Investing in smaller companies

There is an old saying that good things come in small packages – and that certainly seems to be the case in the world of investing.

Smaller companies sectors have been among the standout performers over the past decade with bumper double-digit returns, according to figures compiled by Morningstar.

But why have they done so well – and what should investors bear in mind? In this piece we take a closer look at their performance and highlight funds worth considering.

Remarkable returns

If you were fortunate enough to have invested your money in a smaller companies fund a decade ago, there’s a very good chance you’ll be celebrating now.

The IA North American Smaller Companies sector tops the table with a 13.5% annualised return over 10 years, followed by IA Japanese Smaller Companies on 11.3%*.

IA European Smaller Companies comes next on 10.6%, only marginally ahead of the 10.2% achieved by IA UK Smaller Companies*.

These figures compare favourably against many other areas which invest in larger companies, including the 6.9% average recorded by the IA UK All Companies sector, the 9.1% average annualised return of IA Japan and 9.6% from the IA Europe ex UK sector*. Only the IA North American sector has beaten its small cap rivals, with 14.2% annualised returns helped in no small part by the tech giants*.

Reasons for the success

There are several reasons for the potential success of smaller companies, including the fact they’re often at an exciting growth stage of their development.

It’s a point acknowledged by the experienced team behind the Artemis US Smaller Companies fund, which points out America is home to innovative and entrepreneurial businesses.

“Smaller companies tend to be less well covered by financial analysts than their larger peers, so experienced investment managers can use detailed research to find the leaders of tomorrow before their potential receives wider recognition,” it stated.

Choosing a smaller companies fund

There are plenty of funds that invest in smaller companies. Some will focus on particular regions, such as North American or European, while others take a more global approach.

Choosing which one suits you best will depend on your investment goals, how you see the outlook for certain markets, and your attitude to risk.

Challenging backdrop

While the past decade has been a fruitful one for smaller companies, the past few months have been far more challenging. Over one year, IA UK Smaller Companies funds are down 18.7% on average, while their European, Japanese and US counterparts are down 16.9%, 14.1% and 7.8%*. The sectors investing in larger companies have held up better in the market sell-off.

“The volatile macro backdrop has created an environment in which companies have been de-rated without any news flow catalyst, while earnings ‘misses’ and other corporate disappointments have often been met by quite an exaggerated share price reaction,” stated the team behind Liontrust UK Micro Cap.

It hasn’t all been bad though and some smaller companies have still done well. The Liontrust portfolio’s biggest riser recently has been Netcall, a customer experience software specialist, which rose 27%, for example. “Netcall announced that it had signed a deal putting it on track to exceed expectations for earnings in the year to June 2023,” the team noted.

Stock picking skills

Obviously, it’s crucial for any manager of a smaller companies fund to pick the stocks that they believe will help them achieve their goals.

For example, Rory Stokes, one of Janus Henderson European Smaller Companies fund’s managers, told us that a couple of stocks had caught his eye. They are Karnov, a Swedish listed provider of information products and services to lawyers in Sweden, Denmark and Norway, and Recticel, a Belgian manufacturer of insulation.

“Lawyers will consult Karnov’s products to get interpretations on the law from academics and legal experts,” he said. “It’s an integral part of lawyers’ day-to day-operations and has few competitors.” He particularly likes the pricing power that allows it to protect margins in inflationary environments. “I am very excited about the expansion into France and Spain that is underway,” he added.

As far as Recticel is concerned, Stokes praises the “terrific management team” that has taken it from an “incoherent Belgian conglomerate” to a focused business with huge potential.
“Recticel can help its clients make huge energy savings with its products and help them manage their carbon footprint,” he said. “Having sold its non-core assets, the company has €400m of net cash on the balance sheet giving it lots of optionality.”

Other ways to get exposure

FundCalibre has awarded an Elite Rating to a number of smaller companies funds.

Jupiter UK Smaller Companies fund, for example, offers investors access to a broad range of themes across the spectrum of the UK’s smallest companies, from retailers to manufacturing exporters, from high-tech growth companies to established mainstream brands.

Those looking for a little more geographical diversification could consider the T. Rowe Price European Smaller Companies Equity fund which is pan-European, or ASI Global Smaller Companies, which identifies smaller companies from all around the globe – including emerging markets – that they believe to have the best growth prospects.

Artemis US Smaller Companies is an option for those looking to invest in the world’s largest stock market, while Baillie Gifford Shin Nippon trust focuses on emerging or disrupted sectors in Japan, where the manager sees innovative growth opportunities, and Federated Hermes Global Emerging Markets SMID Equity is a concentrated fund focusing on small and medium-sized companies across global emerging markets.

*Source: FE fundinfo, total returns in sterling to 20 July 2022