How to gain exposure to fast-growing smaller companies

Small may be beautiful, but it is not always loved. Take the ratings of smaller companies on stock markets right now. UK small cap stocks trade on lower valuations than their larger counterparts and amongst investment companies, shares in smaller company specialists currently trade on an average discount to the value of the underlying assets of more than 7%, compared to around 1.5% for all funds.

It's a good example of how short-term and long-term views can collide. We know that over the longer term, smaller companies tend to outperform. There’s no magic formula to that – it is simply a fact that these tend to be earlier-stage companies with more headroom to grow, so those that survive are likely to be more prosperous than more mature businesses.

In the short term, however, UK smaller companies have found it difficult to make progress. In particular, investors have been cautious about the UK’s domestic economy, to which smaller companies are more exposed, ever since the Brexit referendum more than five years ago, with all the uncertainty it has brought. Larger companies with more earnings from outside the UK and a greater ability to deal with post-Brexit red tape have not faced the same headwinds.

The good news is that this sort of disconnect can create opportunities. Private equity funds are already taking advantage: one reason these funds engaged in record M&A activity in the UK last year is that they recognised the value on offer from UK businesses, whether privately owned or listed on the stock market.

However, the window of opportunity will not stay open for ever. The International Monetary Fund thinks the UK was the fastest-growing advanced economy in the world during 2021 and that it will come close to matching that achievement again during 2022. In which case, more domestically-focused smaller UK companies should begin to report some impressive results. Valuations will correct.

Where, then, do investors and advisers look for smaller companies exposure? Well, the obvious answer is the investment companies sector – and not only because of the discounts currently on offer, attractive though they are. To invest successfully at this end of the market, managers need stock-picking ability, but also agility and flexibility. In a closed-ended fund, with no need to worry about inflows and outflows of investors’ money, it is much easier for the manager to move quickly and decisively when necessary.

That’s true of funds that invest in listed smaller companies, but even more important in the case of unlisted stocks. In fact, the investment companies sector is the only route into private equity that is open to many retail investors, offering an opportunity to buy professionally-managed exposure to growing businesses before they make their stock market debut. And many private equity funds currently offer even more generous discounts than their peers in the smaller companies sector.

None of which is to promise that smaller companies will outperform over the year ahead. Making predictions is difficult enough at the best of times, let alone during the period of uncertainty we are currently going through. Nevertheless, the lowly valuations of smaller companies in the UK does increasingly feel like a striking anomaly given the long-term outperformance of these stocks. And for those wanting to take advantage, investment companies currently offer good value.