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History is on the side of small cap fund investors taking a patient view on the recovery

Going back to 1955, small caps have done seven times better than large caps

Mitchells & Butlers -
Mitchells & Butlers has been a contrarian purchase in recent months

Small caps have had a more challenging 2020 than large caps but history is on your side if you invest in small cap funds.

Understandably when markets initially reacted to the coronavirus pandemic in late February and into March, smaller listed companies were hit the hardest and materially underperformed during that period.

As generally happens in crisis situations, there is a flight to liquidity and the greater ‘quality’ of large cap stocks, with UK large caps also enjoyed a greater international bias. 

But since markets rebounded in late March, small caps have done better than large caps, points out Neil Hermon, manager of the Henderson Smaller Companies Investment Trust PLC (LON:HSL). 

“It’s often the way that you get a little more volatility in the short term but on a long term basis you do better investing in small caps.” 

Indeed, history shows that small caps have outperformed large caps from almost any long-term perspective, with research by London Business School showing that, going back to 1955, small caps have done seven times better than large caps.

That’s 3-4% and upwards every year for the last 65 years.

However, looking at AIM stocks, more research by Professors Elroy Dimson and Paul Marsh of the LBS concluded that in AIM’s first 20 years, investors would have lost money in 72% of all the companies that ever passed through the junior market.

As Prof Marsh said at the time, “with more losers than winners, the people least equipped to sort the wheat from the chaff are private investors, and the people best equipped are the professional fund managers.”

Which is where the likes of Hermon and others of ilk come in.

Over the past decade, investment trusts focused on smaller companies dominated the 10 best performers, with half of the top spots, with Hermon’s company in fifth place, topped only by BlackRock Small Companies Trust PLC (LON:BRSC) in the UK subsector, and followed by the Rights & Issues Investment Trust (LON:RII) and the BlackRock Throgmorton Trust PLC (LON:THRG).

Looking to the rest of 2020 and the subsequent one or two years, conditions are certain to remain pretty volatile. 

“We are trying to take a more long-term perspective, so we are not really thinking about the next quarter or two. It’s sort of not really relevant. We are thinking about in a few years’ time,” says Hermon, who is a director of UK Equities at Janus Henderson Investors as well as being a portfolio manager.

He says trying to call the market on a two or three months basis “is a mug’s game — it’s a bit of a phoney war”, with nine and a half million people on furlough and two million more self-employed and many not likely to return to work.

“What will the economy do? When will people be more comfortable going to a restaurant and the pub? Will there be a vaccine in the next six, nine, 12, 24 months? There’s all those kind of things, so we’re taking a perspective that eventually economies will recover, but it may be 2022 or 2023, when you can get back to where you were with the earnings perspective of companies.” 

Hermon says what the coronavirus crisis has really done is accelerate trends, such as the growing adoption of technology and what that facilities, such as the decline of the high street and other property impacts. 

Or in the words of Satya Nadella, CEO of Microsoft, “We've seen two years' worth of digital transformation in two months."

So, Hermon says, “being invested in growth areas is probably the best thing to do in terms of picking coronavirus winners”.

The trust’s investment focus is on long-term growth, which means the portfolio is tilted towards growth areas such as electronics, software, pharma and capital goods. It is also therefore less exposed to the food production, mining, retail and property sectors.

Recent purchases have included perceived bargains for when things return to a new normal, such as Mitchells & Butlers PLC (LON:MAB), “it’s shares fell about 60% to around half its NAV”; and Gym Group PLC (LON:GYM), “fundamentally the need for gyms has not changed and they still have around 80% of their membership”.

Other top holdings include video games developer Team17 Group PLC (LON:TM17), industrial sensors specialist Renishaw plc (LON:RSW) and identity data intelligence specialist GB Group PLC (LON:GBG). 

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