The investors for whom small is often beautiful

(AP)

Evangelical pitches from UK small-cap fund managers may have skated over some of the stock-specific dangers that remain a very real threat in the market.

However, the analysts' warnings about small-cap companies – citing the ongoing lack of corporate finance or availability of credit insurance for retail suppliers, as with HMV this week – have failed to dampen the optimistic mood of investors in this sector.

The reason is that the performance of the Hoare Govett Smaller Companies Index (HGSCI) supports the case for UK small-cap investment, even allowing for the small minority funds that do not benchmark against this index.

The HGSCI measures the performance of the lowest 10 per cent of companies in the UK equity market by market capitalisation and is the benchmark of choice for most funds in the Investment Management Association's UK Smaller Companies sector.

The key point for investors is that the FTSE 100 rose by just 38.9 per cent over the 10-year period to the end of December, compared with a 111 per cent increase in the Hoare Govett SC (excluding investment trusts) Index over the same period. What is more, some funds made more than double this amount. The record is even more impressive over the past decade. There are just four out of 36 funds that have failed to make a profit over 10 years, which equates to 11 per cent of funds in the sector. The trend over five years is similar, with just five funds (14 per cent) in negative territory.

Despite this, over the past year, the majority of smaller companies funds continued to witness considerable outflows across the sector because investors just haven't been convinced by the prospects for small caps, but the figures suggest they have been missing out. There are exceptions, however. For example, Standard Life Investment's UK Smaller Companies Fund, managed by the inimitable Harry Nimmo, has seen the biggest influx of new money within the past year.

According to figures from Financial Express, Mr Nimmo's fund attracted a whopping £205.2m in new money in 2010, easily making it the fastest-growing fund in the sector. The nearest fund in terms of inflows was the Halifax Smaller Companies Fund, which saw £42.7m of new money invested, ahead of the Marlborough Special Situations Fund, which grew by £33m.

At the other end of the spectrum, Aberforth's UK Small Companies Fund was the fund to see the biggest outflows, losing £150.3m within one year. The Artemis UK Smaller Companies Fund ditched £51m, while Baillie Gifford's British Smaller Companies Fund fell £44.4m.

So, investors who are believers in the "safety in numbers" philosophy may be interested to see where fund managers believe the next big thing will be. While there are numerous examples of companies that managers have backed in isolation, there are also a great many stocks where managers have invested together.

What Investment? magazine charted the top 10 holdings of all funds within the IMA UK Smaller Companies sector and identified the companies most consistently named as being a large holding within a fund. Domino Printing Sciences was the company named most often as a majority holding – appearing in 12 of the 57 funds in the sector.

In its December trading update, the company confirmed record sales and declared its 32nd consecutive year of revenue growth. The FTSE 250-listed company has an international profile, with 90 per cent of its business based on exports.

Victrex was another popular holding in 2010, with eight funds in the sector declaring it as a majority holding. In its full-year results, the plastics company declared group revenue of £189.5m, up 82 per cent since 2009. It has a strong balance sheet too, with cash of £77.3m and no debt. Its full-year dividend per share was up 30 per cent at 25p, with a special dividend per share of 50p.

There are three companies tied in popularity terms in third place: the medical research specialist Abcam, the speciality chemicals manufacturer Croda and the scientific kit maker Immunodiagnostic Systems.

For those investors who would rather invest in a fund, remember there are massive differences in consistency, strategy, volatility and management styles. The cumulative three-year rankings show Close Special Situations to be the best-performing fund, followed by SF t1ps, Investec UK Smaller Companies, Standard Life and Aegon, but that doesn't tell the full story.

The Close Special Situations Fund had a stellar 2009 – returning 250.9 per cent in one year – but it has been languishing in the bottom quartile for the other two years.

Deryck Noble-Nesbitt, manager of the fund, says: "If I repeat the performance, people may be more willing to commit money to the fund. It is only £18m and quite small. A lot of people want to see funds of at least £40m before investing."

Noble-Nesbitt's approach was perfectly illustrated in January when he continued to buy up shares in HMV despite the company's profits warning and well documented issues with its suppliers which affected the share price.

Comparatively, Standard Life Investment's UK Smaller Companies Fund – which is ranked fifth on a cumulative basis – was the third best performer in 2010, 30th in 2009 and second in 2008.

Over 10 years it is the Marlborough Special Situations Fund, managed by Giles Hargreave, that is the stand-out performer. Hargreave believes in running a portfolio with a large number of stocks because it allows him and his team to spread risk and look at all situations.

This research is taken from the February edition of 'What Investment?' magazine, available in newsagents from 31 January 2010.