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‘Markets are choppy – but small stocks will always come out on top’

 Close up detail of a smart energy in home display monitor for a smart meter, kettle in background - Chris Hepburn /iStockphoto
Close up detail of a smart energy in home display monitor for a smart meter, kettle in background - Chris Hepburn /iStockphoto

It has not been an easy time for investors in Britain’s smallest listed companies, known as “micro-caps”, particularly those classified as “growth” stocks.

As central banks have raised interest rates to tackle inflation, investors have had to re-evaluate the prospects of fast-growing companies. They had been prized for the promise of future earnings but now higher interest rates have diminished the value of those profits.

This is something that Eustace Santa Barbara, co-manager of the Marlborough UK Micro-Cap Growth fund, is all too aware of. His £1.3bn fund, which he runs alongside Guy Feld, has lost 19pc over the past year, compared with a 14pc loss by rivals.

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Mr Feld has been co-managing the fund for more than 10 years, while Mr Santa Barbara came in last year as veteran stock picker Giles Hargreaves stepped down.

Yet in spite of a challenging 12 months, he says most stocks in his portfolio are profitable and over time their strong potential will receive the recognition it deserves from investors.

He adds that the recent stock market sell-off has created a “rare opportunity” to buy Britain’s smallest companies at a discount.

How do you pick stocks?

One of the attractions of investing in smaller companies is the sheer number of opportunities. There are always new and interesting companies coming on to our radar.

Fewer fund managers and analysts cover smaller companies, so by doing our own research we have an opportunity to identify businesses with the potential to grow before others do.

We like niche companies where there are few, if any, other businesses offering a similar product or service. If the customer has limited alternatives, it gives the company pricing power and that can provide a degree of protection in more challenging economic conditions.

Why do you own so many companies?

Smaller companies can offer big returns to early investors – but if they run into problems, their share prices can plummet. To help manage the risk and stop one stock doing huge damage our portfolio, we have 180 companies in the fund. The vast majority account for less than 2pc of assets each. We do a lot of research but we don’t get everything right all of the time. If a company runs into trouble, the overall effect on our investors’ savings should be limited.

Why have smaller stocks struggled so much?

When markets are worried about the economy, it gets amplified in the share prices of smaller companies. They are less well known and researched, so people are less comfortable owning them when they’re worried about other things. The general view from investors is to favour “safer” large-cap names they’re more familiar with.

Also, a lot of investors have moved into cyclical sectors such as commodities and banks, where you tend to find large companies. They have moved out of areas like technology, where there are quite a lot of micro-cap names in Britain. There has been an indiscriminate sell-off, which has presented us with the chance to buy more of the high-quality micro-cap names we like.

Why should investors consider owning micro-cap stocks now?

Over the past 66 years, listed smaller companies have beaten larger businesses by 3.4 percentage points per year. This is quite material over a number of years, especially when compounded. Markets are volatile right now, but investors can buy high-­quality small and mid-cap names with great prospects at an attractive share price.

There is nothing that makes me believe that smaller companies are not in a position to grow their earnings per share more quickly than large companies over the coming years.

What has been your best investment?

Cerillion provides billing and customer relationship management software to telecoms and infrastructure companies. Its share price has risen nearly six times over the past three years. The execution has been outstanding, its earnings are becoming increasingly robust and it is winning larger customers. It does not have many rivals and we think the management team is solid.

And your worst?

IG Design is one of the world’s leading manufacturers of wrapping paper. The company works with top retailers such as Walmart and Tesco. However, it has suffered from supply chain issues, labour shortages in China and significant costs relating to shipping, paper and ink. The shares have fallen by 90pc over the past three years. This is a good example of why we own so many stocks. We are sticking with the company for now.