Interactive Investor

'How I have returned 13% a year since 2000'

23rd August 2016 12:31

Kyle Caldwell from interactive investor

Since buying his first share more than 40 years ago, Giles Hargreave, one of the UK's most successful smaller company investors, has seen plenty of bubbles: booms followed by sudden crashes. But the first, in early 1970, was the one that taught him the most.

Hargreave, like many other investors at the time, was drawn to a share that was on a hot streak of form: an Australian nickel mining company called Poseidon. The spectacular rise and fall of Poseidon was a classic illustration of how a share price can be dictated by movements in supply and demand.

During the Vietnam war there was a surge in demand for nickel to manufacture weapons. At the same time workers at one of the biggest suppliers of nickel, a Canadian company, went on strike.

With demand high and supply low, news that little-known minnow Poseidon had struck gold, or in this case nickel, led to its share price rocketing.

How to spot a bubble

Hargreave recalls: "The share price kept on doubling almost every day for a couple of months. I thought to myself: this is too good an opportunity to miss, so I bought some shares and also lent my friend some money to buy some.

"But when I came in to work the next day, the share price had fallen by 20% overnight."

There were various factors behind Poseidon's downfall, but the rocketing valuation - its share price rose from $0.50 (£0.37) to a peak of more than $200 - finally burst the bubble.

With the benefit of hindsight, it is unlikely that Hargreave would make a similar mistake today. One attribute he now looks for - a sensible valuation - would be absent and raise the alarm.

Scrutinising the skill and integrity of company management is of great importanceOther key "flags" he uses when assessing whether a new business will sink or swim would also help him spot a bubble. High up on his checklist are businesses with healthy cash flows and low debt.

Hargreave likes businesses that have identified a niche in a market where there are few competitors, so he is drawn to innovative companies.

He places great importance on scrutinising the skill and integrity of company management teams. This cannot be achieved alone, so he runs a team of 15, which he says gives him an edge over other fund managers in the small-cap arena.

Hargreave - who manages the popular £1 billion Marlborough Special Situations fund, alongside co-manager Eustace Santa Barbara, as well as the £560 million Marlborough UK Micro-Cap Growth fund, with Guy Field also on board - has an enviable track record.

Since he took over in July 1998, the average annual return has been 19%. Investors in Marlborough UK Micro-Cap Growth, launched in October 2004, have enjoyed average annual returns of 15.5%.

But Hargreave prefers to be judged on performance from 2000 onwards. He explains that in his first couple of years running Marlborough Special Situations, performance was boosted by its small size. In 1999 the fund rose in value by an incredible 174%.

Running with winners and cutting losses

He says: "Since 2000 the average annual return has been 13.4%, while over the same period the average fund in the Investment Association's UK smaller companies sector has been 6.3%.

"We have had some good years and made money pretty much every year - with 2008 an exception, although we did better than the market.

"It has simply been a case of getting more right than wrong, and when I find the winners, I keep on buying as the businesses expand.

"With investments that do not work out, I cut my losses and invest in another company rather than hang around trying to get my money back. There are plenty of stocks out there and new businesses coming to market, so I prefer not to sit on my hands."

More bear markets are inevitable, but  much more money will be won than will be lost.Hargreave says it was glaringly obvious early in his career that much more money can be made in the small-cap space than the bigger blue-chip pool. Indeed, it is one of the most powerful long-term investment trends. Over the past 60 years smaller companies have outperformed.

Research last year by the London Business School found that investing £1 in 1955 in the Numis 1000 index, composed of the smallest UK-listed companies, would have produced £12,144 by the end of last year.

The same £1 invested in the FTSE All-Share would have grown to just £829. Over 10-year periods since 1955, smaller firms outperformed larger companies five times out of six.

He says: "As the saying goes, elephants don't gallop. This is a trend I expect to continue for decades. By their nature smaller companies are risky, and at times they will fall sharply and suddenly. I have seen shares fall from £20 to nothing.

"But those who are patient and invest for the long term will be rewarded. In the next 25 years more bear markets are inevitable, but I am confident that much more money will be won than will be lost.

"My view is that when a bear market materialises, investors have two choices. They can either sell out of my fund and re-join later, or sit tight and eventually benefit from the fact that I have bought shares at depressed prices that - fingers crossed - should rebound when market conditions improve."

The fortunes of smaller companies are more in tune with their propensity to generate cashDespite the hard evidence that when it comes to investment, small can be beautiful, the small companies sector is seldom flavour of the month. In fact, for most of the past decade, more money has leaked out of the UK smaller companies sector in most years than has been put in.

The familiarity factor is one reason why large-cap companies attract more attention from investors and are perceived to be lower risk. But it is dangerous to assume they are safe, says Hargreave. He points out that large caps are more sensitive to economic trends.

In contrast, the fortunes of smaller companies are more in tune with their propensity to generate cash. Large caps also tend to have much bigger pension deficits.

Moreover, the bigger these businesses become, the more difficult it is to move the dial. Small caps, because of their modest size, can grow exponentially.

Ready to take AIM

In the case of the Alternative Investment Market, Hargreave has a bone to pick. He says: "I feel the market has a bad reputation it doesn't deserve. There are some great companies in AIM, and I have invested in many of them, including fashion website Asos."

He believes that, given the increased incentives to invest in AIM over the past couple of years - particularly now that investors can avoid income, capital gains and inheritance tax if they hold for two years - it is important not to tar the whole sector with the same brush.

He says: "There have been some disasters, but it is unfair to say everything listed on AIM is incredibly risky and suspect. The attitude towards investing in small-cap shares has certainly changed, and success stories like Asos have helped.

"But there are duds, which is why private investors should trust the expertise of fund managers to find the gems."

Restore and Advanced Computer Software were two of Hargreave's best investmentsTo reduce the risk that comes with investing in smaller companies, Hargreave holds a highly diversified portfolio in both his funds. Marlborough Special Situations has around 200 stocks spread across various sectors and industries.

The largest position in the fund rarely exceeds 2%. Marlborough UK Micro-Cap Growth, one of Money Observer's Rated Funds, typically holds 250 shares.

He says: "For Marlborough Special Situations, I consider a universe of 2,000 stocks and aim to buy the best 10%. Initially, I take a position of 1%. Once I see that a company is successfully executing its strategy, I increase exposure.

"There will be a handful of big winners. If I ran a more concentrated portfolio, the overall performance of the fund would go one way or the other. But I would sooner reduce risk."

Hargreave's team has had many successes. He picks out Restore and Advanced Computer Software as two of its best investments.

Renew, JD Sports, RPC Group, Supergroup and Ted Baker also "made plenty of money". The team is one of half a dozen smaller company fund managers to have consistently achieved impressive returns over the past couple of decades.

This article was originally published by our sister magazine Money Observer here

 

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.