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Five golden rules for investing in smaller companies

Important - The value of investments can fall as well as rise, so you could get back less than you invest, especially over the short term. The information shown is not personal advice, if you are unsure of the suitability of an investment for your circumstances please contact us for personal advice. Once held in a SIPP money is not usually accessible until age 55 (rising to 57 in 2028).

Heather Ferguson

Investment Analyst

Why smaller companies?

Leading fund manager Harry Nimmo reveals his investment process in this exciting but higher risk area.

Smaller companies provide some of the most exciting and dynamic investment opportunities in the market.

Small firms can exploit expanding niches and increase profits rapidly. They are typically nimble, entrepreneurial, and able to react quickly to change. As a result they are capable of spectacular performance. It’s easier for a company to double a £10m profit than £100m, and this can have a significant impact on the share price.

The rise of the internet and improvements in distribution mean it is easier than ever for smaller companies to gain attention, acquire customers and achieve success. Importantly, these businesses are often less well-researched than larger firms; this scarcity of information presents opportunities for fund managers to obtain an advantage.

However, while some offer potential for growth, others will inevitably fail. Their focus can be a strength, but it also means their fortunes may rely on the success of just one product or service. All this makes smaller companies a higher-risk proposition.

How to sort the wheat from the chaff – five golden rules

Many investors like to choose their own smaller company shares – and some do so very successfully. However given the higher risks involved, many choose to invest via a fund – a diversified portfolio with the shares selected by a proven stock picker.

Harry Nimmo is one of the UK’s most successful smaller companies investors. He seeks to invest in robust companies with strong balance sheets and low levels of debt. It is an approach that has stood investors in good stead and has built a superb track record with his Standard Life UK Smaller Companies Fund.

Below, Harry Nimmo reveals the five rules he follows when investing in smaller companies and shares some examples of companies which meet his criteria. Please note that Hargreaves Lansdown does not necessarily share his views on these stocks. As ever investors should conduct their own research when buying shares.

Rule #1: Look for sustainable growth

There are two sides to this rule - growth in the business and growth in the dividend. A growing dividend is often evidence of a strong business, one that has excess cash it is able – and confident enough – to distribute to shareholders. However, it is also important to identify growing sectors and the companies best-placed to benefit – often those with a durable competitive advantage over others.

An example of this is First Derivatives - a specialist in ‘Big Fast Data’ which has carved a niche in the financial services sector. Its software has helped businesses detect insider dealing and market manipulation. Harry Nimmo expects increased regulatory requirements to provide further opportunities for growth, and feels the company is well-placed to move into other areas such as market analytics, aerospace and utility analysis. The business has also paid a steady and growing dividend over time, though as always there are no guarantees this can continue.

Rule #2: Go for quality

Only invest in companies with a strong balance sheet and steady cash flow, and avoid those which have high or unsustainable levels of debt, or are unprofitable. Also avoid ‘blue sky’ or ‘concept’ companies – a good idea doesn’t necessarily translate into profits down the line.

Ted Baker, another holding in Harry Nimmo’s fund, has achieved a strong track record of profitable growth since it listed on the stock market in 1997. Originally a UK brand, it has diversified overseas and around 50% of its sales are international. Sterling weakness and a flagging UK economy are just two of the challenges facing UK retailers at the moment, but Harry Nimmo feels Ted Baker's growth is relatively predictable and steady.

Rule #3: Run your winners

Exceptional companies often demonstrate a persistent, competitive edge. If you believe you’ve identified a long-term winner, why not be a long-term investor?

JD Sports has performed well over the past few years as it has benefited from the ‘athleisure’ trend (wearing sportswear outside of the gym), but Harry Nimmo continues to hold the stock as he believes it has further successes ahead. Building on the success of its UK offering, the company is now growing earnings by expanding internationally. However, it’s worth remembering that European expansion isn’t always as straightforward as it seems, tripping up rival Sports Direct in the past.

Rule #4: Management longevity

Long-term management teams offer investors experience and stability. Ongoing founder involvement is another strong signal, typically bringing an entrepreneurial mindset and close alignment to the success of the business.

Dechra Pharmaceuticals manufactures veterinary pharmaceutical products. CEO Iain Page joined NVS – Dechra’s former services business – soon after its formation in 1989 and was an integral part of the management buyout in 1997. Dechra is one of the leading players in its field and continues to benefit from Iain Page’s clarity of vision and experience. From its UK base, the company has developed significantly, now operating internationally with distribution channels across the UK, Europe and North America. As with any high-growth company, however, if results fail to meet the market’s lofty expectations, the share price could suffer.

