Why adding smaller companies can create a more balanced portfolio

You’ve probably heard the most familiar rhetoric about investing in smaller companies.

“You could make a fortune!”

“You could lose all your money!”

Yes, smaller companies can make you great returns, as you’ll see in a moment. And yes, this does come with much higher risks when compared to buying shares in larger companies.

Sadly, many investors think about smaller companies in entirely the wrong way. They look at them in isolation, when they should be thinking about how they fit into a broader portfolio.

This means they overlook a vital benefit of investing in smaller companies: they are a great way to diversify.

Why? Because smaller companies are fundamentally different to every other type of asset:

  1. They have a unique risk/reward profile.
  2. They can be more flexible, and so better able to adapt to shocks.
  3. Smaller companies can be less prone to getting pushed about by stock market sentiment. This is especially true of unquoted companies whose shares don’t trade on a stock exchange.

A unique risk-reward profile

Probably the main attraction of smaller companies is that they offer the kind of growth potential that’s relatively rare among larger companies.

Back in 2009 our Ventures team invested in a little-known property website called Zoopla, adding it to the portfolio of Octopus Titan VCT. By 2017, when the team sold Zoopla, it had grown to become a household name.

Please keep in mind that VCT shares put investors’ capital at risk, and investing in smaller companies means your investment can be more volatile and harder to sell than having shares in big companies. We’ll go into more detail about these risks later on.

Now, Zoopla is just one example to show the kind of success smaller companies can have. Of course this won’t be the case with every investment.

Smaller companies are often more flexible and adaptable

The popular perception of smaller companies is that they’re weak, fragile and vulnerable to shocks. They have fewer financial resources than larger companies, and so might go out of business where a larger competitor weathers the storm.

That can certainly be the case at times. It takes time for a business to build up its profitability and establish a strong balance sheet.

Sometimes, however, the received wisdom is just plain wrong.

Far from being vulnerable to shocks, in many cases smaller companies are the shock.

Today’s technology means a small number of staff can reach millions of people – not just in this country, but worldwide – and sell to them directly. It allows smart businesses to benefit from economies of scale that, in a previous era, were the preserve of giant multinationals with thousands of employees.

Most smaller companies also face lighter regulation compared to those whose shares trade on the London Stock Exchange’s main market. This, combined with smart use of technology, means that the best smaller companies tend to be very nimble. They can switch and focus on more promising regions or sectors much more quickly than larger competitors.

And smart use of tech doesn’t just mean lower costs and faster reactions. In some cases, selling direct also means a better product and a better customer experience.

An example of this is Tails.com, which sells food tailor-made for each customer’s dog (or dogs) direct to people’s doors. This just wouldn’t be possible if they were selling through supermarkets.

Smaller companies’ share prices can be less prone to extreme market sentiment

When stock markets sell off, emotions are fraught. It’s never pleasant watching the value of your portfolio drop substantially in a short space of time.

Investors in unquoted companies can have a bit of an advantage at times like this. That’s because their share prices are worked out periodically, based on the underlying performance of the business rather than the emotions of the herd. So they don’t see the value of their holdings drop suddenly because Mr Market’s having a tantrum.

Of course, if stock market weakness reflects broader economic weakness, then you should expect this to affect quoted and unquoted companies alike.

But if it’s a temporary panic, it’s much easier to stay calm and collected when there’s no sudden share price drop to fret about. And you don’t get that horrible feeling of watching everything in your share portfolio head south all at once.

But can you invest if the shares are unquoted? Yes, you can

If you’re thinking about adding smaller companies to your portfolio, how do you go about it?

In particular, how do you invest in companies whose shares aren’t listed on any stock exchange?

Well, one option for those comfortable with a higher risk investment might be a venture capital trust (VCT). Some VCTs, such as Octopus Titan VCT, invest directly in unquoted companies. You then buy shares in the VCT and get exposure to the companies in the VCT’s portfolio.

There are also tax benefits to investing in VCTs. VCTs offer 30% income tax relief on subscription (up to a maximum investment of £200,000), though you have to hold the investment for at least five years to keep this. Dividends meanwhile are tax free. As we explain below, though, these tax benefits won’t always apply and can’t be guaranteed.

VCTs: risks you should keep in mind

You should always remember that the value of an investment into a VCT, and any income from it, can fall as well as rise. So you may not get back the full amount you invest.

As for the tax benefits just mentioned, tax treatment will depend on individual circumstances and may change in the future. Tax reliefs also depend on the VCT maintaining its qualifying status.

Oh, and the risks mentioned earlier about smaller companies’ shares being more volatile apply here too. VCT shares could fall or rise in value more than other shares listed on the London Stock Exchange’s main market. And they may also be harder to sell as there isn’t an active secondary market for VCT shares in the way there is for larger listed companies.

Conclusion: Smaller companies offer more than just growth potential

Whether they’re investing through a VCT or some other way, investors tend to have the higher risks and higher growth potential of smaller companies uppermost in their minds. That’s fair enough – these are important considerations. But investors tend to miss another benefit of investing in smaller companies.

Because while smaller companies’ shares can undoubtedly be volatile, in some cases they may actually end up lowering a portfolio’s volatility by improving its diversification.

Paul Latham, Managing Director of Octopus Investments

More about VCTs

Personal opinions should not be seen as advice or a recommendation. We do not offer investment or tax advice. We recommend investors seek professional advice before deciding to invest. This advertisement is not a prospectus. Investors should only subscribe for shares based on information in the prospectus, which can be obtained from octopusinvestments.com. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London, EC1N 2HT. Registered in England and Wales No. 03942880. Issued: January 2018. M2-CAM06021-1801.