Small-caps have been deeply out of favour in the UK and elsewhere.
Every month over the past year, the size of small-cap equity funds has shrunk by a third, contracting from £14.5bn five year ago to £9.8bn today, according to data from the Investment Association. This shrinkage has been caused by both outflows and disappointing returns, which have averaged at -15% over the past three years.
But with UK economic growth now improving, inflation easing and signals that a rate cut could come as soon as next month, some of this negative sentiment could start to lift, according to Bestinvest managing director Jason Hollands.
He declared: “It could be quite an interesting time to dip the toes back in.”
“Small-cap stocks are inexpensive and another factor to consider is that the whole UK market is basically up for sale to international bidders at the moment, who can see plenty of value opportunities,” he added.
His message was echoed by Sheridan Admans, head of fund selection at TILLIT, who said the expectation that rates have stabilised or will potentially be cut later in the year “has provided a catalyst for rising investor interest”.
FundCalibre managing director Darius McDermott added that today’s cheap valuations, which are unlikely to last over the long term, represent a “good potential entry point”.
For investors who are tempted by these opportunities, below is a selection of domestic and international small-cap funds to consider.
UK small-caps
Hollands went with the River & Mercantile UK Listed Smaller Companies fund and, for investment trust fans, Henderson Smaller Companies.
The former is managed by George Ensor with a focus on the smallest 10% of companies on the UK market.
“The ES River & Mercantile process includes growth, value and recovery buckets, so the fund has performed well in a variety of market environments,” he said.
Henderson Smaller Companies, managed by veteran Neil Hermon, includes exposure to mid-cap stocks in the FTSE 250.
“It has a quality growth approach and will ‘run its winners’, holding on to its winners as [they ascend] into the mid-cap arena. In common with most UK equity investment companies, it is trading at a fairly big discount at the moment, -13%, which should appeal to bargain hunters,” Hollands concluded.
Admans also admires the River and Mercantile fund, but suggested the Aberforth Smaller Companies trust as another option, with its “unique approach” to investing in companies that are out of favour.
“Its focus on turnaround stories or value investing is a refreshing alternative to the more popular growth-focused funds in the market,” he said.
“What sets Aberforth apart is its team-based approach and its emphasis on dividends and a company's ability to pay them.”
Despite its success, the trust is currently trading at an 11.6% discount to its net asset value, presenting “a great opportunity for investors who are looking for exposure to Aberforth’s specific niche of deep value UK small-caps”.
Other picks included Liontrust UK Micro Cap, favoured by Pharon Independent Financial Advisers head of fund solutions Andrew K O’Shea. It has been "successfully managed" on a team approach by Anthony Cross, Julian Fosh, Victoria Stevens and Matt Tonge since its launch in March 2016 and they have more recently been joined by Alex Wedge and Natalie Bell.
The fund is managed using the "Economic Advantage" investment approach that looks to identify companies with a durable competitive advantage by generating – and more importantly, sustaining – a higher-than-average level of profitability.
"Companies that are successful in gaining a place in the portfolio must also have a minimum percentage of the share ownership held by senior management," said O'Shea.
"The fund currently has a bias towards the technology and industrials sectors, which together account for approximately 50% of the portfolio."
McDermott highlighted the IFSL Marlborough UK Micro Cap Growth fund, which has gone through a period of poor performance due to its style being out of favour but “will recover when the wind changes”.
Small-caps overseas
But it’s not just in the UK that smaller companies could come rally from their low valuations. McDermott was also bullish on US and European small-caps, where many world-class, high-quality companies are trading below their intrinsic value.
To tap into a European small-cap recovery, he highlighted Janus Henderson European Smaller Companies.
“Backed by a large and experienced investment team, this is a true stock picker’s fund where the managers are happy to invest across the entire universe to deliver returns,” he said.
For exposure across the board, abrdn Global Smaller Companies is a “textbook global small-cap fund”, said McDermott.
Based around abrdn’s screening tool 'Matrix', which former co-manager Harry Nimmo helped create, it identifies smaller companies from all around the globe, including in emerging markets, that are believed to have the best growth prospects.
Finally, for investors looking for exposure to the largest stock market in the world and one of the most dynamic parts of it, Admans chose the Artemis US Smaller Companies fund.
“The managers take a flexible approach and aren’t wedded to either growth or value but they look for the large companies of tomorrow,” he said.
“As such, there is a slight preference for long-term structural growth sectors like technology and healthcare. The team managing this fund has significant experience and a track record of investing in US small-caps.”
Investment decisions are driven by both macroeconomic views and bottom-up stock picking, he added.
