some 20 years ago there were more industrials and cyclical companies, so they were more prone to boom and bust. But smaller companies have become more sophisticated. Put simply, it is a much better market.’

The sector has broadened away from a solely domestic focus too. Neil Hermon, manager of the Henderson Smaller Companies Investment Trust, explains, ‘Smaller companies now encompass a wider geographic base, so in the portfolio we can move away from the UK slightly if we want to.’

Smaller companies also have lower borrowing than in previous years. Traditionally, they were more highly geared than larger companies, so as interest rates rose they were stuck paying off more debt, and tended to struggle. However, that is no longer the case. Gervais Williams, manager of the Gartmore Smaller Companies Investment Trust, explains, ‘Over the past few years, the banks have been quite conservative in lending to smaller companies, so they have used equity more than debt.’

Hermon adds, ‘Around 30 per cent of the companies in the portfolio have net cash now. We have always liked a strong balance sheet.’Managers are also positive about the trading prospects for many smaller companies. Williams says, ‘In meeting after meeting, companies are saying, “We can’t see anything negative on the horizon.”’

Stock selection is the key
Managers are, of course, well aware of the negative pressures on the market from broader macro-economic forces. However, they are convinced that careful stock selection allows them to focus on companies in which they can be confident about the future. Hermon says, ‘We are trying to focus on stocks with visibility and certainty of earnings. For 2008, the market is still forecasting double-digit earnings growth, which won’t be the case. There will be some disappointments in the market, so we like companies with visibility of short to medium-term earnings.’

The sector also stands to gain from continued mergers and acquisitions (M&A) activity. Ed Beale, manager of the Dunedin Smaller Companies Investment Trust, explains, ‘The venture capitalists have withdrawn from M&A, but the corporates have stepped up to the plate. Previously they had the appetite and the balance sheet, but venture capitalists were pricing them out of the market.’

As a result, Hermon says, ‘There is quite a lot of bid activity. Companies are taking the opportunity to buy other companies on low valuations. We are seeing a number of bids.’ Williams agrees, ‘Several times a week we are getting approaches regarding stocks in our portfolio for good cash premiums.’

And added to all these positives, because the market has had such a tough time, valuations have fallen, so stocks are looking much cheaper. Williams says there are a number of factors at work in the market at the moment, which have been keeping the valuations of good businesses artificially low.

He feels that ‘Investors are very nervous about the credit crunch and the impact on the real economy. We haven’t seen how far it will spread and investors have taken a safety-first attitude and chosen to exit smaller companies rather than wait. We have got negative weight from the top, the credit crunch and the consumer slowdown.’

In addition, he says, many stocks in the sector did not have the opportunity
to grow as much as they should have during the boom years. Williams explains, ‘The market has had tremendous success in attracting new issues, especially AIM. It reached such a level in 2005/07 that the market got indigestion at the micro-cap end and valuations didn’t go up in the bull market. They have come down even further now. We can see cheap stocks across the whole range, but at the smaller end we can see really stunning valuations.’

Selling has gone too far
Rosemary Banyard, co-manager of the UK Smaller Companies Fund at Schroders, says that the outflow of funds from the sector has added to the trend, with redemptions creating new opportunities as investors withdraw their money and managers have to sell up to generate cash. She explains, ‘We are always on the lookout for things that have been oversold – good businesses that are simply too cheap. This market is throwing up a lot of those companies, because other funds are suffering redemptions.’
As a result, Hermon says, ‘A lot of the stocks we own at the moment are looking cheap and interesting so we are looking to top up.’

Investment trusts have an advantage here over open-ended funds. If they see spectacular value and don’t have the ready cash for more purchases, they can borrow in order to invest. Hermon explains, ‘In terms of finding the cash, we have the ability to gear. We are keeping 11 per cent to 12 per cent geared, which is a sensible level of borrowing.’

None of the managers are taking the opportunity to gear up to the hilt. Beale is remaining within five to ten per cent geared, whereas JPMorgan’s Smaller Companies Investment Trust is sticking with four per cent gearing, which is a fairly low level for this particular fund. However, the option remains for all of them when the time is right to gear up and take full advantage of a recovery in the smaller companies sector.

The fact that they are not yet taking gearing up a notch, is a sign, however, that not everything in the smaller companies sector is rosy. Any examination of smaller companies would be falling short if it didn’t face up to the drawbacks of the sector – most notably that in tough times performance can be dire.

A market of extremes
UK smaller companies underperformed every other sector in 2007, underlining their vulnerability and volatility. Cockerill explains, ‘When the outlook is more negative, smaller companies tend to get hit because they are not seen as being so robust. Sometimes one particular product is the mainstay of the business and if that gets impacted it can affect the company as a whole. Hence they have fallen out
of favour in the past nine months.’

These factors, therefore, put smaller companies at the riskier end of the spectrum for most investors. They fit well into a portfolio that already has a solid core of UK mainstream investments, and is looking for satellite holdings that help add a little more potential return for a little more risk.

But investors, even when looking for precisely this kind of investment, have been turning away from smaller companies. Dampier reports that ‘When we send a mailing to clients about UK smaller companies, we never get as good feedback as when we send something out about a Russian or Indian fund.’

This lack of popularity has to do with the concentration of investments that most investors had when the technology bubble burst. People thought that by diversifying across both large and small companies, they would be insulated from any potential falls, but in reality they both fell together. Dampier says, ‘If you buy other UK funds you already have some small-cap exposure, so people don’t feel they need a specialist fund.’

The star players
Nowadays investors are more likely to look overseas for riskier exposure that offers higher potential returns. They could well be missing a trick in doing so, as UK smaller companies have the advantages of being closer to home, and therefore easier to get to grips with, and having no currency risk inherent in the investments.

However, it is only when the market and investors grasp the potential of smaller companies that both the stocks and the investment trusts will see the gains that the managers say they deserve. Dampier points out, ‘There are great discounts, and there might be bargains to be had, but only if the discount closes up, and there’s no sign of that happening at the moment.’

There are all sorts of smaller company funds with a huge variety of aims and investment records, so investors will need to investigate each one thoroughly. Dampier says, ‘You need to read the report and accounts of each investment trust.
Get three or four sets of accounts covering a number of years and check how the fund is doing. From that you’ll get a good view of the sorts of companies it is buying and the style they have.’

There’s no quick fix, but there are plenty of strong investment trusts out there, so there should be a style to suit every investor. As long as its risk and investment profile match your needs, it doesn’t matter how unfashionable the sector is, it’s going to fit well within a balanced portfolio.