Why the UK’s smaller companies can present attractive opportunities

Jeff Bezos, now the world’s richest man, created the online retail titan Amazon in the garage of his house in Seattle, while closer to home UK supermarket giant Tesco started life as a market stall in the East End of London.

The huge businesses that dominate the upper reaches of today’s stock markets all have one thing in common – they began life as much smaller companies.

What investment managers focusing on smaller companies seek to do is to identify which of the minnows of today have the potential to become the success stories of tomorrow.

The Investment Association’s definition of UK smaller companies is those that form the bottom ten per cent of the overall value of the UK stock market, based on the total market value of all of their shares. The figure will change as stock market values fluctuate, but at the time of writing UK smaller companies are those whose total shares are valued at £1.85 billion or below.

These smaller companies provide a fertile hunting ground for investment managers like Giles Hargreave and Eustace Santa Barbara, Co-Managers of the Marlborough Special Situations Fund, who have more than 2,000 stocks to choose from, including those listed on the Alternative Investment Market (AIM) and the FTSE SmallCap and FTSE Fledgling indices, in addition to the lower reaches of the FTSE 250. The sheer number of potential opportunities dwarfs those available to investors focusing just on the FTSE 100 and FTSE 250.

While it is not always the case, smaller companies tend to be younger businesses, often shaking up existing markets with innovative new products and services or opening up completely new markets. When a smaller company’s products or services do take off, there is significant potential to grow and increase their profits.

The flipside is that these smaller companies can run into difficulties. If, for example, the innovative new product they are selling does not work as well as expected or the business has seriously overestimated demand. When that happens the share price can fall very sharply.

The job of fund managers like Giles and Eustace is to identify the companies with strong long-term growth prospects and to avoid the potential problem stocks and the ‘me-too’ businesses with less attractive offerings and less inspiring futures.

Intensive research

There are fewer investment analysts covering companies at this end of the stock market, which helps to create opportunities for specialist investment managers to uncover hidden gems. This is a labour-intensive process. Giles and Eustace work with a team of more than a dozen investment professionals, with almost 200 years’ combined experience of investing in small and medium-sized UK companies.
They study company reports and, if they think there is the growth potential they are looking for, they will meet the management team running the business to hear first-hand their vision and strategy. On average, Giles, Eustace and the team will meet between 25 and 30 companies a week.

If they like the company’s story then they will consider investing, but initial positions are usually less than 1% of the fund. Then if the management team deliver on their goals, they may buy more gradually over time. To manage the increased risk associated with smaller companies though, they hold a highly diversified portfolio of more than 150 stocks and even their largest positions are rarely more than 2% of the overall fund. That way if something does go wrong with one company, the impact on the fund as a whole is limited.

Longer-term view

Investing in smaller companies can require patience. It is not unusual to invest knowing that it could be one or two years before the company’s story really begins to play out. In terms of how long Giles and Eustace might expect to hold a stock, when they consider investing they are assessing the potential value of the company in three to five years’ time. But if a business continues to achieve the growth they are looking for, then they might hold it for ten or more years. Running winning stocks in this way is an important part of their strategy.

A bottom-up approach, where you lift the bonnet on individual companies and really get to understand what makes them tick, is particularly important in the smaller companies arena. These are often young companies operating in markets that are not yet fully established and that means assessing their potential requires time and expertise. But therein lies the opportunity. By applying experience and resources to identifying companies with strong growth prospects, Giles and Eustace aim to add value for investors over the long term.

While they may not succeed on quite the same scale as Amazon or Tesco, there are certainly businesses with strong growth potential among the UK’s diverse and substantial universe of smaller companies. It is the job of Giles and Eustace to continue to find them.

Risk Warnings

Giles Hargreave and Eustace Santa Barbara are the investment managers of the Marlborough Special Situations Fund. 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. The Fund invests in smaller companies which carry a higher degree of risk than larger companies. The shares of smaller companies may be less liquid and their performance more volatile over shorter time periods. The Fund invests mainly in the UK, therefore it may be more vulnerable to market sentiment in that country.

Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.

Marlborough Fund Managers Ltd is authorised and regulated by the Financial Conduct Authority (reference number 141660)