Small but full of potential

The world is full of exciting small companies that can make terrific investments.

These innovative businesses operate in a wide variety of sectors and yet fly under most people’s radars. For example, environmental firm Clean Harbors, advertising company Criteo and Descente sportswear are all very attractive firms, even though they’re not household names.

So, how can you find these innovative gems? Fortunately, there is no shortage of investment funds specialising in discovering and supporting these fast-growing firms.

Here we look at the pros and cons of putting your money into global smaller companies, as well as the portfolios that might be worth considering.

Why invest in smaller companies?

The simple answer is that smaller companies tend to outperform larger companies over the long term, so you’re effectively buying future potential.

As these businesses aren’t followed as closely by stock market analysts as their larger cap cousins, there is always the possibility of them surprising on the upside. Their share prices may rise sharply if they achieve better-than-expected results, introduce exciting new products, or secure lucrative contracts.

Of course, the dream ticket is to find the next Microsoft or Apple at an early stage of their development and watch the value of your investment soar in line with their success.

Downsides of smaller companies

Unfortunately, there are no guarantees in the world of investment – and that’s certainly the case with smaller companies, many of whom will be young and unproven.

Along with the high profile success stories, there are plenty of sadder tales recounting how firms with huge potential failed. This also means that investors in these businesses can lose substantial sums, usually without hope of the company being able to recover.

How to invest in smaller companies

How much you allocate to smaller companies will also depend on how much money you have to invest, your existing positions, longer-term goals, and attitude to risk.

Would-be investors can certainly buy individual shares, however, this can be particularly risky. A better route may be to opt for an investment fund run by a professional manager. Then you can choose from portfolios that focus on smaller companies in individual countries or opt for a global fund that providers broader geographic diversification, depending on your own investment goals.

Funds to consider

One-stop-shop

If you’re after more of a one-stop-shop approach, then the abrdn Global Smaller Companies fund is definitely worth a look.

Manager Kirsty Desson scours the world, including the emerging markets, to find companies with the best growth prospects.

The United States currently has the largest geographic representation in the fund with 43% of assets under management. Other countries – each of which are worth less than 10% – include Japan, Taiwan, Australia, Italy, Germany, the UK, and Sweden*.

To identify a valid company, the team uses abrdn’s proprietary screening tool, known as the Matrix, which looks for four key factors: quality, growth, momentum and value.

When valuing a company, Kirsty also considers what expectations have been built into the current price and identifies drivers that could lead to an increase.

We consider her a safe pair of hands at the helm and this fund is a strong contender for providing long-term exposure to this asset class.

An alternative to this one-stop-shop approach is to cherry pick funds that focus on specific markets, using them in either isolation or as part of a diversified approach.

UK smaller companies

Let’s start with our home market. The Liontrust UK Smaller Companies fund aims to deliver capital growth over the long-term, defined as being at least five years.

Its largest holding is in YouGov, the internet-based market research and data analytics firm. Alpha Group International, the business intelligence business, is the next biggest, followed by Brooks Macdonald, the investment management firm*.

While it invests in UK-listed firms, Liontrust has highlighted Factset data estimating the portfolio’s overseas sales exposure to be more than 50%**. This illustrates that it’s actually pretty global in focus.

We like the fund’s emphasis on quality and avoiding cyclical stocks as this has worked particularly well for it, and has helped to produce excellent relative and risk-adjusted performance figures.

US smaller companies

When talking about smaller companies, you simply can’t ignore the US, as the country is home to some of the most entrepreneurial, advanced companies on the planet.

One way to access them is through the Artemis US Smaller Companies fund, whose lead manager is the experienced Cormac Weldon.

The portfolio typically holds around 50 to 70 companies, which have stock market values mostly below the US$10bn mark. This ensures a decent spread of diversification.

Clean Harbors, a provider of environmental and industrial services, is currently the largest individual holding*.

We like the steady and consistent outperformance this fund has achieved and believe it’s a very repeatable process.

European smaller companies

Europe is another region that’s rich in exciting smaller firms – and one fund to watch in this area is manager Ollie Beckett’s Janus Henderson European Smaller Companies fund.

This portfolio looks to identify trends that drive consistent performance and invest in good quality European companies with strong competitive positions and long-term potential.

We like the fact it’s willing to invest in the smallest of companies as this allows them to find the hidden gems that may be ignored by their peers.

According to the fund’s recent commentary**, one stock that was added this year has been Hellenic exchanges, which runs the Greek stock exchange, for good reason: “The Greek economy continues its remarkable rehabilitation, and the national exchange stands to benefit from increased capital flow.”

Japanese smaller companies

The final region we’re featuring is Japan – and our suggestion for getting exposure to this area is an investment trust.

Baillie Gifford Shin Nippon, which has been providing long-term capital growth since 1985, invests in smaller companies listed on the Japanese stock market.

These include Toyo Tanso, the carbon products supplier; Descente, the sportswear provider; and Shoei, which manufactures crash helmets.*

While it’s fair to say that the trust’s performance can be a touch on the volatile side, patient investors have been rewarded in the past.

We believe it’s best suited to those interested in the growth potential of Japanese smaller companies, and who understand the additional risks involved.

* Source: fund factsheet, 30 June 2023

**Source: monthly manager commentary, June 2023

_{Photo by Katie Azi on Unsplash}