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The Analyst: Smaller companies are beautiful too

Many professional investors, including such luminaries as Fidelity's Anthony Bolton, have recently been moving their portfolios towards larger companies. I don't disagree that some of them look good, but I think investors ignore smaller companies at their peril.

The dynamism and flexibility of smaller companies gives them superb potential to succeed. We have seen in recent years how even household names such as Marks & Spencer and Tesco have started operating smaller stores as a way of boosting their profits. The growth potential of true small companies is even greater.

Just 10 companies account for more than half of the FTSE 100 Index of leading UK companies. These huge multinationals dominate press attention; their accounts are poured over by hundreds of analysts. Very little about them is unknown. This makes for a highly efficient market, where share prices frequently represent fair value – making profits much harder to come by for investors.

By contrast, the smaller-company index is the most inefficient area of the UK market. This is great news for shrewd investors because the index is more likely to contain companies whose true potential has gone unnoticed.

Smaller companies are often perceived as being much higher risk and more volatile. There is truth in that, but don't get too carried away – during major market setbacks, investors tend to sell their most liquid holdings first, and this tends to mean their larger companies.

I believe that most UK investors should have a little exposure to a high-quality smaller companies fund. This week I will be looking at a fund from Standard Life Investments, a company that has made great strides over the past few years. The performance of their fund range has improved markedly, but one that has always been strong is Harry Nimmo's UK Smaller Companies Fund.

Mr Nimmo's maxim is that he is buying tomorrow's larger companies today. He looks for proven business models with reliable revenue. Many an investor has had their fingers burnt over the years on "blue sky" companies that have a great story behind them but end up never making a penny. Mr Nimmo strives to avoid this trap by only investing in companies that are already profitable. He also tends to operate a buy-and-hold strategy rather than trying to trade around the market according to short-term momentum. This gives his fund a slightly lower risk profile than the average fund in its sector.

It has long been accepted that smaller companies must be reliant on the health of the domestic economy. This is less true today than it was 20 years ago. Back then, the smaller company sector was dominated by manufacturing, which was indeed very much aligned with the economic cycle. Today, however, many smaller companies have a technological edge that allows them to be world leaders in a niche market.

The valuations on the smaller-company indices are higher than on the FTSE 100, with an average price at 14.5 times earnings, as opposed to 11.7 times for the larger companies. However, earnings growth is also noticeably higher, so those valuations are somewhat justified. I know that for the long term I would rather have my money invested in smaller companies, where opportunities abound and experts like Harry Nimmo can demonstrate his stockpicking talent.

One of Mr Nimmo's top holdings is Lavendon, which hires out powered access equipment – for example, scissor lifts and vehicle-mounted platforms – across the world. It has been a beneficiary of strong growth in the Middle East and a recovering German market. Another major holding is in Autonomy, which produces software for internet search engines; another, Paddy Power, is a growing bookmaker.

One of the most interesting things about the Standard UK Smaller Companies Fund is that it tends to hold up better than many of its peers when markets are struggling. It also has a history of performing relatively well when large companies are leading the market forwards. In that respect, it seems to provide investors with a good each-way bet. I continue to believe that it makes an excellent core holding for the smaller companies portion of a UK portfolio.

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