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Mar 20, 2023

Three things investors always get wrong with small

23 May 2023 Baillie Gifford’s Brodie on what really matters when investing in

23 May 2023

Baillie Gifford's Brodie on what really matters when investing in small-caps – and what doesn't.

By Matteo Anelli,

Reporter, Trustnet

Smaller companies aren't like other asset classes and investors often misunderstand them, generating potential for "awkward" conversations with fund managers, according to Douglas Brodie, FE fundinfo Alpha Manager of Baillie Gifford's Edinburgh Worldwide Investment Trust.

Against a backdrop of rising interest rates and declining credit availability, investors tend to shun smaller companies, which might suffer more than their more established counterparts as the economic landscape turns against them.

"Investors have a very short-term view on things. Market concerns or geopolitical concerns bring up the investment horizon and generate a flight to so-called safety, which is why today people are more interested in other instruments," he said.

But this is where the misunderstandings begin, as this is too short-sighted an approach.

"In the finance industry, we are bombarded with short-term trends and things that we are told matter – inflation numbers, consumer price index readings, moves in interest rates – and people will try and extrapolate trends and make sense of that.

"I find it odd and somewhat embarrassing to work in an industry where time horizons are measured in months. That feels quite alien to me and I can moan about it but I'm never going to change that. This time horizon dissonance is probably the starkest thing for a strategy like ours."

In the £588m trust, Brodie typically invests in companies with a market capitalisation of less than $5bn at time of initial investment which he believes offer long-term growth potential. While the portfolio has underperformed its peers over the short term, it positively stood out out over a five and 10-year horizon, as the chart below illustrates.Performance of fund over 5 and 10yrs against sector

Source: FE Analytics

Investing in small-caps through a growth lens means taking a high-conviction stake in businesses that are being built from a very early stage, which is why investors should allow enough time for them to grow, Brodie argued.

"Small-cap investing is undoubtedly a long-term endeavour. You cannot do it properly if your time horizon is measured in months. We have to have a longer time horizon and accept that the market doesn't."

Another fallacy of taking a short-term view to small-cap investing is that it doesn't allow enough time for disruptive mega-trends to come through.

"There are some mega-trends that are always at play independently of the macro picture, for example the deflationary trends of technology. This pattern repeats time and time again, as technologies such as genome sequencing or processing power for semiconductors (classic ‘enabling’ technologies) deflate to a point when they are applicable as tools for a whole host of innovators to then build solutions," explained Brodie.

"This silent human progress is very much alive and well at any point in time. Pessimistic news from around the world doesn't make a dent in this. Things like the dotcom bubble or the Covid pandemic create a lot of noise and narratives in stock markets but don't upset these long-term trends where you want to be invested."

Another concern in this area is the fear of companies going bust, but this is also something that investors need to re-frame, said Brodie.

"There will undoubtedly be businesses that don't work, where your investment hypothesis may have looked good on paper but when it came to execution a whole host of things could have gone wrong. They could have lost to the competition or the management team could have over-promised and under-delivered. Frankly, in our industry that tends to be what people obsess about," he said.

"That also makes for some awkward conversations with clients, particularly those that are quite short term. And it's the painful side of investing, but if you don't tolerate the risk, you unlock the potential. And that's the ability to make multiple times your money in these special businesses as they are being built. There's always a fine line between the ones that don't work and the ones that do."

Finally, small-cap over-compartmentalisation is also a thing of the past.

Small-caps used to be thought of as smaller versions of larger companies, but that worked until 2010, when a lot of "interesting small businesses" started to come up with global ambitions and "break the mould" of how people thought about small-caps.

In particular, the approach of more traditional funds was to break small-caps down into themes and regions to cope with their complexity, which isn't fit for purpose anymore and had to re-adapt to the new, global context.

"Traditional portfolios used to break things up by regions being large-cap, mid-cap and small-cap and forget the fact that great, interesting investments should be allowed to run and should be allowed to grow. This is why in our own fund, we have a time horizon of 10 years," concluded Brodie.

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