Investors need to consider the international exposure of smaller companies and be ready to buy when domestic market concerns send globally-focused stocks lower, according to James Thorne, manager of Threadneedle UK Smaller Companies.
The manager of the four crown-rated fund said volatility in the last 18 months has presented a number of opportunities for investors, with internationally-focused smaller companies becoming mispriced.
Some investors have shied away due to preconceptions that the smaller the company, the more linked to the domestic economy it is.
“A lot of them are exposed to global markets and you can actually construct a portfolio that doesn’t have that much of a domestic bias,” Thorne said.
He added that there are some companies that are very domestically-focused, such as furniture retailers DFS and SCS, which he avoids.
Instead, Thorne looks for companies with “interesting market share positions” that can take market share from the major players of a sector, but that also have opportunities to internationalise their business.
He said that these companies are still domestic, but would be less affected by concerns around the UK economy.
“Yes, okay, if GDP went to -2 per cent it wouldn’t be a very pleasant place to be but ultimately if GDP is 1 or 2 per cent it really doesn’t make a lot of difference to those companies,” the manager said.
Yet, investors still tar smaller companies with the UK domestic brush and as such, Thorne is trying to achieve a portfolio that is as internationally-facing as possible.
“The difficulty then is the perception [that UK smaller companies are domestic-only businesses] and that perception gives us opportunity when there is volatility – and there has been volatility around,” he said.
“We have been able to further invest in companies we really like because the share price is reflecting the short-term perceived view of the market.”
Performance of fund vs sector and benchmark since manager start
Source: FE Analytics
Since the manager joined the fund in 2013, it has returned 75.69 per cent, a top quartile return in the IA UK Smaller Companies sector. Thorne co-manages the £198m fund with Matthew Evans who is leaving at the end of the summer to join Investec. It has a yield of 0.8 per cent and a clean ongoing charges figure of 0.89 per cent.
While, on the surface, the fund may look domestically-focused, he said there are a number of businesses that have international exposure that is not recognised by the market.
The largest area is the retail space, where the fund is 6.5 per cent overweight (28.4 per cent total) to consumer discretionary firms.
As the below shows, the areas was hit particularly hard after the Brexit vote in June last year as many became concerned over the health of the UK economy outside the European Union.
Performance of retailers vs FTSE All Share since Jan 2016
Source: FE Analytics
Thorne said: “We do invest in retail and the commonality of all our names is there is a growth opportunity in the UK market because they’re small, their brands have been well built and the proposition in the UK is interesting to the UK consumer, but the bigger long-term opportunities are overseas.
“In the UK we are now world leaders in terms of online adoption, with everything from Rightmove to online retail but are also positioned right in terms of fast fashion and our retail proposition is up there in the world as one of the market leading.
“That’s where you want to be from a UK small cap point of view – your industry is world leading, you’re flexible and you are adopting new technology faster than other people but you’re not taking a huge risk in terms of the multiple.”
The three retail names he owns are fashion labels Ted Baker and Joules as well as chocolatier Hotel Chocolat.
Performance of stocks vs FTSE All Share General Retailers since EU referendum
Source: FE Analytics
All three have outperformed the wider FTSE All Share General Retailers, though some have taken longer to recover from the post-Brexit falls than others.
The stock that has struggled the most of the three is Ted Baker, but Thorne remains positive on the prospects of the company. 
“We have been involved with Ted Baker since before I was here and that is an owner-managed business that was originally a UK-focused company but they have now developed,” Thorne said.
“Ted Baker has become quite international and while the shares have been sold off because the US has been quite difficult they have never discounted, so they are not in fashion as such, they have built a brand that is completely separate to that.”
Moving to Joules, the business has built up a brand that has a very strong proposition within the country fayre market in the UK, but has more recently begun exporting to markets including Germany and the US.
“They’re differentiated in that a lot of clothing suppliers go and get agencies to supply their fabrics while a lot of their fabrics they own the print for,” the manager said.
This means the firm has a brand that is unique in its prints and makes it difficult for competitors to enter the market.
“Their opportunity is really coming from German and US wholesale and those are great markets because they’ve differentiated their product offering,” Thorne added.
This is similar to Hotel Chocolat, which he said is currently building a strong brand in a niche area that has the potential to expand rapidly.
“When we looked at that business we also looked at Lindt & Spruengli and it was very clear that the premiumisation of chocolate was something that the majors had wanted to get into and hadn’t really succeeded in doing,” Thorne noted.
“There was an opportunity to build a global business and they’ve done that very slowly and haven’t really monetised all of that,” he added, but said the business is growing strongly and has the potential to be a big contributor to the market in the future.
“If you looked down my portfolio you would say those three are my domestic exposure but the reality is they are growing from an international point of view even though their UK bit is still growing as well,” the manager added.