Small stocks can make big money. Here’s the proof!

Investing in companies worth less than roughly £250m – described as ‘micro-cap’ or ‘small-cap’ stocks, depending on who you ask – can prove very lucrative.

If you had invested £1 in the UK’s smallest companies in 1955, for example, your money would have grown to an astounding £15,213 by January 2019, compared to the £991 generated through the FTSE All-Share Index (Numis, 2019).

Wow! What gives?

There are a number of factors that explain this outperformance.

First, what tiddlers lack in scale they make up for in nimbleness. It’s much easier for a minnow to adopt a new strategy that could dramatically improve revenue and profits than it is for a lumbering FTSE 100 giant.

Second, smaller firms operating in markets ripe for disruption can quickly steal market share from those who have been established for a while and may take their customers for granted. 

Last, small companies are often at the cutting edge, allowing them to offer new products to consumers/clients before the heavyweights get involved. 

Taken collectively, these reasons are why I think patient, young investors should contemplate getting some exposure.  

Where do I sign?

Hang on! Clearly, this kind of return doesn’t come without a few caveats.

First, past performance is no guide to the future. Investment professionals are obligated to highlight this to clients because, well, it’s 100% fact. History can provide some guidance but, ultimately, no one knows what returns will be like in the years ahead. 

Second, few of us will be able to stay in the market for over six decades. Many self-proclaimed ‘long-term investors’ have trouble holding the same stocks for more than a few months before selling and moving on! 

Third, small- and micro-cap investing is high risk and only appropriate for those who can stomach the inevitable ups and downs. Vastly more businesses fail than succeed, hence the need to know what you’re doing. 

Given the above (and lack of relevant passive trackers to invest in), I think the best solution is to let a professional money manager sort the wheat from the chaff and, for once, earn their (high) fees.

Some examples

One of two funds that feature in my own portfolio is the Marlborough UK Micro-Cap Growth fund, managed by veterans Giles Hargreave and Guy Feld. Almost half of the fund is made up of stocks with valuations of less than £250m. 

Performance over the long term (which is what we should really be interested in when judging manager skill) has been excellent. From the end of January 2010 to January 2020, for example, the fund returned 370%. The sector average was 246% and the FTSE All-Share returned 60%. 

Another fund I own is Lionstrust UK Micro-Cap, managed by Anthony Cross, Julian Fosh, Victoria Stevens, and Matt Tonge. At less than four years old, it’s too early to comment on performance over the long term. However, I’m cautiously optimistic given the stonking total return of 1,432% achieved since inception to December 2019 by Liontrust’s UK Smaller Companies fund (compared to the sector average of ‘just’ 705%).–

In 2019, the UK Micro-Cap fund achieved a total return of 29.1% compared to the sector average of 25.3%. Even more impressive, in my view, is the fact that the same fund achieved a gain of 3% compared to an average loss of 11.7% in 2018. This highlights how hiring good stockpickers can pay off in both good and not-so-good years.