Five golden rules of small & mid-cap investing

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Five golden rules of small & mid-cap investing

The sharp fall in sterling after the EU referendum in 2016 against a range of currencies had predictable effects on UK equity markets. Large-cap stocks, with on average 70% of earnings overseas, were mechanically re-rated to take account of 'cheaper' valuations.

Conversely, for the first time since the financial crisis, mid-caps endured a steep sell-off. This correlated with mid-caps' lower percentage of overseas earnings and commodity exposure.

Since then, we have seen a revival in mid-sized companies - the FTSE 250 (MCX) now only lags the FTSE 100 (UKX) by two percentage points.

Moreover, mid-caps have outperformed the FTSE 100 over almost every other time period. For example, the representative mid-cap index delivered 93.7% versus the FTSE 100 return of 56.2% over the last five years.

Over 10 years, the small-cap index has soared past the FTSE 100, returning 170.09% against a large-cap return of 69.9%. While small and mid-caps are susceptible to pockets of volatility, they remain the market's best source of long-term growth opportunities.

Moreover, carefully navigated, both small and mid-caps can provide a perpetual source of alpha generation. Below is an outline of our five golden rules to unearthing small and mid-cap firms that can deliver sustainable growth.

Capitalise on thin broker coverage

As you go down the market cap scale, the efficacy of a quantitative approach to investing diminishes. This opens up the opportunity for alpha capture. When we identify a company in a far corner of the UK with a lack of institutional share ownership and limited analyst coverage, we know we may have found a hidden gem.

For example, last year, we met with the Mortgage Advice Bureau (MAB1), a mortgage broker network run by an impressive entrepreneur.

Before our visit, the firm had not seen a single analyst that year. Over the course of a day, the team took us through the company's newly-customised process and we had full access to management, brokers and even customers.

Since taking the decision to invest in the firm, the share price has doubled. Mid-cap due diligence means extensive travel to far corners of the country visiting niche companies, but it can reap a rich harvest.

Know when to take profits

'Buy low and sell high' may be oft-quoted investment wisdom, but in practice, it's hard to do. Certainly, in our experience, the first part is easier.

A defined process paired with an instinct honed from years of experience sharpens the eye for attractive entry points.

Unfortunately, when it comes to selling, deep behavioural biases can interfere with an investor's radar. For example, a trend known as 'anchoring' occurs where, in the absence of better or new information, investors assume the market price is the correct price.

The only way to avoid behavioural biases is by incorporating a defined sell-discipline into a fund's process.

For example, Blue Prism (PRSM) and Mortgage Advice Bureau have been fantastic performers for the portfolio - but their meteoric stockmarket rises demanded that we top slice and take profits. This locks in gains and rebalances the risk profile of the portfolio.

Be discerning about the IPO market

We see two principal types of IPOs. The first is a genuine capital-raising exercise, where management seeks to raise cash for expansion while retaining a significant stake (e.g., Blue Prism). The second is an attempt by private equity to unload a company they cannot trade sale or sell to other private equity funds, of which there have been numerous current examples.

Usually, the latter is far less attractive than a genuine capital-raising IPO, but there are exceptions. One relatively recent example was Morses Club (MCL), where a combination of a small market cap and fund manager reluctance to buy a post-crisis HCC (Home Collected Credit) business made the valuation compelling.

Since investing the stock has returned 24%, although we added significantly to our position when the stock temporarily fell below the float price. Discernment is crucial when navigating the IPO market. Currently the IPO market is looking frothy and the quality of issues has gone down, so we are maintaining a watching brief.

Always remember: cash is king

Classic growth stocks are the engine of a successful small and mid-sized portfolio. They deliver strong, stable growth with high returns on capital and rising dividends. We like to find these opportunities often in unloved companies with low PEs but with great growth prospects.

Phil Harris is fund manager of the UK Equity Growth Fund, EdenTree Investment Management.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

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.