2022: The year of the smaller company?

David Prosser looks at the advantages of smaller companies and reasons to look at them in 2022.

smaller

Will 2022 be the year of the smaller company for investors in the UK? We know that over time, smaller company shares have a tendency to outperform large-cap stocks – and while that trend was in evidence over 2021, it could accelerate over the year ahead.

One driver of smaller company outperformance lies in the economic outlook. In 2022, the International Monetary Fund predicts that the UK economy will be among the fastest-growing of all developed countries; that should augur particularly well for companies with more of an exposure to the domestic economy – smaller companies, in other words, rather than large multinationals.

Another argument in favour of smaller companies is their agility, which looks especially important right now given the volatile market landscape. Businesses in a position to scale activities up or down at pace, and to take advantage of emerging opportunities quickly, will do better in 2022. All the more so if they are able to exploit new technologies. Again, this is good news for smaller businesses.

A third reason to look at smaller companies in the UK is that there appears to be a valuation opportunity right now. The UK stock market has consistently underperformed its international counterparts in recent years – going all the way back to the Brexit referendum. That is increasingly attracting international investment – hence the record investment by private equity in British businesses in 2021. Smaller companies will benefit disproportionately as more investors hone in on these opportunities.

Against this backdrop, where are investors and their advisers most likely to find attractive routes into the UK’s smaller companies? Well, one obvious answer is the two dozen or so investment companies that currently specialise in investing in these businesses. Shares in these funds currently trade on an average discount to the underlying value of their portfolios of 7.5%.

Leaving that opportunity aside, investment companies have some inherent advantages when it comes to investing in smaller companies. Most obviously, they don’t have to worry about liquidity in the same way as their open-ended counterparts; with a fixed pool of cash to invest, rather than inflows and outflows of investors’ money to manage, managers can invest in small, often illiquid stocks as they see fit.

That applies both to listed securities – the smallest companies on the market, including the Alternative Investment market – and unlisted companies yet to go through an IPO process. Indeed, through sectors including private equity and growth capital, the investment companies industry offers investors a route to unquoted company exposure that is otherwise blocked to them.

Remember too that investment companies have a unique ability to take on gearing – borrowing that accelerates returns in a rising market. All other things being equal, an investment company with gearing will automatically outperform another type of fund if their portfolios rise in value. The average smaller companies investment company has gearing of 8% in place according to the AIC’s statistics.

The final point to make is that smaller companies are where specialist and experienced fund managers prove their value. Large companies are tracked in minute detail by huge numbers of analysts – from an investor’s point of view, this makes securing an advantage much more difficult, since everyone has access to large amounts of information. Amongst smaller companies, by contrast, the opposite is true. The best fund managers take advantage, uncovering hidden gems and profiting from anomalies. And the investment companies sector has frequently been the place to find those managers, with many funds run by the same specialists for many years.