Rule #5: Valuation is secondary

Investors will look at a company’s valuation – the amount you pay today for future expected earnings – to help drive investment decisions, aiming to avoid companies which look expensive. However, Harry Nimmo feels valuation is a poor metric to use when investing in smaller companies – a low valuation often indicates major issues within the firm, and it can often be worthwhile to pay a premium for quality.

Accesso Technology is a world leader in ‘virtual queuing technology’ for theme parks and attractions. The company is highly valued by investors and, as such, expensive to own. However, Harry Nimmo feels the technology is a game changer for the entertainment industry. Innovation in areas like this means the formulas applied by analysts to predict future earnings cannot be applied. So while the company might appear expensive, he believes the potential for growth ahead of expectations means it is worth paying for.

Read more: Our view on Harry Nimmo’s Standard Life UK Smaller Companies Fund

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Why I back smaller companies to boost my fund’s growth potential

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Lee Gardhouse

Chief Investment Officer

Why I back smaller companies to boost my fund’s growth potential

Heather Ferguson’s Q&A with HL Chief Investment Officer Lee Gardhouse

Lee Gardhouse has led the Hargreaves Lansdown Multi-Manager team since inception in 2001. The HL Multi-Manager UK Growth Fund represents our one-stop solution for investors seeking long-term capital growth from the UK stock market.

While many funds with this objective will invest predominately in large blue-chip companies, Lee Gardhouse and his co-manager Ellen Powley, have a relatively high exposure to smaller-company fund managers in the fund. Below I interview Lee to understand why. The fund is run by our sister company HL Fund Managers Ltd.

Q. Why do smaller companies feature so heavily in the HL Multi-Manager UK Growth Fund?

Larger companies’ fortunes are often driven by global trends, and factors outside their control. In contrast smaller companies are generally more in control of their own destiny. Strong management can often exert a bigger influence over a smaller company’s prospects than their counterparts at larger firms, and the growth potential of these companies can be much higher than more established businesses – though we must remember the risks of failure are also greater.

Smaller companies are less researched, meaning quality fund managers can identify good businesses others have overlooked. There are also many smaller companies listing on the stock market for the first time. These new issues tend not to be available to private investors, so fund managers can often invest before the wider market, which can prove highly lucrative when they get it right.

All this means quality smaller company managers are able to add more value through their stock selection than those focused on larger firms.

Q. Why is a fund manager’s ability so important when investing in smaller companies?

Shares are volatile investments – smaller companies especially so. They are likely to move in price rapidly and can be unpredictable. A small business is also more likely to go bust than a larger business, so the likelihood of losing money on an investment is higher.

It is therefore even more important when investing in smaller companies that the individual company selection is sound. Our analysis has identified a number of excellent fund managers in this area, with proven track records of adding value for investors over the long term. We only invest with those that we feel are consistently able to identify companies that go on to perform well.

Q. How do you identify a good smaller company fund manager?

Track record is the key, and there are many good fund managers in this area so we can afford to be extremely picky. We analyse a manager’s performance using our proprietary quantitative tool, which allows us to determine what proportion of a fund’s performance is down to skill (good stock selection) or luck (investing in the right areas of the market at the right time).

We feel stock selection is the most important factor and favour managers who demonstrate skill in this area. We also spend considerable time face-to-face with fund managers to gain a deep understanding of their process.

We also feel it is important that a smaller company manager keeps their fund at a manageable size. A manager with many billions to invest is not as nimble as one with less, and is often less able to invest in very small companies.

Q. What makes Harry Nimmo and Giles Hargreave stand out in particular as first-class managers?

Managers Harry Nimmo and Giles Hargreave are exceptional stock picking investors, in my view. They both have long and successful track records and have a proven ability to add value for investors over the long term through their strong stock selection. They are also surrounded by capable and experienced teams.

Read more: Our view on Harry Nimmo’s Standard Life UK Smaller Companies Fund and Giles Hargreave’s Marlborough Nano Cap Growth Fund

Richard Troue

Senior Investment Analyst

Investment idea

Harry Nimmo's Standard Life UK Smaller Companies Fund

  • Aims to invest early in the success stories of tomorrow
  • Outstanding long-term growth potential
  • Harry Nimmo has an exceptional track record in this high-risk area

Every large company was once a small business. Spotting the most promising early can be highly lucrative.

Harry Nimmo, a renowned smaller companies investor and manager of the Standard Life UK Smaller Companies Fund, aims to find world-leading companies capable of becoming tomorrow’s household names. He likes to invest early and will hold these companies for the long term, participating in their success as they grow.

Harry Nimmo’s forensic approach is designed to identify companies with a competitive advantage, capable of sustainable growth. He likes those embracing the internet as a means of reaching customers and successes have included Rightmove and ASOS.

