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The pros & cons of investing in smaller companies

01 September 2018

UK smaller companies have held their own since the vote to leave the EU in 2016 but investing in this sector carries its own particular set of risks.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • What the advantages of smaller companies are.
  • Why liquidity can be an issue.
  • How to invest.

Despite ongoing political and economic uncertainty surrounding Brexit , UK smaller companies have proved resilient, outperforming their larger counterparts over recent years.

According to latest statistics from the Investment Association, the UK Smaller Companies sector has performed better than any other UK sector over five years. Over a decade, it is the fourth best performer of the IA’s 38 sectors, behind Technology and Telecommunications, Japanese Smaller Companies, and North American Smaller Companies.1 However, past performance should never be relied on as a guide to the future, and there are no guarantees that this sector will continue to do well in future.

Here, we weigh up some of the pros and cons of investing in smaller companies, to help you decide whether small really is beautiful. If you’re unsure where to invest, seek professional financial advice.

The advantages of smaller companies

Smaller companies tend to have greater exposure to their domestic economies, with typical examples including retailers and house builders. Companies focusing their performance on home soil may provide a buffer against a volatile global economy during an uncertain political climate. They are less exposed to global trade, which could potentially be hurt by growing protectionism from political leaders across the world.2

These companies may also have the potential to grow faster than larger businesses, despite a challenging environment. They are often more easily able to diversify in order to expand, being typically more dynamic and innovative. For example, initiatives may include launching a new product, or moving into different regions and overseas.

Among the main attractions of smaller companies is the likelihood of mergers and acquisitions activity in this sector, with larger companies often snapping up smaller ones to expand their own businesses , and being willing to pay a premium to the existing shareholders to take control.

The downsides

Investing in smaller companies is a fundamentally more risky approach than picking bigger firms, which have larger economies of scale and diversified revenue streams. If smaller companies get into difficulty their share prices can fall sharply, and if they don’t have substantial reserves on their balance sheets to shore up any losses, they could even go bust.

During the global financial crisis, as many as 50 smaller businesses were closing their doors each day.3

Investors also have to watch liquidity. Shares in smaller companies can be far harder to sell if you want to cash in your investment, with potentially fewer buyers around, particularly when times are hard. This means that it can be difficult to sell for the price you want, with a big gap between the price you buy at and the price you can sell at, known as the ‘spread’. This could make it tricky to exit and might compound any losses.4

If you’re an income-seeking investor, larger companies are more likely to provide an income stream in the form of dividends paid from the profits they make.5 Their smaller counterparts, however, are more likely to choose instead to reinvest any profits in the company, with the objective of growing the business.

How to invest

In general terms, smaller companies are businesses that aren’t listed on the FTSE 100. You’re more likely to find them listed on the the Alternative Investment Market (AIM).

AIM is a sub-market of the London Stock Exchange largely made up of smaller companies, and you’re able to buy shares in these. You can place AIM stocks in an investment ISA (Individual Savings Account), meaning you won’t have to pay capital gains tax on profits or income tax on any dividend payouts received. You also don’t pay any stamp duty when buying AIM shares.6 But please bear in mind that tax rules can change and their effects depend on your individual circumstances.

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However, if you’d rather not hunt for small company bargains yourself outside the FTSE 100, you can enlist the help of a professional fund manager. There are plenty of smaller companies funds to pick from that spread risk, with holdings in a wide range of companies in different sectors.

Examples of funds in this sector include Fidelity UK Smaller Companies, AXA Framlington UK Smaller Companies, Unicorn UK Income, and Liontrust UK Smaller Companies. Bear in mind that our mentioning these funds doesn’t constitute a recommendation and if you’re unsure, you should seek professional financial advice.

Another way of gaining exposure to smaller companies is to invest in a passive exchange traded fund (ETF) or tracker fund that tracks the performance of the small cap index.

However, remember that portfolios usually benefit from a diversified approach to investing, taking in both large and smaller UK companies to deliver returns.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.

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