Questor: British smaller companies’ returns have been dire but investors should not give up

AIM portfolio: improving long-term economic outlook is set to catalyse performance

Investors in UK-listed smaller companies have endured a torrid time in recent years.
Indeed, since Questor launched its AIM portfolio in October 2017, the FTSE AIM All-Share index has slumped by around 25pc as a combination of protracted economic challenges and political uncertainty has weakened investor sentiment.
Against this backdrop, our AIM portfolio holdings have fallen by around 2pc on average. This is undoubtedly a disappointing performance over an extended timeframe. 
Many investors may question whether there is much point in persisting with UK-listed smaller companies. After all, the whole point of buying them is to generate relatively high returns that more than compensate investors for the inherently greater risk and elevated share price volatility.
In Questor’s view, now is not the time to give up on UK-listed smaller companies. While their relative dependency on the UK economy – when compared with larger firms that have a more international focus – has previously been a liability, it is now set to gradually become an asset.
Inflation that is more closely aligned with its long-term average is set to ultimately prompt a sustained reduction in interest rates, the timing and speed of which are a known unknown. But an era of modest price rises and monetary policy easing is likely to prove highly beneficial to the economy’s growth rate as time lags pass.
A stronger rate of economic growth over the long term should provide much-improved operating conditions that allow smaller firms to generate higher profits. In turn, this should lead to higher market valuations from their current low ebb. And as history shows, trend-following investors usually find rising share prices too tempting to ignore, thereby creating a snowball effect that pushes market valuations higher.
A relatively stable political environment is also likely to prove highly beneficial to UK-listed smaller companies. After several years of political uncertainty, an extended period of relative calm could boost investor sentiment at a time when other developed economies face more turbulent near-term futures. 
While potential changes to fiscal policy may weigh on share prices in the short run, dirt-cheap valuations among UK smaller companies suggest they are more than adequately factored in.
In order to capitalise on an improving outlook for UK smaller companies, Questor intends to follow a very similar strategy to that employed since the inception of our AIM portfolio. Notably, our central objective is to only hold stocks that have solid financial positions. While this is important with any size of company, it is even more so with smaller firms that lack the size and scale of FTSE 100 stocks. 
Therefore, while falling interest rates may mean that most investors begin to pay less attention to company debt levels, this column will continue to select firms that have modest net gearing and ample net interest cover. Risk reduction will, of course, be further enhanced by having a diverse portfolio that does not rely on a small number of holdings.
We will also continue to seek companies that have a clear and sustainable competitive advantage. And since small-cap stocks have delivered extremely disappointing returns over recent years, our requirement that any new holding offers a wide margin of safety may not prove a difficult hurdle to overcome. 
As ever, we anticipate relatively high share price volatility will persist across our portfolio holdings. Even though the outlook for UK smaller companies is likely to improve, their share price instability is inherent. While this may deter some investors from purchasing smaller firms, our long-term focus means it will not be a consideration for this column in future.
Of course, the potential for inheritance tax relief from owning certain AIM shares continues to be a major motivating factor for many holders, and it remains too soon to know what the current Government’s tax policies will be. But given that Questor is by no means a tax expert or adviser, readers should continue to avoid the assumption that any holdings in our AIM portfolio are guaranteed to qualify for inheritance tax relief.
Overall, the long-term prospects for our AIM portfolio are upbeat. A gradual improvement in the UK economy’s outlook and a stable political environment are set to catalyse the market valuations of holdings that currently offer wide margins of safety. With a continued focus on holding a diverse range of companies that have sound fundamentals, we expect the portfolio’s returns to significantly improve over the coming years.
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