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The Analyst: Smaller companies, bigger returns

This week, I shall revisit a fund I featured in November last year – Standard Life UK Smaller Companies. Back then, I said that it could make an excellent core holding for the smaller-companies proportion of a UK portfolio – and this is still very much my view.

I also said that the fund tends to hold up better than many of its peers when the market is struggling. Thankfully, this has been proved correct; since November the fund has lost about 5 per cent, but its sector average is down by more than 10 per cent. What is more, the fund is actually up slightly so far this year, when most of its peers have lost money.

So, in a time when we have had extreme pessimism, and when you would expect a UK smaller-companies fund to suffer severely, this fund has been very impressive.

Many investors have been selling their smaller-company exposure and moving into larger companies in recent months. I can hardly fault that decision as it seems an entirely logical one. However, where some investors may be going wrong is in moving out of the sector lock, stock and barrel. This is not what most professionals do, because they know there are always some opportunities to be found in smaller companies. If you can identify the top managers, then it is worth sticking with them. In my opinion, Harry Nimmo at Standard Life is one of the very best.

It often surprises me that few investors have much exposure to UK smaller companies. It is the area in the stock market where the most pricing anomalies and under-researched companies can be found. This offers superb opportunities for talented investors to outperform. For example, if you look at the FTSE 100, just 10 companies account for more than half the index. Their accounts are pored over by hundreds, if not thousands, of analysts around the world, which tends to make this quite an efficient market and one where it is hard to make excess returns.

Mr Nimmo's maxim is that he is buying tomorrow's larger companies today. He is looking for proven business models with reliable revenue streams. He does not look for esoteric companies that are marketing some fancy new technology, simply because most of those end up going bust.

Harry Nimmo often refers to his fund as an "each way bet", by which he means that the fund doesn't tend to lose out by too much if larger companies make most of the running. This is borne out by the fact that, even though the FTSE All Share has performed better than the FTSE Small Cap Index this year, Mr Nimmo's fund has actually done better than an average broadly based UK fund. This reinforces my belief that making moves just for asset allocation purposes can often turn out to be wrong.

There is a vast number of smaller companies out there, so it can be a tough universe to keep track of, but Standard Life has a great starting-point. It has developed a system it calls "the matrix", which allows it to rank hundreds of companies against many different criteria, and helps to sieve out some of the dross. In this way, it can focus its in-depth research on the more promising companies.

Mr Nimmo is supported by an experienced team of three other fund managers, each specialising in specific areas so that together they have a high level of expertise across the market.

Smaller companies are very different compared to when I started in the investment industry in the early 1980s. In those days, they tended to be highly cyclical and domestically orientated industrial companies. In effect, this meant that they went through especially exaggerated periods of boom and bust.

There are still plenty of domestic UK companies around, but more of them have strong revenues and sound business models. For example, in Mr Nimmo's portfolio you will find Dignity, the funeral-home operator. However, these days far more small UK companies derive a lot of their earnings from overseas. These include firms such as Chloride Chemring Group, First Quantum Minerals and Salamander Energy.

The three largest holdings in the portfolio are Asos, which is very successful in online clothing; Paddy Power, the sports bookmaker; and Aveva, which designs engineering software. There's plenty of diversification amongst that lot.

So, in conclusion, if you want a well-managed UK smaller companies fund where you won't lose your shirt, and where over time you should make good money, take a look at the Standard Life UK Smaller Companies Fund.

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