Read more: Harry Nimmo’s five golden rules for investing in smaller companies

Harry Nimmo has delivered exceptional returns for investors over the long term. Since the fund launched in January 1997 it has returned 1,254% compared with 306% for the FTSE Small Cap Index and 559% for the average fund in the sector. Remember that past performance is not a guide to future returns – this fund has performed exceptionally well over the past two decades, but there are no guarantees this can be repeated. Like all stock market investments the fund will fall as well as rise, so you could get back less than you invest. The fund has the flexibility to use derivatives, which can increase risk in some circumstances.

For investors looking to benefit from the long-term growth potential of some of the UK’s best companies we believe this fund is an outstanding choice. Our analysis suggests Harry Nimmo is one of the best stock pickers we have come across.

Standard Life UK Smaller Companies - performance since launch

Standard Life UK Smaller Companies - performance since launch

Past performance is not a guide to future returns

Source: Lipper IM, 30/01/97 to 31/05/17

Annual % growth May 12-13 May 13-14 May 14-15 May 15-16 May 16-17
Standard Life UK Smaller Companies 31.5 10.1 10.4 12.3 24.7
IA UK Smaller Companies 29.7 23.0 8.2 2.1 27.8
FTSE Small Cap (ex. IT) 46.1 23.9 8.6 0.3 24.0

Fund information

Investment goal: Growth
Net initial charge: 0.00%
Ongoing charge (OCF/TER): 0.99% p.a.
Ongoing saving from HL: 0.22% p.a.
Net ongoing charge: 0.77% p.a.
Vantage Service Charge: 0.45% p.a.
Maximum overall charge: 1.22% p.a.

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View our charges

Standard Life UK Smaller Companies

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Investment idea

Giles Hargreave's Marlborough Nano Cap Growth Fund

  • Our analysis shows Giles Hargreave is an exceptional smaller companies investor.
  • This fund allows him to use his talents at the smallest end of the market with the greatest growth potential.

Uncovering hidden gems is where Giles Hargreave and his team excel. In our view he is one of the best smaller companies managers in the UK.

Along with his strong and experienced team he has featured on our Wealth 150 list of preferred funds since 2005. They have added considerable value through stock selection. We believe their experience, knowledge, and depth of resources stand them in good stead to deliver excellent returns for long-term investors. Our analysis allows us to piece together a fund manager’s track record across their entire career. As you can see from the chart, Giles Hargreave has delivered returns which are nothing short of outstanding – though as ever investors should remember past performance is not a guide to future returns. This track record has been achieved across a variety of funds with different objectives and there are no guarantees the Nano-Cap Growth Fund will perform in the same way.

We added the Marlborough Nano-Cap Growth Fund, which Giles Hargreave manages alongside Guy Feld, to the Wealth 150 when it launched in October 2013. It is a small and nimble portfolio filled with opportunities they have identified among the UK’s very smallest companies. The largest constituent of the FTSE Small Cap index is worth £860m, but within this fund Giles Hargreave will only initiate an investment in a business worth less than £100m. Whilst this focus offers opportunity, it does make this fund a higher risk proposition. Like all stock market investments it will fall as well as rise in value so you could get back less than you invest.

We believe it is an exceptional choice for investors who seek exposure to this exciting but higher-risk area of the stock market.

Giles Hargreave - career track record

Giles Hargreave - career track record

Past performance is not a guide to future returns

Source: Lipper IM, 30/12/90 to 31/05/17

Annual % growth May 12-13 May 13-14 May 14-15 May 15-16 May 16-17
Marlborough Nano Cap Growth n/a* n/a* -3.8 6.8 33.0
IA UK Smaller Companies 29.7 23.0 8.2 2.1 27.8
FTSE Small Cap (ex. IT) 46.1 23.9 8.6 0.3 24.0

*Full year performance not available

Fund information

Investment goal: Growth
Net initial charge: 0.00%
Ongoing charge (OCF/TER): 0.81% p.a.
Ongoing saving from HL: 0.15% p.a.
Net ongoing charge: 0.66% p.a.
Vantage Service Charge: 0.45% p.a.
Maximum overall charge: 1.11% p.a.

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View our charges

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Nicholas Hyett

Investment Writer

AIMing for dividends

Nicholas Hyett explains why he thinks dividends are the key to picking smaller companies.

One of Harry Nimmo’s rules of thumb, when running his Standard Life UK Smaller Companies Fund is to look for companies that pay a dividend. We agree, and think it’s even more important when investing in the volatile world of AIM shares.

