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Investing in smaller companies comes with greater risk but offers higher rewards

city of london
city of london

Smaller companies are inherently riskier than larger ones. They lack the geographical, customer and product diversity, as well as financial strength, of their large-cap peers. This means that their progress can stall following disappointing news that would probably be little more than a “bump in the road” for a larger rival.

The high level of risk that comes with small-cap investing is evidenced in the performance of Questor’s inheritance tax (IHT) portfolio. Since its inception in October 2017, one of our holdings has gone bust and several positions are currently trading at significant capital losses amid a challenging economic environment that is weighing on investor sentiment.

Overall, our Aim-focused portfolio is down around 7pc. While this is vastly better than the FTSE Aim All-Share index’s 30pc slump, the FTSE 100 is flat over the same period.

Of course, smaller companies also offer greater reward potential than their larger peers over the long run. The performance of few, if any, large-cap stocks can rival the 274pc capital return of our holding in Volex since it was added to the portfolio in August 2018, for example.

The manufacturer of cable assemblies that are used in a wide range of applications including consumer electricals and electric vehicles recently released upbeat half-year results. Revenue rose by 11pc, while cost reductions led to an improved profit margin. This meant that operating profits increased by 17pc versus the same period of the prior year.

During the first half of the year, the firm acquired manufacturer of electrical wiring harnesses and automotive battery cables, Murat Ticaret, for $195m. The purchase has the potential to catalyse growth and provides cross-selling opportunities as Volex persists with its five-year plan to deliver annual revenue of $1.2bn by 2027 while maintaining an operating profit margin of 9-10pc.

Achieving that sales figure would represent a two-thirds rise versus 2023’s total annual revenue, which equates to an annualised growth rate of roughly 14pc. As a result, the company’s price-to-earnings ratio of 12.9 suggests it offers good value for money ahead of a new era of accommodative monetary policy that is likely to positively catalyse the world economy’s growth rate.

Unsurprisingly, the acquisition meant that the company’s net debt increased during the first half of the financial year. It now stands at $174m, up from $104m six months prior, but still equates to a modest net gearing ratio of around 56pc. Alongside a net interest coverage ratio of five, the company appears to have the financial means to overcome an uncertain near-term outlook.

As a small company, Volex is undoubtedly less protected against economic and industry-related challenges compared with its larger peers. But with a wide margin of safety still present despite its share price surge, it continues to offer investment potential based on its medium-term growth targets and ongoing strong performance. Hold.

Questor says: hold

Ticker: VLX

Share price at close: 309.5p

Update: Totally

While Volex has soared, our holding in healthcare services provider Totally has slumped. Its shares are down by 43pc since the release of its half-year results at the end of November. Its capital loss since being added to our IHT portfolio in January 2021 now stands at 81pc. At one time, the company’s shares showed a paper profit of 74pc following our notional purchase.

This provides yet further evidence of the high-risk nature of small-cap stocks.

The company’s interim results showed that sales declined by 21pc due largely to a tough operating environment, with rising costs and recruitment difficulties proving persistent. This meant the firm made a pre-tax loss of £1.9m in the first half of the year, with the loss of contracts proving to be costly.

Further difficulties would be unsurprising in the short run, which means additional share price falls cannot be ruled out.

However, the company is seeking to become more efficient via a reorganisation, with £0.5m of cost savings having been delivered in the first half of the year. Its net debt-to-equity ratio of just 10pc highlights the importance for companies, particularly smaller businesses, to limit their borrowings due to the potential for unforeseen challenges.

With demand for healthcare services set to rise over the long run, and inflation due to fall in the coming months, the prospects for Totally are likely to ultimately improve. Its low levels of debt and cost-saving strategy mean we will continue to hold in anticipation of an eventual share price recovery. Hold.

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