Smaller companies rallied strongly following the 2008 financial crisis and were the stock market darlings through 2012-13 when they performed particularly well. Performance faltered in 2014, and with hindsight it was easy to spot they were due a setback – but it is never so easy in practice.
Paul Marriage, manager of the Schroder UK Dynamic Smaller Companies fund, made hay through the good times and posted stunning returns. However, the fund fell further and faster than its peers during the subsequent correction.
This can be partly attributed to the large inflows to the fund during the smaller company rally. It more than doubled in size in a short period – a situation difficult for any fund manager to handle.
There is less liquidity in smaller stocks, making it harder to place deals for large sums of money. In addition, as there are fewer investors in these companies, large purchases can often drive up the share price, making future purchases more expensive.
I have repeatedly said I believe there is far too much "momentum investing" going on with unit trusts and this highlights why. Investors chase good performance, then flee at the first sign of trouble.
Over the past year the manager has had to contend with large outflows. From £1.3bn invested in the fund a year ago, it is now a much more manageable £500m.
When I saw Mr Marriage in 2014, I asked him to tell me when he felt the prospects for smaller companies had improved. Recently he made that call, citing three points.
First, he spends considerable time meeting company management and feels they are beginning to provide more evidence of good performance.
Second, companies in his traditional hunting ground of £50m to £500m are undervalued relative to the rest of the market.
Finally, earnings forecasts are being revised upwards.
Against this more positive backdrop, there has been an increase in the number of companies coming to market. Mr Marriage has been active in this area and his selections have generally performed well. Alongside new listings, he also expects the increase in M&A activity to continue as companies look to grow through acquisition.
It is noticeable that small caps have been improving over the past couple of months; indeed they have performed better than their larger counterparts. Schroder UK Dynamic Smaller Companies is a genuine smaller company fund, and the reduction in its size has given the manager the opportunity to reduce the number of holdings from 80 to 50. As a talented stock picker, this concentrated approach allows each investment to have a greater impact on the fund's returns.
After suffering its punishment in 2014, I feel it is well worth backing again.
Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds in this column, visit www.hl.co.ukReuse content