Don’t write off small companies

Most professional fund managers would happily avoid smaller companies. They are poorly researched, individually risky and very labour-intensive. The entire market value of the bottom 10% of the UK market, excluding those that are investment companies, is less than that of the UK's largest company, Royal Dutch Shell. If they didn't consistently outperform, investors would avoid them.

However, over the last 62 years, the Numis Smaller Companies index, which measures the performance of smaller quoted UK companies, has beaten the FTSE All-Share by an annualised 3.4%, according to research by Elroy Dimson and Paul Marsh of the London Business School. This is part of a global phenomenon; the average small-cap outperformance globally since 2000 has been 5.5%. This trend continued in 2016 with a 5% outperformance globally.

Unusually, the Numis index lagged the broader market by 3.9% last year. Research by Dimson and Marsh shows that this was the result of the fall in sterling that accompanied the vote to leave the EU. At that time, the relative performance of small- and mid-cap companies fell behind, and only partially recovered in the rest of the year. (In absolute terms, they still posted double-digit returns.) Digging deeper, the professors worked out that 72% of the sales of FTSE 100 companies occurred overseas.

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This was true for only 46% of FTSE 250 companies' sales, and 41% for the Numis index, meaning they benefited less from sterling's devaluation. They also compared the move in the overall market with that in the year following three previous and comparable devaluations. Interestingly, this research suggests that the All-Share index should move much higher in the next six months, having returned just 11% since the devaluation, compared with a historical average of nearly 40% over a year. The potential upside for smaller companies as the benefit of sterling's devaluation spreads could be higher.

What about the outlook for 2017?

In anticipation of a jump in earnings, which is probably justified given the devaluation, the All-Share index was re-rated in 2016 from 16.8 times earnings to 18.8 times. But the Numis index, excluding investment companies, was de-rated from 14.6 to 12.5 times earnings. The 33% discount of the Numis index to the broader market has only been higher once in the last 40 years, during the mega-cap bubble of the late 1990s. Therefore, strong out-performance looks highly likely in 2017, and even more likely on a two-year view.

This could prove an excellent time to invest in small firms and potential investors are spoilt for choice. There are 11 investment trusts in the UK small-cap sector and a further two micro-cap trusts. On average, these trade at a 15% discount to net asset value (NAV), which should come down, enhancing returns, as performance picks up.

Smaller company trusts from BlackRock (LSE: BRSC) and Henderson (LSE: HSL) trade on especially attractive discounts to NAV, while offerings from Strategic Equity Capital (LSE: SEC), Standard Life UK (LSE: SLS) and Invesco Perpetual (LSE: IPU) all trade on lower discounts to NAV.

All have good records all told, eight of the 11 mangers outperformed over the last five years. However, the largest trust in the sector is Aberforth (LSE: ASL). This does not invest in Aim stocks, nor does it use gearing and it is unusual in being a value rather than a growth investor. Growth has outperformed value in the small-cap sector in recent years, which raises the question of whether the fortunes of value managers may be about to turn.

Funds news round-up

Nine out of ten customers of Hargreaves Lansdown, the UK's largest execution-only stockbroker, do not hold a single passive fund in their portfolio, says Aime Williams in the Financial Times. Although this has increased from 6% of customers in 2011 to its current 10%, the vast majority of customers still remain faithful to more expensive, actively managed funds.

This comes despite abundant evidence that these funds mostly underperform their benchmarks after fees: 86% of actively managed equity funds in Europe underperformed their benchmark over the past decade, according to a study published last year by data provider S&P Dow Jones indices. The Financial Conduct Authority, the UK finance services regulator, recently voiced concerns that financial advisers and online fund supermarkets were "not doing enough to promote passive funds to customers", notes Williams. It found that only 6.9% of the funds sampled from brokers' "best-buy" lists were passive funds.

Index-tracker provider Vanguard has cut the charges on its LifeStrategy fund range for the third time since it launched in 2011, say Dylan Lobo and Gavin Lumsden on CityWire. The firm has reduced the annual ongoing charge on its five LifeStrategy funds, which hold varying proportions of equities and bonds, from 0.24% to 0.22%. The most recent reduction makes Vanguard's funds slightly cheaper than the 0.22% 0.23% charge levied on a comparable range offered by rival BlackRock. These fees compare with an average of around 0.75% for active funds.

Activist watch

Railway veteran Hunter Harrison is teaming up with activist investor Paul Hilal in an attempt to "shake up management" at Canadian railroad company CSX, say David Benoit and Jacquie McNish in The Wall Street Journal. Harrison recently stood down as chief executive of rival Canadian Pacific, a role he won after a "brutal proxy fight" which ended in Hilal's former fund, Pershing Square Capital Management, taking control of the board. During his time at Canadian Pacific, Canada's second biggest railroad by revenue, Harrison cut costs and improved the company's margins, while also attempting to consolidate the industry. It is expected that the pair will try to put Harrison in a senior management position at CSX.