Three ways to invest in small-cap stocks

Small-cap stocks should be a core part of your portfolio but make sure you pick managers with complementary strategies, says Jon Rebak.

For many years, investors have bought into the idea of a "small-cap premium" the theory that stocks with a low market capitalisation can be reliably expected to earn higher returns on average than stocks with larger market caps. Whether this premium really exists is unclear (see bottom) andI would not rely on it to underpin my investment decisions in any case. However, I still like to include small caps in my portfolio, mainly through funds. If you exclude small caps, you've decided to ignore about 90% of the available stocks in the world, which is a bit blinkered. In addition, because research coverage of smaller companies tends to be limited, there are likely to be significant rewards for those who can unearth opportunities.

Investors typically add small-cap funds as a small "satellite" position on top of a "core" of large-cap funds. I take a different approach and believe that small-cap investments should be a material part of a portfolio. I also think that it's wise to hold a number of small-cap funds, since any fund is likely to do well in some market environments and not so well in others. Small-cap managers vary in the type of companies they look for and by typical valuation or profitability metrics that drive their buy and sell discipline, so it's sensible to look for managers who have different approaches and time horizons.

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Some investors think that small caps have been left behind by larger companies of late and are due a period of outperformance. I'm not so sure. Although smaller stocks trade at a decent valuation discount to larger ones, recently their price momentum has been quite strong. So it makes sense to be selective, rather than buying small caps indiscriminately. I believe that this environment favours an active approach rather than using a tracker fund to invest in the small-cap segment and suggest the following three small-cap funds (I am invested in all three).

A long-term fund to lock away

My first recommendation is Artemis UK Smaller Companies Fund, an open-ended fund managed byMark Niznik. He invests in companies that have a good business model, solid financials, potential for decent earnings growth, high return on capital (a measure of profitability) and an attractive valuation (as measured by free cash-flow yield). Mark is very self-reliant and most of his day-to-day work is based on company meetings to understand each company's strategy and business plan. He has been following this approach at Artemis and previous funds for about 20 years. The result is a growth-orientated portfolio that has defensive characteristics: he tends to avoid companies that are obviously cyclical and the fund has a bias towards higher-quality businesses. The holding period on his investments can often be long, with quite a lot of adding to and trimming of positions as valuations change.

Historically, Mark's strategy has tended to lag when smaller companies are doing well. However, the fund's lower volatility (compared with peers) was one of the reasons I liked it, and hence could usually conjure up a good reason to own the fund in the client portfolios I managed. If your main concern is absolute returns (rather than returns relative to a benchmark), this is the sort of fund to lock away and forget about at least until Mark decides he's had enough. My main complaint is that this is a unit trust rather than the newer open-ended investment company (Oeic) structure and hence operates split pricing (one price for buying and one for selling). This means that you are likely to pay more ofa spread than I would like when you first invest.

A tactical trading opportunity

My second pick is Aberforth Smaller Companies (LSE: ASL), an investment trust. Aberforth Partners, the manager, follows a value approach, and has been investing solely in UK small caps since 1990. Currently there are seven managers in a team that has seen a few changes in recent years. Ideas generated by the team members, who have different sector-research responsibilities, compete for space in the three funds that Aberforth runs. Assets under management (AUM) in these funds are circa £1.8bn, which seems like quite a lot for successful active management, but active share which is a measure of the difference between the fund and its benchmark is a healthy 75%. It is worth remembering that significant AUM is less of a problem for a value manager than a growth manager, because the value investor is typically buying when others are selling and vice versa.

This trust is not an investment you should buy and forget about, because the underlying stocks tend to be sensitive to expectations about the global economy. As a result, I've found good trading opportunities to add value by buying and selling the trust over time. The strategy worked quite poorly over the past year or so, but performance reached a nadir just after the result of the EU referendum. After doing a back-of-the-envelope calculation on the value of the underlying portfolio using Aberforth's favourite valuation metric (enterprise value/earnings before interest and tax EV/Ebit), I thought this was a good time to buy. In addition, the trust's shares were trading at a discount to net asset value (NAV) in excess of 15%. Although the shares have rallied, the discount is still decent at 14%.

Provided the global economy continues to behave itself, I think a small-cap value strategy still has some way to go. Portfolio gearing is currently minimal, which says to me the managers are not gung-ho about prospects, and in the trust's latest results Aberforth conducted a valuation scenario test for the portfolio under recession conditions that I thought provided some comfort. This trust is one of my larger holdings at the moment.

A high-conviction micro-cap trust

My final recommendation is River & Mercantile UK Micro Cap (LSE: RMMC), a Guernsey-registered investment company. The manager, Philip Rodrigs, joined R&M from Investec in 2014 and manages two other funds for R&M (Smaller Companies & Dynamic Equity). He is one of three equity fund managers at the firm, which is a mid-sized boutique. The trust targets mostly Aim-listed stocks with a market cap of £100m or under. This is a high-conviction strategy, with the largest holdings being very material parts of the portfolio (although holdings are reasonably diversified across sectors). An additional risk is that the fund may sometimes hold a significant percentage of a company's shares.

Rodrigs appears to be tapping the appetite for entrepreneurial capital among small UK companies that have an opportunity for transformational growth. There is little real underlying economic exposure to the UK and large weights to the technology and services sectors, particularly firms that have a unique market position that can grow independently of the global economy. Many of the investments have been seeing rapid revenue growth, but some have not yet translated this into profits. These companies can be very susceptible to news and speculative flows, and volatility and underlying share-price dispersion should be expected to be high.

The share price has recently risen strongly and caught up with underlying NAV, having traded at a discount of 10% on occasion over the past year. The trust has a market capitalisation of £100m and liquidity in the shares is low, which means the trading spread is high. Investors should note the trust is allowed to carry out a compulsory redemption of some shares and return capital to investors if the NAV exceeds around £110m in order to prevent the portfolio growing too large for successful micro-cap investing. After the run-up, I wouldn't be surprised to see a period of consolidation and indeed the discount has recently widened to 5% again. However, this is an investment that I hope to own for the long term.

Is the small-cap premium real?

There is some evidence that small-cap stocks have earned higher returns than large-cap stocks, but the data is highly variable and there are long periods when they don't. Early research by Eugene Fama and Kenneth French found that from 1927 to 1981 US small caps outperformed larger companies by 3.1% per year. However, during the 1950s and 1980s, small caps lagged the wider market.

Some more recent studies have shown a smaller premium of about 1%, while others show negligible differences. One possible explanation of a declining premium is the proliferation of small-cap funds competing for opportunities. Most studies focused on the US and there is less evidence of a small-cap premium in other markets such as Europe, Japan and Asia.

Over long periods, small-cap value has a better record relative to large-cap value. Most small-cap growth stocks don't outperform (just as with large caps), as investors typically overpay for growth. Index funds are not ideal for small-cap investing as they usually screen out the most illiquid stocks, which may offer higher expected returns.