UK smaller companies are “misunderstood” to some extent, according to Fidelity Personal Investing’s Daniel Lane, but there are a number of funds that can find investments where large-cap focused managers are not looking.
At a time when Brexit and the health of the UK economy are never far from the headlines, Lane noted that a common misconception is that smaller companies are just exposed to the UK economy.
However, he pointed out that nearly half of all sales in the FTSE UK Small Cap index come from overseas. Reflecting this, smaller companies have posted positive earnings results, especially in healthcare and technology, even as investors shied away from the UK market.
“The result of all of this is a wealth of opportunity out there for fund managers willing to look where no-one else does and capitalise on mispriced opportunities when they see them,” he said.
Below, Lane looks at three popular IA UK Smaller Companies funds that have strong track record and well-established approaches.
Merian UK Smaller Companies
The first strategy highlighted by Lane is £1.4bn Merian UK Smaller Companies fund, which is headed up by FE Alpha Manager Daniel Nickols. As the chart below shows, since Nickols took over in January 2004 it has generated a 772.83 per cent total return, which is the third highest in the sector.
Performance of fund vs sector and index under Nickols
Source: FE Analytics
“While many active managers prioritise company research and sometimes deliberately filter out the macroeconomic ‘noise’, Merian’s Dan Nickols likes to draw from both approaches,” Lane explained.
“He uses trends in gross domestic product (GDP), inflation, and interest rates and complements the ‘big picture’ with company research which emphasises both sustainability and the potential for change.”
Merian UK Smaller Companies’ top holdings include high-end drinks mixer firm Fever-Tree, ASOS competitor Boohoo and litigation finance provider Burford Capital.
This reflects Nickols’ preference for companies that dominate their industries, as this creates the opportunity for faster earnings growth and greater profitability. He also likes to find good companies while they are still underappreciated by other investors.
Lane also pointed out that the manager considers facetime with company executives to be vital when investing in smaller companies, so he holds more than 300 company meetings each year.
“For the manager it’s just as important for a company to court Nickols as it is to show that he is serious about making an investment,” he noted. “It is also slightly easier to derive unique insights into a smaller company than a large one through meetings because fewer competing analysts are actively following the same firm.”
Merian UK Smaller Companies has an ongoing charges figure (OCF) of 1.03 per cent.
Fidelity UK Smaller Companies
Next on the list is a member of Fidelity’s stable: FE Alpha Manager Alex Wright’s £366m Fidelity UK Smaller Companies fund, which has Jonathan Winton as co-manager. Its 419.39 per cent total return since launch in February 2008 is the highest in the IA UK Smaller Companies sector.
While many smaller companies funds focus on a limited number of growth stocks that have compelling stories and exciting products, often leading to well-liked stocks getting bid to high valuations, Wright and Winton have a contrarian approach that focuses on unloved companies.
Performance of fund vs sector and index since launch
Source: FE Analytics
“The managers look for companies with the ability to buck lukewarm expectations; however, the Fidelity team pays close attention to limiting the downside, should companies not fulfil their potential,” Lane said.
“They look specifically for undervalued companies attracting negative market sentiment, judging that a poor outlook is already baked into the share price, limiting downside risk and presenting good opportunity to significantly beat expectations.”
Wright and Winton’s approach to individual stocks tends to have three stages: building a position, waiting for the thesis to play out and a re-rating to occur and finally recycling proceeds into new opportunities. This takes an average of 18 months to play out, although the exact timing depends on the speed of a stock’s recovery.
Top holdings in the portfolio include Irish drinks business C&C, global hotelier Millennium & Copthorne Hotels and infrastructure investor and manager John Laing Group.
Fidelity UK Smaller Companies has an OCF of 0.92 per cent.
Marlborough UK Micro-Cap Growth
The final fund on Fidelity’s list is Marlborough UK Micro-Cap Growth. This fund, which is run by FE Alpha Manager Giles Hargreave and Guy Feld, concentrates on stocks with a market cap less than £250m (often below £150m) – smaller than most smaller companies portfolios would consider.
“Companies at the low end of the cap scale often carry a higher risk of failure – something the managers keep in mind and attempt to mitigate by holding a diversified portfolio of more than 250 names,” Lane added.
“Supported by a large team, the managers are also well-positioned to analyse each company in detail, rarely investing without meeting company management face to face. The pair specifically look for businesses operating in niche markets, with reliable management, solid balance sheets and evidence of good free cash flow.”
Performance of fund vs sector and index since launch
Source: FE Analytics
Lane also noted that the smallest companies are able to grow much faster than their larger peers, which mean relatively few investments need to exhibit significant outperformance to benefit the overall portfolio.
“Hargreave and Feld can therefore run their winners and cut the losers – a job made easier by compiling such a large portfolio of opportunities,” he added.
Current holdings include Future, the Bath-based magazine publisher on the FTSE Fledgling index, audio equipment manufacturer Focusrite and digital marketing firm Next Fifteen.
Marlborough UK Micro-Cap Growth has a 0.78 per cent OCF.