Equities: Strategies for investing in small-cap companies

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on January 29, 2018 - February 04, 2018.
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Companies with a small market capitalisation and whose founders are their significant shareholders and part of the management team make for attractive investments, says Dale MacLennan, investment director of Aberdeen Standard Investments.

Such companies tend to have a stronger entrepreneurial spirit and are more innovative in their business approach, which is positive for profits and future earnings, he adds.

“It is usually their (the founders’) entrepreneurial spirit that helps grow the companies from a start-up to a listed entity,” explains MacLennan, who oversees equity investment strategies at his firm.

These companies also take a longer-term perspective in managing their operations as their founders want to ensure their legacy lives on and their businesses grow organically and in a sustainable manner.

However, such investment strategies come with a risk — as majority shareholders, their founders can make business decisions on their own, disregarding the rights of the minorities. Thus, it is important to know the background of the founders and their track record in upholding shareholder rights.

“This is where corporate governance comes in. We want to ensure the founders are willing to listen to shareholders and have been doing the right thing. This is important,” says MacLennan.

He cites the US-listed Align Technology, which offers a range of technology-based treatment solutions to dental professionals, as a good example of small-cap companies. It is well known for its removable and virtually invisible braces called Invisalign. Last year, it was the best-performing stock on the S&P 500 Index, rallying to US$223 from US$96 at the beginning of the year.

“Align has very innovative products and is seizing market share — especially among the younger ‘selfie’ generation — from companies that sell traditional braces. It is also expanding into other parts of the world and marketing itself heavily through social media,” says MacLennan.

Fever Tree is another example, he adds. The UK-based company produces premium drink mixers, such as tonic, and has been growing aggressively in the last couple of years, extending its reach overseas.

“Both companies are of very high quality. They are also leaders in their own sector. These are the kind of companies we capture in our smaller company portfolio,” says MacLennan.


Mitigating liquidity risk

Institutional and retail investors looking to enhance their investment returns should start allocating some of their money to small-cap companies, MacLennan advises. “Based on historical data, small-cap companies globally have generated a premium return of 5.5% over the past 17 years compared with large-cap companies.”

To maximise returns, investors looking to invest in small-cap companies should do it for the long term instead of jumping in and out of the market, he adds.

“A very strong message I would reiterate to investors, whether institutional or wholesale, is to take a longer-term perspective when investing in smaller companies. We don’t see it as an asset class for which you should be trying to tactically time an entry and exit.”

He says investors should look at companies with a strong balance sheet, cash flow and earnings visibility. These companies also operate in less cyclical sectors and have sustainable earnings with low financial leverage. “In short, we want to invest in high-quality smaller companies that have, what we call, a ‘durable competitive advantage’.”

Why is this important? MacLennan says it is because those who invest in small-cap companies face liquidity risk when trading in the market. This can be mitigated when investors buy into high-quality companies for the long term as there is less need for them to actively trade in the market. Also, the share price of high-quality companies tends to be less volatile as there is usually little negative news about them.

“This is also a strategy Aberdeen adheres to. We don’t trade stocks in and out actively. This is shown by the turnover rate of our investment portfolio, which is around 20% [annually],” says MacLennan.

The turnover rate shows the percentage of a unit trust fund’s holdings that change over a year. The higher the rate, the higher the trading activity that took place within the portfolio of a fund.

MacLennan also advises investors to “run the winners and cut the losers”. It means stay invested in high-quality companies that constantly post good earnings to ride their share price momentum. Investors should also be firm about cutting their losses when there are changes in a company’s fundamentals and its share price continues to drop.



First global small-cap fund launched

Affin Hwang Asset Management Bhd recently launched its Affin Hwang World Series — Global Quantum Fund, which gives investors access to global small-cap companies.

Launched on Jan 18, it is the first global small-cap fund in Malaysia. It is also a wholesale fund that only sophisticated investors with total net personal assets exceeding RM3 million can invest in.

The fund feeds into the target fund, which is the Standard Life Investments Global SICAV 2 — Global Smaller Companies Fund. The feeder fund invests a minimum 80% of its net asset value (NAV) in the target fund and a maximum 20% in money market instruments, fixed deposits or other liquid assets.

The minimum initial investment amount is RM10,000. Investors have to pay a sales charge of up to 5% and an annual management fee of up to 1.8% per annum.