Mark Dampier: Small can be beautiful for those investors who think long term

Ask most investors where they think the best returns have come from over the past 20 years and "emerging markets" is likely to be a popular answer. I have always been a fan of emerging markets and economic growth has indeed been strong. It should be remembered though that strong, economic growth doesn't necessarily translate into stock-market returns.

I have made the point about divorcing economic and stock-market prospects many times, most recently in relation to Europe. Many investors have ignored the region because of its economic woes, but it is home to many great companies and stock markets there have performed well of late.

Similarly, I find many investors happily write off their own stock market or economy far too easily. The problem is probably one of not being able to see the wood for the trees. It is easy to be negative when the city and financial pages of newspapers are full of woe.

Yet the UK is full of excellent companies and not just those in the FTSE 100 that most investors have heard of. The UK Smaller Companies sector has been a lucrative place in which to invest over the past 20 years, with the average fund rising 574 per cent compared with 186 per cent for the average fund in the Global Emerging Markets sector.

During my working life smaller companies have evolved as an investment. They used to be highly sensitive to what was happening in the wider economy and any recession would see them plummet. Just look at what has happened over the past five recessionary years – smaller companies, as measured by the Numis Smaller Companies Index, have outperformed the main FTSE 100 Index by almost 150 per cent.

One of the best funds in the sector and one we have been investing in for over 10 years is Old Mutual UK Smaller Companies, which is managed by Dan Nickols. Old Mutual has had a cracking UK team for quite some time and their mid-cap fund has also performed well. More recently they recruited the highly regarded Richard Buxton to run the UK Alpha Fund, which focuses more on larger companies.

I recently caught up with Mr Nickols and found him optimistic. Perhaps this is surprising given the fund's superb performance over the past five years. I might have expected him to suggest a setback was due. We started by discussing his economic outlook, and he expressed a high degree of confidence in the UK's economic recovery. He also made the point that the global economy looked relatively robust and he expects investors' appetite for riskier assets to remain.

The fund has been repositioned to reflect his positive view. Less is now invested in defensive companies that tend to perform better when the economy is weaker. Exposure to smaller companies in the market has been increased – at one point the fund had 70 per cent overlap with the Mid Cap Fund, but this has been reduced to 45 per cent.

Mr Nickols also suggested he expects earnings growth of around 10 per cent next year, which is below the historic average, but he still believes smaller companies will be capable of generating better returns than most other asset classes.

The number of companies listing on the stock market has increased in 2013 and Mr Nickols believes this will continue. He is encouraged by the quality of those coming to the market and believes this will be a source of opportunity. Short-term setbacks could be caused by on-going speculation over the US slowing its quantitative easing programme, but this may throw up buying opportunities.

With the fund around £760m in size it can take longer to buy positions in very small companies and Mr Nickols has increased the number of holdings in the fund. He is not short of opportunities though, with Restaurant Group, Telecom Plus, and Topps Tiles among those he highlighted as having good growth potential.

Smaller companies are often overlooked because they tend to be inherently more volatile. In 2008 they had an awful year, for example, but they bounced back stronger than almost anything else. If you can think long term, as you should with areas like emerging markets anyway, UK smaller companies should also form a part of your portfolio. I believe Old Mutual has one of the best teams on offer.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial advisor and stockbroker. For more details about the funds included in this column, visit hl.co.uk/independent