Mark Dampier: Unicorn gets the picture with smaller companies

Smaller companies have been a lucrative, albeit higher-risk, area to invest over the long term. The Numis Smaller Companies Index has, since 1955, achieved an annual return of 15.8 per cent compared with 12 per cent for the broader UK stock market.

Now, you might think that is taking long-term investing a bit too far, but even over ten years the smaller companies index has risen 258 per cent, while it is up 223 per cent over five years.

Smaller companies had a poor time in the late 1990s when larger blue-chip companies were performing well. By 2000/01 blue-chips were clearly overvalued though and small caps have again made the best returns since. The past two years have been good for smaller companies despite the economic problems the UK had to contend with. Many of the best-performing stocks in the market over this period have been smaller companies.

Even within the equity income sector it has tended to be funds with significant exposure to smaller companies which have dominated performance tables. These include Unicorn UK Income and Marlborough Multi-Cap Income. The former also runs a successful UK smaller companies fund, Unicorn UK Smaller Companies, and what is interesting is it is only £50m in size. It is managed by Simon Moon and his co-manager John McClure, who also runs the Unicorn UK Income fund.

Size can count for a lot when running a smaller companies fund. Once a fund's size approaches £1bn it can become difficult to buy meaningful positions in favoured companies and invest in some of the smallest companies in the market. This is a genuine small-cap fund and you won't find a large weighting in medium-sized companies.

In addition, the smaller a fund is the more nimble it is, meaning the manager can take advantage of opportunities quickly. There is no great concentration in any sector and as I have said before in this column smaller company investing has changed almost beyond all recognition over the past 25 years. Many smaller businesses are far more globally focused and no longer dependent on conditions in their home economy.

Unicorn wants companies to be cash-generative and profitable with strong balance sheets at the point of investment. It is seeking unloved and under-owned companies which it can add to the portfolio. To Mr Moon the most important point is meeting the management so he can better understand their business philosophy.

While this is a fund that focuses on the prospects for individual companies rather than the wider economic environment there are some themes running through it. These include smaller companies that can benefit from strong US economic growth and the reindustrialisation of America.

Given the strong returns from smaller companies I asked Mr Moon what he thought of the current flow of companies listing on the stock market. Usually deterioration in the standard of companies listing is an excellent early warning sign of the top of the smaller companies market. He reports that the financial crisis delayed many listings and companies used the time to consolidate and become even stronger, so he believes the quality of companies coming to the market is strong.

The fund holds approximately 50 companies with a low portfolio turnover rate. At present exposure to AIM is constrained to 20 per cent, but Mr Moon is looking to increase this to 40 per cent to 50 per cent. Smaller companies will always be vulnerable to short-term shocks, but here we have a small fund with an experienced team in an area that has historically delivered strong long-term returns. This is a potent mix.

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