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Darius McDermott: Five timeless small-cap funds boasting big returns

03 September 2018

Chelsea Financial Services managing director Darius McDermott highlights five of his favourite smaller companies-focused funds from a number of different markets.

By Darius McDermott,

Chelsea Financial Services

It's been a difficult time for investors to have much conviction in anything. Valuations across the board are looking stretched, and we're now almost 10 years into a bull run.

However, one investment that I think is timeless is smaller companies. If you pick the right manager and hold them for several years, you have a great chance of beating the market and really putting your cash to work. Below, I've picked out five of my favourite small-cap funds from different regions.

 

LF Livingbridge UK Micro Cap

Within the home market, I've opted for LF Livingbridge UK Micro Cap, which is managed by Ken Wotton. As its name suggests, the fund will only hold companies which are at the very end of the market cap spectrum – at less than £250m in size at initial investment – and will hold these for between three and five years.

These companies are chosen based on a number of factors; Ken wants to hold firms which can grow quickly, but stably. Ideally he looks to invest in companies which can double in size within five years, and which are run by sensible management teams with long-term time horizons. The manager also looks for any companies which could get targeted with a takeover bid.

Ken is unafraid to hold significant positions in companies that he believes in. For instance, his largest holding Impax Asset Management accounts for 4.79 per cent% of the overall portfolio. In total, the portfolio consists of 46 holdings.

 

Mirabaud Equities Europe Ex-UK Small and Mid

A complementary smaller companies fund – given it won't invest in UK equities – is Mirabaud Equities Europe Ex-UK Small and Mid. It is headed up by Ken Nicholson, who has been working in asset management for more than 30 years. He looks for the 'hidden champions' which have often been overlooked or under-researched by the broader market; he does this through meeting the management teams themselves and ignoring most macroeconomic factors.

In fact, the team is so focused on meeting managers that they plan out intensive and targeted road trip programmes – both to seek out new investment ideas and to keep up-to-date with existing holdings.

There is also a quantitative arm to Ken's stock selection. Before even deciding to meet managers, companies must pass a rigorous 13-screen process, which filters out any firms which are too speculative, are reliant on single bets, or which are overly sensitive to any index movements. The fund has a very concentrated portfolio of just 30 holdings.

Hermes US SMID Equity

On the other side of the pond, lead manager of Hermes US SMID Equity Mark Sherlock hand-picks US stocks with market caps of between $1bn and $20bn. He looks for high-quality businesses with minimal debt, and which are in industries with high barriers to entry. Essentially, it is very much a plain vanilla, bottom-up stock selection equity fund. This is by no means anything to be sniffed at; it means the fund tends to do exactly what it says on the tin and shouldn't expose investors to any nasty surprises. By Mark's admission, he is avoiding the shooting stars and seeking out the firms that have fallen under Wall Street's radar, with the firm belief that the tortoise always wins the race.

The fund's stock selection process starts with looking at the Russell 2500 index and removing any capital-intensive companies or companies with too much debt on their balance sheets. From here, the manager seeks out businesses with sustainable competitive advantages and strong balance sheets.

This leaves him with a watchlist of around 200 stocks, which is whittled down through management meetings and detailed company analysis.

 

Baillie Gifford Global Discovery

Baillie Gifford as a company has growth at its core and, in our view, Baillie Gifford Global Discovery is the purest embodiment of this. Manager Douglas Brodie hunts out innovative small-cap firms which are ahead of the game in terms of their use of technology and being able to adapt to our changing world. As such, the fund tends lean towards tech stocks and currently has a notable bias towards e-commerce firms; its list of top 10 largest holdings includes Ocado, US home goods company Wayfair and mobile food ordering company Grubhub.

The team isn't afraid to pay up for high-quality firms which can grow faster than their peers. Douglas prioritises capital-light, early-stage companies with sustainable competitive advantages and a firm eye on the future.

It will hold between 75 and 150 stocks at any one time, across no more than six different regions. The fund tends to be more volatile than its peers because of its growth bias and focus on start-ups, but investors with a strong stomach and some patience could be well rewarded.

 

F&C Global Smaller Companies investment trust

For those looking for an investment trust, F&C Global Smaller Companies investment trust could be a good option. It is managed by Peter Ewins, who believes that picking stocks is far more important than investing in the right sectors or in the right economies. As such, he is not afraid to look for high-quality stocks in unloved or overlooked areas of the market. Ultimately, Peter looks for firms with strong franchises and motivated management teams, and which are attractively valued.

While smaller companies tend to be more volatile than their larger peers, the investment trust structure lends itself to investing in this part of the market. This is because they are better equipped to deal with illiquid holdings; if a large investor moves in or out of an open-ended fund, it can affect the share price. With a trust, however, money cannot be removed freely and shares have to be sold.

Peter can also take advantage of his ability to use gearing, which means he can borrow money to make further investments if he sees a wealth of opportunities.

Darius McDermott is managing director of Chelsea Financial Services. The views expressed above are his own and should not be taken as investment advice.

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