Get cheap, reliable growth from smaller companies

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The notion that "what goes up must come down" is hardwired into the thinking of many investors, but buying what's down and selling what's up is a dangerous game when it defies persistent long-term trends. One of the most reliable of these is the long-term outperformance of smaller companies.

There are many reasons for this, but renowned stockmarket operator Jim Slater summed them up in the observation that "elephants don't gallop". Nearly 30 years ago, the London Business School showed that small companies (the bottom 10% of the All-Share index, now the Numis Smaller Companies index) in the UK had outperformed the FTSE All-Share by 3.4% a year since 1955. This has continued at the same rate this millennium. It is also replicated in nearly all markets, although the global average is rather higher, at 5.2% a year. In 2017, however, the Numis index returned 18.8%, nearly 6% ahead, while thanks to a poor year in the US the global average was zero.

Smaller, but mighty

By most standards, these are not particularly small companies; the cut-off for the Numis index is a market value of £1.5bn. This covers 703 companies, of which nearly half are actually investment companies. Including companies listed on Aim, all but six of which are below the Numis valuation cut off, increases the number to 1,655 (of which 390 are investment companies), and the combined value to £360bn. Aim historically held back combined returns, but in 2017 it boosted them to 20.6% evidence that Aim, after a poor first 20 years, is performing at last. Medium-sized companies performed similarly, so it is only the FTSE 100, and in particular the very largest companies, that held the overall market back. Yet the FTSE 100 accounts for more than 75% of the All-Share index.

Logic suggests that persistent outperformance would result in a premium valuation, but this is not so. The valuation of the Numis index (excluding investment companies) is, at 14.3 times earnings, above its long-term average of 12.8. But, in the last 40 years, it was only lower relative to the overall market at the end of the 1990s. Smaller stocks are not necessarily cheap in absolute terms (though expected earnings growth of 11% suggests they are good value), but they are well placed to beat larger companies.

Investors are spoilt for choice

Even more surprising is that small and mid-cap trusts trade on wider discounts to asset value (the value of the underlying portfolio) than those investing primarily in larger firms. These discounts narrowed in 2017, but still averaged 11% at the end of the year. This isn't due to poor performance the average fund in these sectors has beaten its benchmark index over one, three and five years. Investors are almost spoilt for choice.

BlackRock Smaller Companies Trust (LSE: BRSC), its stablemate Throgmorton (LSE: THRG) and Henderson Smaller Companies (LSE: HSL) all trade on double-digit discounts, despite having returned more than 30% last year. Standard Life UK Smaller Cos (LSE: SLS) is on a discount of only 3%, but also returned 30%-plus, as did JPMorgan Smaller Companies (LSE: JMI), on a discount of nearer 20%, thanks to duller performance over three and five years. JPMorgan Mid-Caps (LSE: JMF), on a discount of 6%, is the star performer in its area, having also returned 30% in 2017. Aberforth Smaller Companies' (LSE: ASL) focus on value rather than growth means it's lagged the others, but it would benefit from a change in wind direction.

An update on my tips

Back in January, I picked the River & Mercantile UK Micro Cap trust as an investment idea for 2018. The reported departure of its manager, Philip Rodrigs, as a result of "a professional conduct issue", is very disappointing, although the company notes that this was "unrelated to his portfolio management responsibilities". Rodrigs' deputy on the trust, George Ensor, has stepped into his shoes and is well supported by Daniel Hanbury, a highly regarded small-cap manager. The outlook for smaller stocks in general, and micro-caps in particular, is very favourable (see above), so existing holders of the trust should stick with it. New investors, however, might prefer to wait and see how the fund settles down without its star manager.

Short positions a run of bad luck for Woodford

Neil Woodford's Equity Income fund has lost more than a fifth of its assets since May, says Attracta Mooney in the Financial Times, as investors react to "a series of bad bets and disappointing performance". The fund's assets under management fell from an all-time high of £10.15bn last May to £8.2bn in December, after a year in which the share price at several of Woodford's large holdings, including doorstep lender Provident Financial and technology investment company Allied Minds, fell sharply. And the problems have continued this year, notes Mooney. The fund manager saw a loss of roughly £40m on paper after the share price of outsourcing company Capita fell by 47% last Wednesday. Over the past 12 months, the fund has lost more than 2%, while the Investment Association's UK equity income benchmark is up 10%.

Scottish fund house Baillie Gifford plans to launch a US-focused patient-capital investment trust, says Yoosof Farah on Investment Trust Insider, in what would be its first new investment company in 32 years. The trust would start off as a mirror of the £1bn Baillie Gifford American fund, which invests in listed large-cap US stocks, but would gradually shift "increasingly off market" as managers find unlisted investments. The firm is targeting a £200m initial public offering, and Baillie Gifford partners are backing the trust with around £10m to £20m of their own money.