Small Caps  

Why small caps can bring balance

Indeed, selecting stocks from the small and micro-cap universe – or a fund invested in those stocks – can have the effect of lowering the overall level of volatility in your portfolio.

What might those stocks look like in this context?

Well, for one thing, some sectors of the market are more cyclical than others; in particular, businesses focused on the discretionary spending of consumers, which tends to be squeezed during tougher parts of the economic cycle, are naturally prone to greater volatility.

Similarly, the natural resources sector is vulnerable to the volatility of commodity prices and therefore often the direction of travel for the business will not be fully in the control of the management team.

By contrast, well-managed businesses with a strong financial record – balance sheet stability and recurring revenues, for example – and a focus on their market opportunity, are better able to ride out the cycle.

Source: Bank of England

An example of this would be XPS Pensions Services (formerly Xafinity), an actuarial consultancy providing advice to the trustees of defined benefit pension schemes that have an ongoing multi-decade obligation to their members to account for and manage their scheme effectively. 

By assessing stocks through our filters, it is possible to find businesses that are well-placed to maintain and grow dividends and to deliver capital performance.

These businesses are well-placed to maintain their dividends and deliver that capital performance. Importantly, such businesses can be found throughout the small and micro-cap universe, sometimes on more affordable ratings than their blue-chip counterparts.

Far from adding to the potential for overall portfolio volatility, such companies can help reduce it. In other words, they can offer a valuable diversification opportunity.  

Embrace volatility

The bottom line is that volatility is a fact of life for investors in equities. 

However, with a portfolio strategy that is focused on careful diversification, it is possible to reduce this form of investment risk. The idea that small and micro-cap holdings should be an intrinsic part of such a strategy may feel counterintuitive.

But in practice, many blue-chip stocks are vulnerable to greater volatility than is often realised – and many smaller companies deliver greater consistency than expected.

As such, adding some of the latter to a portfolio dominated by the former makes a great deal of sense for many investors.

Ken Wotton is a fund manager of Livingbridge Equity Funds