Smaller companies are inherently higher risk, and the AIM market is less stringently regulated than the main market on which most shares are listed. This has led to some high profile problems with corporate governance in the past and means small company investing requires particular care and attention. Investors should also bear in mind that liquidity is often lower among AIM stocks, making it more difficult to buy and sell shares and resulting in higher bid/ask spreads.

Our research suggests that over the long run, the total return from investing in smaller companies that pay meaningful dividends is significantly better from that achieved by low or non-dividend payers.

Investors who have sought out shares that offer a higher yield have done much better, as the chart below shows. As ever though, this should not be taken as an indication of future performance, and any investment can see investors getting back less than they invested.

Smaller companies – performance of high yield vs low yield stocks

Past performance is not a guide to future returns

Source: Thompson Reuters, Hargreaves Lansdown quantitative analysis, March 1985 – April 2017

There are a number of possible reasons for this trend. Firstly, while dividends are not guaranteed, they are more predictable than capital movements in the market. So a portfolio of dividend payers is likely to have a smoother returns profile than one that earns only capital gains.

Secondly, we believe that a dividend is a good initial indicator a company is profitable and generating cash. That may sound obvious, but a large number of AIM companies never break out of the red and into the black on either measure. A commitment to paying a dividend conveys confidence that the company is in sufficiently good financial health to return some excess cash to shareholders. It’s also an indicator that management are prioritising shareholders' interests.

With around 24% of AIM companies paying a dividend, I highlight two I believe look interesting;

Nichols - full of Vim

CVS Group

When people think of soft drinks they think of American giants Coca-Cola and Pepsi, but the UK has a rich history in the soft drinks industry too. Vimto may not be as stereotypically British as Britvic’s Robinson’s and AG-Barr’s Irn-Bru, but we think that only adds to parent company Nichols’ strengths.

UK sales accounted for 77% of the group’s £117m sales last year. Rapid 7% growth was largely thanks to the acquisition of frozen drinks company Noisy Drinks in January 2016, although Vimto sales sweetened by a market-beating 4.7%.

International sales account for the remaining £26.6m of sales, up 2.7% at constant currency. The group has delivered a steady positive performance here in recent years, with Africa and the Middle East accounting for 83% of international sales. Vimto is a, perhaps improbable, favourite in many Muslim countries during Ramadan, and although the timing of this year’s holy month held back sales in the Middle East, Africa saw sales growth of 19.7%.

An established and powerful brand has helped the group build a margin that even Unilever would be envious of. Combined with steadily increasing sales that’s allowed the group to maintain or grow the dividend every year since 1995, with the shares currently offering a prospective yield of 1.8%.

Recently the drinks industry has been challenged by the increased focus on healthy eating, and particularly reducing the amount of sugar in drinks. That saw the demise of the group’s Panda Pops range in 2011 and recently culminated in the Soft Drinks Industry Levy in the UK.

However, the group has long focused on promoting the health aspects of its products, indeed Vimto itself was initially developed as a health tonic in 1908. We think that leaves it well-placed versus many competitors.

View our Nichols factsheet

CVS Group – profits from pets

CVS Group

Given the low percentage of AIM shares that pay a dividend at all, we believe investors should treat any yield as an initial indicator, although no guarantee, of quality. That includes companies such as CVS where the prospective yield is just 0.3%.

The group is one the UK’s leading providers of veterinary services, with 388 practices in the UK, a 13% share of the UK small animal veterinary market as well as Laboratory, Crematoria and online dispensary businesses.

Acquisitions have been key to growth, and recent years have seen CVS hoover up independent practices around the country, 67 last year. Combined with steady like-for-like growth, that’s fuelled compound annual profit growth of 19.7% since listing in 2007.

As new surgeries are bought, the group brings its wider service offering to new customers, including diagnostics, the crematoria, own-brand drugs and pet accessory lines. CVS is currently exploring adding pet insurance to the stable in combination with a third-party underwriter. The group’s Healthy Pet Club loyalty schemes now has 291,000 members and offers discounted services and products, with the goal of creating loyal customers who are willing to spend significant sums of money – we’re a nation of animal lovers after all.

Despite the increased scale, margins have remained stubbornly flat over recent years, in the mid-teens at the EBITDA level (earnings before interest, tax, depreciation and amortisation). That’s a source of potential concern, since acquiring small independent practices should provide opportunities for cost savings and cross selling.

Nonetheless cash generation has been strong and that has allowed it to keep debt under control despite the acquisitive growth strategy. Following a £30.2m placing in December, net debt stands at around £68m, a little over twice last year’s EBITDA.

Unfortunately, the fact that CVS is a high quality company is no secret, and that is reflected in its price/earnings ratio, which at 29x is considerably higher than many comparable companies.

View our CVS Group factsheet

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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