Precious goods come in small packages

Smaller companies can grow more quickly and have some advantages over their larger counterparts on the stock market, writes Laura Slattery

Bigger is not always better, according to Standard Life, which this week made its UK Smaller Companies Fund available to Irish investors.

Standard Life Investments claims that size isn't everything and there could be more value for investors at the more modest end of the market.

"Smaller companies tend to grow quicker and are more nimble at taking advantage of new market opportunities. For a large company like Shell to double in size is a major challenge. However, in the small-cap universe, this is more of a possibility," says Harry Nimmo, head of the UK smaller companies desk at Standard Life Investments.

Standard Life cites research by global banking group ABN Amro that shows that, over the past 50 years, smaller company shares have delivered an average of 3.5 per cent higher returns per annum than larger companies.

The Standard Life UK Smaller Companies Fund, which has a minimum investment of €10,000, has achieved an average annualised return of 13.5 per since its introduction in 1997.

The past two years have been particularly good, according to Nimmo, who manages the fund, with growth of 20-30 per cent. This year, he forecasts growth of 10-15 per cent.

The 67 companies in the Standard Life portfolio, which include Harry Potter publisher Bloomsbury, Domino's Pizza and Scottish Radio Holdings, all have a market capitalisation of £1 billion (€1.5 billion) or less.

But is there really better value available to investors at the smaller end of the market?

"Often smaller companies do have better growth potential, by their nature. But the risks tend to be greater as well. Smaller companies just don't have the earnings track record that larger companies have," says Stuart Draper, head of research at Dolmen Stockbrokers.

"The conservative investor will find that the household names give them some comfort, although often it is true that those who make the most money are involved with some of the lesser names at an early stage."

Nimmo argues that the risks involved in investing in smaller companies are minimised in the Standard Life fund, which holds a maximum of 5 per cent in any one stock and limits exposure to the top 10 companies in the fund to less than 30 per cent of the total holdings.

So if one newish company fails to get off the ground and its shares plummet, investors will not bear the full brunt.

By contrast, someone investing in a tracker bond linked to the growth of the FTSE 100 would have 53 per cent of their investment exposed to just 10 companies. On an Iseq-linked investment, this figure is even higher at 77 per cent.

In addition, maximum exposure in the Standard Life fund to companies listed on the "faddish" Alternative Investment Market (Aim) is 20 per cent.

If the Aim-listed firms are included, UK small caps account for 40 per cent of the entire European small-caps market.

Back home, Goodbody Stockbrokers' annual smaller companies review, published in April, points out that, while smaller-cap companies have outperformed their larger counterparts across all western markets over the past few years, many of these companies trade at premiums relative to larger caps.

Macroeconomic factors now favour larger caps over smaller caps, according to Goodbody.

"While there might be some downward pressure on interest rates in the short term, over the longer term the expectation would be that interest rates will rise, which would be more favourable for larger caps in terms of outperforming smaller caps," Goodbody comments.

Nimmo attributes 2005's lower forecast for the Standard Life fund to rising interest rates in the UK.

Currency movements, specifically an appreciating dollar, could favour larger caps, which tend to have more exposure to dollar-denominated currencies.

A recent sharp widening in corporate credit spreads also suggests that investors are becoming more risk averse.

But although the valuations have moved on, Goodbody notes that Irish smaller caps still have a lot going for them because of their high exposure to the Irish economy - still one of the fastest growing in Europe.

Irish smaller-cap companies rose by 27 per cent in 2004 and rose almost 9 per cent in the first four months of 2005.

The smaller companies review, which analyses the outlook for 20 Irish companies with market caps of between €100 million and €1.5 billion, recommends that investors pick a mix of quality stocks and "speculative plays" that have limited downside.

Paddy Power, IAWS and United Drug are the three companies Goodbody has highlighted as quality companies with good defensive characteristics.

"All three have impressive track records, strong growth outlooks and operate in sectors that are likely to remain immune to any weakness in the external economic environment," Goodbody says.

The speculative plays it recommends are C&C, Eircom and Greencore.

Investors looking for consistent earnings growth, high-cash generation and strong balance sheets that can be leveraged for growth will find that the Irish smaller-cap market offers good choice, Goodbody concludes.

The Standard Life UK Smaller Companies Fund does include Irish stocks such as Paddy Power and UTV, which are also listed in London.

But the fund is still mostly made up of stocks that are unknown here and, in the UK, often ignored.

The fact that the companies, many of which are global leaders in their fields, are rarely in the spotlight is to the fund's advantage, according to Nimmo.

A big company such as Vodafone can have more than a dozen stockbroker research notes dedicated to them in the space of a fortnight, while small caps are hardly covered at all, he says.

This, he adds, makes it easier for the fund's researchers to spot undervalued companies and add them to their portfolio in search of supersize returns.