Investors might consider the Franklin UK Smaller Companies funds as an alternative to the heavyweights in the sector.
With assets under management of just £21m, it is significantly smaller than many of its peers.
While the fund has been lacklustre for some time, languishing in the bottom-quartile over three, five and 10 years, since FE Alpha Manager Paul Spencer and Richard Bullas took over the underperforming portfolio in June 2012, it has shot ahead on the performance tables.
Bullas says the pair allowed themselves two months to revamp the portfolio and since September last year it has been one of the best performing funds in the IMA UK Smaller Companies sector, beating small cap stars Harry Nimmo and Giles Hargreave.
The fund has also outperformed the Numis Smaller Companies ex ITs index over the period.
Performance of fund vs sector and index since September 2012
Source: FE Analytics
Bullas says the restructuring took place in June and July last year and since then the fund had seen a “dramatic turnaround in performance.”
“We were quite brutal at the start but we felt like we had to be,” he said.
Bullas said he and Spencer removed 33 stocks from the portfolio and took the first few months to populate the fund with new holdings.
According to Bullas, they inherited the portfolio with 59 stocks, 24 per cent of which were mining and oil & gas companies while 51 per cent of the portfolio was actually in AIM and overseas stocks.
Bullas said they reduced the risk in the portfolio by removing illiquid micro-caps and instead focusing on the higher-quality companies ranging from a market cap of £100m to £1bn.
“We had to get away from micro-caps. It is quite risky down there. We’re not taking a high risk approach at the very small, illiquid micro-cap end.”
He adds that the eradicated out-of-favour mining stocks and opted for a highly concentrated mix of growth and value companies in an effort to turn around the performance of the fund.
“By early September we felt really happy with the portfolio,” he said.
The manager said they bought 15 new companies within the space of a few months.
Among the new holdings in the fund are inkjet printhead supplier Xaar, high street retailer Ted Baker and British student accommodation company Unite Group.
Bullas said he and Spencer set out to rebuild a portfolio of 40 to 50 investments held over a three to five year investment horizon. He adds that every new holding that was put into the fund since they took over last year is still in the fund.
They won’t hold any position at less than 1.5 per cent of the fund and cap individual company exposure at 5 per cent.
Bullas said they look at four key factors when selecting a company to add to their portfolio.
1 – Business risk
2 – Balance sheet risk
3- Management risk
4 – Valuation risk
“[The process] leads itself to eliminate quite a wide area of the market,” he said.
As a result of their strict criteria, Spencer and Bullas don’t include any companies with debt or startups in their funds.
“We’re looking for established small caps rather than the speculative area of the market,” Bullas said.
More than 40 per cent of the portfolio is invested in the FTSE 250 index, while 23.9 per cent is in the FTSE Small Cap index, roughly even with the AIM index which has a 24 per cent weighting.
The pair have taken a strong view on the house building sector and upped their weighting to UK home builders.
“We’re very bullish of the housing market recovery and we have been for quite a few years,” he said.
Bullas said there was still a lot of capacity in the portfolio, but they would look to review the fund when it reached the lower end of £300m-£400m.
The fund requires a minimum investment of £1,000 and has ongoing charges of 1.7 per cent. It has a small yield of 0.27 per cent, according to FE Analytics.
Hargreaves Lansdown’s Richard Troue says the management change has been positive for the fund.
“We increasingly saw Stuart Sharp as a lone ranger, constructing his own portfolio outside of the views of the wider team,” he said.
“Between them Paul Spencer and Richard Bullas have plenty of experience and have brought the portfolio back into line with the team’s core philosophy.”
“The UK team at Franklin is close-knit and we rate them highly. Since taking over and reorganising the portfolio the results have been encouraging, albeit over a relatively short time period.”
“The only negative is Richard Bullas’ inexperience managing his own portfolio, but with the support of Paul Spencer and the wider team we believe he is capable of generating strong long-term returns.”