Although some investors remain cautious over backing UK small-caps in the current climate – with Brexit uncertainty overhanging the market – there are those who believe backing smaller growth companies in certain sectors could see solid returns over the long term.
While those companies whose revenue is generated largely in the UK are likely to bear the brunt of any new tariffs and the pressure on sterling from Brexit-related crosswinds, some smaller businesses could also prove Brexit-proof and outperform regardless of the macroeconomic environment.
This is due to the fact that they often operate in niche areas of the economy – such as the technology, media or healthcare sectors – and are less affected by top-down themes.
As data from FE Analytics shows, since the EU referendum in June 2016, the FTSE Small Cap index has outperformed the FTSE 100 and FTSE 250 indices by 5.33 and 12.68 percentage points respectively with a total return of 27.09 per cent.
Performance of indices since EU Referendum
Source: FE Analytics
Below, FE Trustnet considers two highly-rated smaller companies strategies – Standard Life Investments UK Smaller Companies and Liontrust UK Smaller Companies – and ask fund pickers which of the two they prefer.
The first of the two is the four FE Crown-rated Standard Life Investments UK Smaller Companies, that has been run by FE Alpha Manager Harry Nimmo since launch in the late 1990s.
As the analysts at Square Mile Investment Consulting & Research noted, the fund’s underlying investment process is based upon Standard Life Investments’ ‘focus on change’ philosophy.
This consists on the belief markets are inefficient at valuing a company’s fundamental when it is going through a period of structural change.
“Nimmo’s basic premise is to uncover and invest in organically growing companies that have the potential to be tomorrow’s larger companies,” the analysts said.
“To do so, he looks for companies with sustainable business models, recurring revenues and cash flows and ultimately prefers lower risk businesses that are already profitable.”
Another key differentiator of the experienced manager is the use of its proprietary quantitative screen called ‘Matrix’, which assists in idea generation and monitoring existing holdings by scoring and ranking companies based on variables such as value, growth, dynamic and quality factors.
The second fund under consideration is the five FE Crown-rated Liontrust UK Smaller Companies, which is overseen by FE Alpha Managers Anthony Cross and Julian Fosh, who were latterly joined by Victoria Stevens and Matthew Tonge in 2015.
As Willis Owen head of personal investing Adrian Lowcock noted, Liontrust UK Smaller Companies offers a distinctive approach to investing in smaller companies with a focus on the intangible assets of a business: including its intellectual capital, distribution channels and repeat business.
This approach, Lowcock said, tends to lead to a bias towards less capital-intensive businesses in support services, technology and media.
“The fund tends towards smaller companies in its space and the managers are not concerned about benchmarks,” he explained. “Given the unique style, this fund is a good diversifier for investors looking for something different.”
Performance of fund vs sector and index since launch
Source: FE Analytics
Indeed, the Liontrust fund has a higher emphasis on small- and micro-caps with 70 per cent invested in the FTSE AIM index and a 12.6 per cent in the FTSE Small Cap (ex ITs) index. The Aberdeen Standard strategy is more tilted towards mid-cap stocks, with a 42.3 per cent weighting in FTSE 250 stocks.
Another difference between the two is size, with the £866.9m Liontrust UK Smaller Companies fund almost half the size of its £1.5bn peer, something Charles Stanley Direct pension and investments analyst Rob Morgan noted, makes it easier for the Liontrust team to introduce new ideas.
His views are shared by Andrew Merricks, head of investments at Skerrits Wealth Management, who said while both are “really good funds” he favours the Liontrust strategy.
“When we launched our model portfolios in 2008, we held both but got burnt when Standard Life soft-closed their fund and had to sell out of it,” Merricks said.
“That remains a concern for us as it is still very large for a small-cap fund, which probably explains its mid-cap holdings for liquidity purposes.”
He added: “Liontrust does concern us as well as it is not too far below the £1bn level, at which any smaller companies fund must be considering its ability to continue unchanged.”
Merricks said what appeals to the team at Skerrits Wealth Management is its stability – although it’s sold-off quite aggressively in the last month or so – and relatively low volatility.
“We made the decision in June 2016 to withdraw completely from the UK as an investment opportunity, except the Liontrust UK Smaller Companies fund which we continued to hold to good effect,” he said.
“If we were to buy the Standard Life team again, we would probably do so through their closed-ended alternative rather than the open-ended fund,” Merricks concluded.
Indeed, Nimmo also oversees the £447.4m Standard Life UK Smaller Companies trust, a closed-ended vehicle that is run with a similar investment approach. As opposed to the open-ended strategy, Standard Life UK Smaller Companies trust has a lower weighting to FTSE 250 stocks (31.7 per cent) and a higher exposure to the FTSE AIM (35.9 per cent) and FTSE Small Caps (20.1 per cent) indices.
The trust is trading at a 6.4 per cent discount to its net asset value (NAV) and is not currently geared, data from the Association of Investment Companies (AIC) shows.
While Standard Life Investments UK Smaller Companies and Liontrust UK Smaller Companies have both delivered “impressive long-term returns” and are overseen by highly experienced and respected investors, said Chelsea Financial Services managing director Darius McDermott, he prefers the Liontrust fund.
“Liontrust has better risk-adjusted returns though, with over 30 per cent less volatility over a five-year period,” he explained. “One reason behind this is due to the Liontrust fund having less economically-sensitive holdings, which comes about through the more flexible process. This downside protection has allowed it to outperform.
“Both funds are both considerably above-average against their peers and exhibit well-defined and repeatable processes, but due to the extra flexibility and adaptability in the process, which has shown better downside protection, we prefer Liontrust at this point in time.”
Performance of funds vs sector over 5yrs
Source: FE Analytics
Liontrust is leading the pack over five years, up 100.15 per cent compared with a 65.59 per cent total return by Standard Life Investments UK Smaller Companies and a gain of 54.93 per cent for the average fund in the IA UK Smaller Companies sector.