Mean reversion doesn’t apply to smaller companies and investors should forget about price-to-earnings multiples when looking at small-caps, according to FE Alpha Manager Harry Nimmo. 
It’s a widely accepted investment principle that styles come in and out of favour, as do stocks, and at some point those that are currently unloved will eventually come back into favour.
This was demonstrated last year by the resurgence of the value style, which outperformed for the first time in three years but remains significantly behind the growth style over the last decade.
Performance of indices over 10yrs
Source: FE Analytics
As the above graph shows, the MSCI United Kingdom Growth index is 32.46 percentage points ahead of the MSCI United Kingdom Value index over the past 10 years, but many believe this gap should begin to close as mean reversion takes hold.
However, Standard Life Investments UK Smaller Companies manager Nimmo says this logic does not apply to small-caps.
“Mean reversion and fade rates are the accepted wisdom, the Holy Grail of fund management, in that comparative advantage always gets competed away and that’s what they teach in business schools,” he said.
“Well our experience is that this is just not the case. Companies can retain their comparative advantage for a very long time if they really are good businesses with predictable growth.”
He says this is being backed up by academics, such as professors Dimson and Marsh – the inventors of the Numis Smaller Companies index.
“Every year they do a bit of analysis and come up with an exercise looking at low-risk baskets and high-risk baskets,” Nimmo said.
“They rebalance them every six months to keep them in that character and track how they performed and what was clear was that the performance of the low-risk basket was considerably better than the high-risk.”
One reason that helps to explain the outperformance of the high risk basket of stocks is that analysts build in big fade rates into their earnings forecasts, Nimmo said.
This means they add in an expected level of earnings growth fading without necessarily taking into account the maturity of the business; as smaller companies are more likely to grow faster this fade rate is often left redundant.
“An example of this is Fevertree, which last year grew its earnings at 90 per cent or something like that,” he said.
Over the last year the company is up 185.94 per cent and since floatation in November 2014 it has rocketed 938.52 per cent.
Performance of stock since launch
Source: FE Analytics
“The analysts’ forecast for Fevertree this year have it growing at 12 per cent next year and 8 per cent the year after,” Nimmo said.
“Now to me there are built-in upgrades here as it is definitely going to grow by more than 12 per cent but under-promise and over-deliver is the watch-word and their broker has no doubt drummed that into them.
“They are cautious people who don’t want to set out false expectations but on the basis of what we can see they are going to do much better than that.
“Now it looks really expensive, particularly when you’re growing fast – you use an historic P/E it’s on 60 times and even on the forecast it’s on 45 times (earnings) but actually the reality is that in a few years it could be on a much lower P/E.
“So that’s a built-in earnings upgrade and business and earnings momentum are one of the things we really track closely.”
Nimmo says he looks for companies like this that can under-promise and over-deliver as a way to mitigate the risks associated with smaller company investing.
He couples this with the ability to run his winners, with more than 50 per cent invested in the FTSE 250. JD Sport is a good example of this.
“JD Sport, which is the third largest holding in the Oeic, is getting on for £4bn now and that listed in 1996 but has quintupled in the last four or five years. You want to run that winner because it is clear that this business has real momentum,” he explained.
“But it is almost on the cusp of the FTSE 100 and that is the time that we would look to sell the stock.”
As such, the companies in his fund tend to be on higher multiples, but he says this is easier than trying to time investing into a falling company and spotting a turning point.
“We are always trying to cut down risk in the portfolio because smaller companies are slightly riskier as a group though not by as much as you would think and certainly investors think they are more risky,” the manager said.
“So we try and reduce that risk and by doing so you also build in a greater level of resilience to market shocks, to bear market conditions, and our best years have been in the down years.”
As a result, the stocks he owns are generally more resilient and able to withstand market shocks than the market (represented by the Numis Smaller Companies ex IT index).
Nimmo’s Standard Life Smaller Companies fund has outperformed the index and the IA Smaller Companies sector by 53.96 and 64.08 percentage points respectively over the past decade.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
It has also been less volatile than its benchmark over the last decade, experiencing 16.24 per cent volatility (17.38 per cent for the index) and a lower maximum drawdown – the most an investor could lose if buying and selling at the worst possible moments.
“In 2007-2008 our unit price went down less quickly than our competition because we had an overwhelming focus on lower levels of risk. Our experience of smaller company investing is that lower risk equals better returns which is the opposite to your normal efficient market’s view of high risk equals high returns,” he said.
Nimmo adds that the fund has a slightly larger company by size than the average in the index and this is due to his belief that value isn’t everything.
“Actually the dividend yield and earnings (price-to-earnings ratio) are on considerably higher valuations than the market and price-to-book likewise,” the manager said.
“Growth [is measured by our] much better historic earnings per share and sales growth and quality (return on equity) by our average company’s return, which is 23 per cent against the average of 13. So you would expect this quality portfolio to have higher resilient to difficult market conditions.”
The £1.2bn fund has a clean ongoing charges figure of 0.99 per cent.