Smaller companies are increasingly key for a UK equity income fund’s ability to outperform, according to FE Alpha Manager James Henderson. Henderson (pictured), who manages three investment trusts and one open-ended fund, describes himself as a true multi-cap manager who feels as comfortable holding an AIM stock as a global mega cap in his top-10.
Shortly before taking charge of the Lowland Investment Company in 1990, the manager says he realised that small caps would always win out against larger companies over the long-term, and would always make up a big bulk of his portfolios as a result.
"The light bulb moment in investing for me was when I found an old copy of the FT from 1934. Having been a few years in the job I suddenly realised there were a lot of companies that were no longer there," he said.
"There were a load of plantation companies and oil companies that are long and gone and it struck me – why do people want to be in big companies all the time if that is what is going to happen to them?"
Henderson says small caps’ importance is increasing as the life cycles of companies is on a downward trend, meaning that so-called safe and secure large caps are more susceptible to big losses.
“Companies have life cycles and these are getting shorter,” he said. “It took many years for Mr Ford to build up Ford and for it to become the largest company in the US stock market.”
“However, Microsoft was built up in a much shorter period of time and companies like Amazon and Apple have grown in an even shorter time.”
“That cycle from high growth to big decline, and then perhaps reinvention, is becoming compacted into shorter time periods. Companies are more asset light than they were in that old FT which required years to build up their asset base.”
Henderson says this trend is particularly true in tech.
“These days the big companies are about intellectual property and answering problems. The wonderful thing about intellectual property is it gives good return on capital but its duration is so short,” he said.
“Price comparison websites show who the best are quickly and there is no appetite from the consumer to see the big company trundle along.”
He recently told FE Trustnet that university spin-offs and start-up tech companies are among the most attractively valued areas in the UK equity market at present, pointing out that their knowledge bases are much greater than their capital bases.
A high weighting to small caps has contributed to Lowland’s significant outperformance over the long-term.
The trust has returned 584.05 per cent since 1995 – as far as our data goes back – compared to 270.42 per cent from the IT UK Equity Income sector average. The FTSE All Share has gained 304.02 per cent over the same period.
Performance of trust, sector and index since 1995
Source: FE Analytics
Henderson is also ahead over three, five, 10 and 15 year periods.
The trust has been significantly more volatile than its peers however, again linked to the small cap overweight. Smaller companies are more susceptible to sharp sell-offs than large caps, and indeed a poorer period for the FTSE Small Cap and FTSE AIM indices has contributed to his underperformance so far in 2014.
Performance of trust, sector and index in 2014
Source: FE Analytics
Henderson says it is necessary to retain a sizeable exposure to large caps because it helps to weather volatility.
“I don't have a clue about market levels or Scottish independence; all I know is that I need genuine diversity in my portfolios and that if the world modestly grows over the next 20 years we should be all right,” he added.
AIM stocks currently account for around a third of the money run in the Lowland trust. While his top-10 includes mega caps such as Shell and Glaxo, he has major positions in smaller companies such as Senior, Velocys, Hiscox and International Finance. He also holds FTSE Small Cap companies Hill & Smith in the top-10 of his Henderson UK Equity Income & Growth fund.
“AIM accounts for a third of the money I run in the trust but accounts for half my time,” he said.
“It’s right that it [takes up more of my time] because that is where the long-term returns will come from. If my large cap selection stays reasonably positive then that will be an achievement. It is far harder to create alpha in the area.”
Henderson concedes that the trust has suffered more than he would have liked in down markets and that he should have had a greater exposure to large caps in 2007 and 2008; the trust lost 61 per cent between October 2007 and April 2009.
However, he says the trust’s long term outperformance has rested on buying high growth stocks such as ASOS, and he has no plans in change his ways.
“A few successes such as ASOS – which will always come out of AIM – will help the overall return and that has driven so much of my return, despite the volatility,” he said.
“It is so much easier to create Alpha as an investment manager if you are in small caps.”
Henderson says ASOS is the best stock he has ever bought. He benefited from its meteoric rise between 2009 and 2014, but thankfully sold out of it before the share price crashed in March of this year.
Performance of stock since 2008
Source: FE Analytics
ASOS is again down 14 per cent today, after it downgraded its profit forecast for the coming financial year.