Big opportunities in medium-sized and smaller companiesContributor Ian Cowie
Medium-sized and smaller companies can offer greater scope for capital growth than businesses that are already very large and may have their best days behind them. But not every acorn grows into an oak and higher risks may accompany the potential for higher rewards when seeking the corporate winners of tomorrow.
Active stock selection by experienced professional fund managers can help to identify medium-sized and smaller companies with sustainable competitive advantages trading at discounts to their intrinsic value. Whether these funds focus on stock markets in Britain, Continental Europe or the USA, they may be held within individual savings accounts (ISAs) to generate tax-free capital gains – and some also provide tax-free income.
The closed-end structure of investment trusts may help medium to long-term investors withstand fluctuations and volatility in stock market sentiment and valuations during the economic cycle. For example, The Mercantile Investment Trust plc is more than 130 years old and now manages over £2bn for its shareholders who receive quarterly dividends. JPMorgan Mid-Cap Investment Trust plc is another fund focussed in the UK All Companies Sector, seeking capital growth and steady dividends from businesses outside the FTSE 100 index of Britain’s biggest shares.
Investment opportunities do not end at Dover and investment trusts offer a convenient and cost-effective way to gain exposure to markets overseas. For example, JPMorgan US Smaller Companies Investment Trust plc focuses solely on capital growth from North American smaller companies and JPMorgan European Smaller Companies Trust plc seeks a mixture of both income and growth in Continental Europe, excluding the United Kingdom.
Actively aiming for growth
Stock market indices, such as the FTSE 100 or the Standard & Poor’s 500, are based on size or stock market capitalisation – the total value of shares in issue by each constituent company – and so they inevitably tend to be dominated by the corporate winners of the past. However, past performance is not necessarily a guide to the future and so these shares do not necessarily offer the best bargains for buyers today or the greatest growth prospects for tomorrow.
Tracker funds that passively follow the FTSE 100 Index or S&P 500 Index automatically had high exposure to technology shares by the time the dot.com bubble burst in 2000 and had also invested heavily in banks and insurers before the global financial crisis began in 2008. This demonstrates the risk of investing by auto-pilot or algorithm in yesterday’s winners in much the same way that it is dangerous to drive by only looking in the rear-view mirror.
By contrast, experienced professional fund managers seek to mitigate the risks inherent in investment through active stock selection, aiming to identify companies that have sustainable competitive advantages while shunning over-priced shares that may be fashionable today but might fall from favour tomorrow. Investment trusts enable individual investors to share the cost of active stock selection which aims to buy low and sell high to generate capital growth.
Where to find the winners of tomorrow
Just as trees do not grow all the way to the sky, diseconomies of scale can impose limits on the growth of very large companies. Corporate monoliths sometimes become difficult to manage and may lack entrepreneurial zeal. Senior executives and their remuneration incentives can diverge from the interests of customers, shareholders and staff. Some or all of these factors played their part in the decline of corporate giants including Carillion, British Home Stores and Woolworths.
Medium-sized and smaller companies may be nimbler and more readily able to rapidly reflect changes in consumer demand and stock market conditions. However, it is important to remember that these companies can be higher risk than their larger rivals because they are less likely to have substantial reserves or diversified businesses to help them survive economic shocks or other setbacks.
So great care must be taken when considering potential opportunities among shares listed on stock market indices that include mid-cap (companies with a market capitalization between $2 billion and $10 billion) or smaller companies (companies with a market capitalization between $300 million and $2 billion), such as the FTSE 250 Index or the FTSE All Share Index. Dedicated professional fund managers are able to visit potential investments to ‘kick the tyres’ and interview these businesses’ senior executives in a way few individual investors could do for themselves. The idea is to identify companies with sustainable competitive advantages, priced at a discount to their intrinsic value with senior executives who are capable stewards of shareholders’ capital.
Investing effectively for the medium to long term
It is important to remember that share prices can fall without warning and you may get back less than you invest in the stock market. One way to reduce the risk inherent in stock markets is to invest money you can afford to commit for five years or more, as this will substantially diminish the danger of selling when prices are temporarily depressed.
For example, one of the most comprehensive and longest-established analyses of investment returns found that shares reflecting the changing composition of the London Stock Exchange beat cash deposits over 75% or three quarters of all the periods of five-consecutive years since 1899 (1). However, if shares were only held for two years their historic probability of outperforming cash fell to 68%.
What’s special about investment trusts?
Diversification is a tried-and-tested way to diminish risk. The principle is the same as not putting too many eggs in too few baskets. Pooled funds, such as investment trusts, automatically put this into effect by spreading individual investors’ money over dozens of different companies’ shares to reduce their exposure to the danger of setbacks or failure at any company. However, diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investment trust shareholders also enjoy another important advantage over investors in other forms of pooled funds – such as unit trusts or open-ended investment companies - because investment trusts are closed-end funds. This means their managers are never forced to sell underlying assets to raise cash to meet redemptions if sentiment changes, as it often does at different stages in the economic cycle. By contrast, open-ended fund managers may be forced to dispose of whichever assets can be sold when confidence falls, share prices decline and short-term speculators wish to get back into cash.
How it worked in practice: Big returns from medium-sized and smaller companies investment trusts
According to the Association of Investment Companies (AIC) (2) the average total return from all investment trusts – excluding specialists such as Venture Capital Trusts - over the last five years was 99%. Over the last decade, the average return from all AIC members on the same basis was 199%.
The past is not necessarily a guide to the future. However, these historical facts do demonstrate how medium-sized and smaller companies investment trusts have delivered big returns and may be worth considering as part of a diversified portfolio for investors seeking growth and income or a mixture of both in future.
Investors should remember that share prices can fall without warning and they may get back less than invested. However, investment trusts seek to diminish the risk inherent in stock markets by diversification and professional fund management. There are hundreds of investment trusts to choose from. For more details see the Association of Investment Companies: www.theaic.co.uk
- JPMorgan European Smaller Companies Trust plc
- The Mercantile Investment Trust plc
- JPMorgan US Smallers Companies Investment Trust plc
- JPMorgan Mid Cap Investment Trust plc
(1)Barclays Equity Gilt Study 2017, page 145: figure 8.
(2) Association of Investment Companies as at February 2018