FE Analytics shows the average fund in the IA UK Smaller Companies lost 1.65 per cent during 2014, which was a stark reversal from the previous year when investors flocked to the smaller end of the market and the sector was up 37.18 per cent.
Some of the peer group’s dominant players lost money that year. Harry Nimmo’s Standard Life Investment UK Smaller Companies fund, the largest in the sector with assets of £1.1bn, was down 8.54 per cent, Daniel Nickols’ £823.3m Old Mutual UK Smaller Companies fund lost 1.22 per cent and Paul Marriage and John Warren's £642.3m Schroder UK Dynamic Smaller Companies fund shed 8.81 per cent.
However, the best performance of the sector was turned in by one of its smallest members – Judith MacKenzie's £10m PFS Downing Active Management fund, which led the pack with a 23.63 per cent return in 2014.
To put this in perspective, the second best performer in the IA UK Smaller Companies sector last year was Henry Lowson’s £98.4m AXA Framlington UK Smaller Companies fund, which returned just 6.55 per cent.
Performance of funds vs sector over 2014
Source: FE Analytics
Although the manager says last year’s gains were quite broadly spread between its holdings, she highlights fire alarm manufacturer Sprue Aegis, timetabling software firm Tracsis and business supplies specialist office2office as three holdings that performed well for different reasons. These stocks are unlikely to be on the radar of most fund managers.
The strong 2014 means the fund sits in the top decile on a three-year view with a 90.84 per cent return, against the sector’s 56.94 per cent; since MacKenzie took over the portfolio in February 2011 it’s been the peer group’s fifth best performing fund with a 78.01 per cent gain.
MacKenzie attributes the five FE Crown-rated fund’s strong performance to its methodical approach to stock picking, a bias towards the value style and willingness to look much further down the market cap spectrum than many of its rivals in the sector.
“For us, the portfolio is our greatest risk so we want to spend a lot of time on that. When we’re making investment decisions it takes on average about eight months. While some might be happy to invest in a company after a 45-minute meeting and a presentation, we take ages doing it,” the manager explained.
“We go on site visits, we speak to the non-execs, we meet the chairman, we meet the competitors, we dig up industry data, we’ll read all the sector reports we can get our hands even going back 25 years, we pull the private company accounts.”
“This is quite an anal way of going about things but it gives us a really good picture of what the company is, what it does and what the drivers are. That might be a different approach to some of our competitors, who are a bit more willing to take a trading approach.”
Performance of fund vs sector and index over manager tenure
Source: FE Analytics
The manager tends to look at prospective investments with more of a private equity eye, scrutinising details such as a firm’s return on capital. Company management having a meaningful amount of their own money in the business and shares trading on cheap multiples are other plus points for the fund.
On the other hand she is reluctant to invest in firms where there are “too many snouts in the trough”, taking a negative view of companies where management set themselves generous compensation packages with easy targets.
She is also happy to drop holdings if management start to change their behaviour, for example selling down their investments or changing the rewards and targets so they become more generous. “That’s a no-go area for us and we’ll just walk away,” she said.
PFS Downing Active Management tends to have a concentrated portfolio of between 25 and 30 holdings. MacKenzie explains that her preferred hunting group is the very bottom of the AIM market – an area where she built up experience during her time management VCT and private equity investments at Aberdeen.
While the fund’s small assets under management may prove off-putting to those investors who prefer the safety blanket feeling offering by a larger fund and the knowledge that plenty of other investors have taken the plunge with them, the manager says this is vital to its success.
“The size element is quite important. Other people have said they’ve got micro-cap funds but they may have £150m to £300 under management. We saying that if you want to be truly micro-cap, you’ve got to limit the size of your fund and really only works with a boutique fund manager like ourselves,” she said.
“If you look at where some of our really good returns have come from over recent years, they’re from the under the £25m to £30m market cap range. I’m very keen, for various reasons, to have no more than 25 to 30 or so investments. If you extrapolate that back, it means you are going to be restricted in fund size.”
“For us, we’d probably soft-close at £30m and then might end up with 10 or 20 per cent more than that. The importance of maintaining that track record is absolutely crucial for Downing.”
Despite being the sector’s best performer last year, MacKenzie is keen to point out that the fund won’t necessarily top the peer group each year or in every market condition. For example, she expects the fund to lag in strongly rising markets as it is more focused on grinding out steady returns from its holdings.
This was demonstrated in 2013, when the average IA UK Smaller Companies fund was up 37.18 per cent on the back of surging investor risk appetite. PFS Downing Active Management, on the other hand, was one of the worst performers in the sector – although it was still up 28.60 per cent, which many investors would consider to be a solid return.
The fund also looks interesting on other metrics. Since MacKenzie joined the fund, its Sharpe ratio – which measures risk-adjusted performance – is the second best in the sector. Meanwhile, its volatility and maximum drawdown are not only lower than the sector average and the AIM but the blue-chip FTSE 100 index.
In her outlook for the coming year the manager is positive on the prospects for her preferred part of the market, arguing that micro-cap companies, defined as companies with a market cap of under £50m, currently offer the more attractive valuations of the UK stock market.
Source: Downing
“During 2014 there was a flight to perceived quality in the small cap sector, with many investors selling down true micro-cap stocks and buying the larger end of the small cap universe,” she said. “In addition many investors sold micro-cap stocks to invest in IPOs, many of which subsequently struggled. This has now created an excellent buying opportunity for micro-cap investors.”
PFS Downing Active Management has ongoing charges of 1.56 per cent.