Eustace Santa Barbara: How UK smaller companies can make a difference to a portfolio

In light of the turmoil, many investors are now looking further afield in a bid to optimise risk and return in their portfolios. But exactly what might they seek out in the vastness that lies beyond the realm of Big Tech?

UK smaller companies have been largely unloved for some years. They have felt the full force of a perfect storm, the principal elements of which have included the COVID-19 pandemic, inflation and rising costs.

Now, finally, there are several reasons why they could at last regain wider attention. Although smaller companies can be disproportionately impacted by market downturns, many have demonstrated tenacity in the face of multiple challenges. In addition, a history of long-term outperformance remains on their side¹ .

Yet identifying a genuinely promising UK smaller company is by no means easy. It tends to be somewhat trickier than, say, discerning the appeal of a US tech titan worth trillions of dollars.

As a result, this is an arena in which it can be useful to have an edge. So where might such an advantage be found? This is where market knowledge, direct engagement and informed stock-picking can make a difference.

The importance of specialist insight

As well being underappreciated, UK smaller companies are under-researched – sometimes massively so. They are relatively overlooked even by investment analysts, the people whose work is central to buy and sell decisions worldwide.

As Marlborough’s own surveys have revealed, the number of analysts likely to monitor a business can vary substantially. Market capitalisation is usually a decisive factor in this respect.

Each constituent of the FTSE 100 Index, which is home to large-cap businesses typically valued at more than £8 billion, might be “eyeballed” by around 20 analysts. A member of the FTSE 250 Index, which is the domain of mid-cap companies typically valued at between £1.6 billion and £8 billion, might have an audience of around 10.

Meanwhile, at the other end of the spectrum, the figure for micro-cap companies – that is, those typically valued at between £40 million and £235 million – is normally two or fewer. In other words, it is often zero.

This dramatic decline in coverage may sound like bad news for investors keen to unearth opportunities in the lesser-known reaches of the equity sphere. But all is not lost.

We believe such a landscape strengthens the hand of investment teams that carry out their own research. We also believe it is very much to the advantage of fund managers whose track records make them a first port of call for specialist brokers able to spot hidden gems.

Understanding the potential of undervalued stocks

In addition to being underappreciated and under-researched, UK smaller companies are frequently undervalued. This mispricing persists even though many have solid business models and a capacity for growth.

Such anomalies can favour “early adopters”. Investors who buy shares in an undervalued stock before the wider market acknowledges its long-term promise may get the most out of its recovery and subsequent success.

With this aim in mind, there could be occasions when quantitative analysis alone is insufficient to reveal the full extent of a business’s potential. As experienced stock-pickers, we consider face-to-face engagement also essential.

Meeting executives at smaller companies can tell us a great deal about an organisation. Many have a much more detailed and intimate understanding of their companies than their large-cap counterparts.

We are especially interested in the relationship between a CEO and a CFO. Is the latter willing to stand up to the former? Do they share a vision and a pragmatic strategy? Is their dynamic likely to underpin or undermine the way ahead?

Just as significantly, managements need to recognise our role. As active shareholders, we expect the best. Our job is to ensure a business survives and thrives. On behalf of clients and other stakeholders, we want our investment to deliver maximum benefit.

Diversification still matters

Armed with all this information – derived from both analysis and engagement – we are much better equipped to navigate a fascinating corner of the investment universe. We can feel confident about our choices.

Such an approach might be used for numerous asset classes and regions, of course. In-depth research, strong relationships and an on-the-ground presence can help in many investment settings.

In our view, however, the difference made is far more substantial in some cases than in others. This is particularly true of investment sectors that suffer from an undeservedly low profile.

UK smaller companies offer a classic illustration. This is a long-overlooked space in which it is possible to profit from drawing on a level of insight most would-be market participants are likely to lack.

Not least when volatility strikes, such an edge could help mark the line between resilience and vulnerability for a portfolio. The fact is that a sensibly balanced asset allocation still matters – even in the age of Big Tech.

There will probably always be investors who put all their eggs in one basket. But over the long run, as recent events have reminded us all, it is those who diversify who are likely to bring home the bacon.

^1. See, for example, Deutsche Numis: “Smaller Companies Index” – https://dbnumis.com/equities/deutsche-numis-indices#:~:text=Over%201955%2D2023%20the%20Deutsche,larger%20companies%20by%202.9%25%20p.a

‍

‍

The value of equities (shares in companies) may fall as well as rise. As a result, investors can lose some or all of their investment. Investment in smaller companies can involve greater risk than is generally associated with investment in larger, more established companies. 

This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.

‍