Star fund manager Neil Woodford got into trouble with small, illiquid assets. Scott Longley explains what investors should look out for when sizing up smaller companies.
Of all the issues highlighted by the implosion of the Woodford Equity Income Fund, liquidity is perhaps the most worrying. No one likes to feel they have been trapped by events outside their control. In the Neil Woodford saga there are two conflated issues. Firstly, the liquidity of the fund; secondly, the liquidity of some of the underlying firms. It is in the latter respect that some clarification of terms would be a good idea.
“There is some real ambiguity in this area,” says Gervais Williams, senior executive director and fund manager at Miton. The term small cap can apply to a company that is worth £50m or more, or “some loss-making, privately owned businesses where valuations are completely speculative”. Moreover, companies can be illiquid in different ways depending on who has the holdings and how much of a company’s shares they control. A company worth, say, £10m, but with a spread of investors, could be more liquid than a company ten times the size, but with one very large shareholder on the register.
More broadly, Williams worries that if investors are scared off smaller companies because of limited liquidity, it will cut off access to the most dynamic sector of the economy and hamper its growth. We should be funding “companies that provide employment and taxes. It is profoundly adverse for the economy if we aren’t doing that”.
The liquidity opportunity
Perhaps counter-intuitively, one important element when it comes to smaller listed companies is that illiquidity is one of the things that makes them attractive as an investment. “Sometimes the lack of investors in a company is the whole point,” says Stephen English, head of Aim at Liverpool-based investment managers and stockbrokers Blankstone Sington. “An element of good investment practice is… identifying good companies [and] getting on board early,” he says. “Then you can benefit when the institutions can no longer ignore the stock and have to buy in at higher ratings.”
Last year a regulatory change, Mifid II, made hunting for bargains easier. Owing to the mandated separation of research from other fees the universe of stocks covered by analysts has shrunk, with fewer brokers following fewer companies. “We have been helped by Mifid II,” says Paul Mumford, fund manager at Cavendish Asset Management. “That has led to fewer brokers so it is in effect easier to find hidden gems, companies that simply have no one following them. The value in these companies will emerge in due course.”
The buy-and-hold mantra of long-term investing is especially relevant to companies at the smaller end of the scale. “I’m a big fan of investment into unquoted and illiquid firms,” says Ben Yearsley, director at Shore Financial Planning. “However, with this type of investment you need to buy and forget about it for at least a decade. Unfortunately most investors don’t have the patience for patient capital. Woodford had the right structure with the Patient Capital Trust, but I’m not sure that he had the right type of investor.”
Expect the unexpected
Just being a long-term investor doesn’t insulate anyone from mishaps, of course. While Aim has gone some way towards shedding its “Monaco” reputation – a sunny place for shady firms – unexpected blow-ups still occur, with Patisserie Valerie being the most recent example. This is why opting for an Aim fund makes more sense for most people than investing directly in shares. Mumford points out that no one firm will be worth more than 1.5% of the total fund. “If something goes wrong, I won’t lose much,” he says.
Others are more worried about being in companies that are too rich for their tastes. In the realm of Aim IHT portfolio services, for instance, most are invested in a similar basket of popular qualifying stocks. English, who works in this area, says he tries to avoid the names that recur the most within other portfolios. English is referring to the potential for the government to look again into the tax treatment of shares in companies that qualify for business relief. Unfounded fears late last year that the Treasury was primed to make a move were among of the factors behind the fourth-quarter slide in Aim share prices.
With Aim stocks and other small caps, outside events have to be monitored as much as with large caps, but always bear in mind the potential for greater losses due to illiquidity, greater volatility and a higher chance of corporate failure.
“However, if you get it right then the rewards are potentially much greater than, say, with FTSE 100 companies,” says Yearsley. As long as investors are aware of the risk and reward of small caps – and the problem with Woodford is that many would appear to have been unaware of just how risky some of his investments really were – then issues around liquidity shouldn’t loom too large.