Baillie Gifford British Smaller Companies has the ingredients of a sound small cap play for investors.
Although this fund hasn’t shined as brightly as some of its peers over the past year, lead manager Iain McCombie has delivered strong results for investors over longer periods. The fund has generated top quartile returns in its IMA UK Smaller Companies sector over the three- and five-year periods. McCombie has returned 14.4 percent for shareholders in the period from July 2001 to the end of April 2007 (he started managing the fund in mid-June 2001). That showing also compares favourably to the Morningstar UK Small Cap equity category average of 12 percent over the same period.
The performance reflects McCombie’s longer-term orientation. He’s not interested in chasing the latest trend du jour in order to keep up with the pack. Instead, he tries to find companies that he believes can deliver sustainable growth over the next three to five years, and keeps turnover low at 29.6%. McCombie likes companies with the ability to generate free cash flow and plenty of working capital to keep the business running over the long term. He typically shuns companies with high levels of debt and likes to note how goodwill is capitalised because it can make a company’s valuation look misleadingly high. He also insists on a high level of interaction with company management: both before he considers buying and while he is invested to make sure their strategy is in keeping with his investment thesis. The resulting portfolio is a blend of growth and core stocks; financials and business services companies frequently meet his criteria.
As is the case with most small-cap funds, returns here can be volatile and much can be lost in a short period. September 2001 was a difficult environment for small cap funds and this particular fund lost 17.4 % in just that one month. McCombie manages risk in part by focusing on the fundamental strength of his picks. He also uses Baillie Gifford’s internal risk-management team to stay aware of the fund’s risk exposures, and tries to keep the fund’s tracking error between four and eight percentage points of the FTSE Small Cap ex IT index. Such measures have helped keep volatility just about even with the Morningstar UK Small Cap category norm.
McCombie’s emphasis on picking stocks based on long-term fundamentals can cause the fund to lag its peer group in certain environments. For example, during a speculative period in 2003, the fund delivered a bottom-quartile showing. We like managers to apply their style consistently, but investors should be aware the fund may under perform its peers when lower-quality fare leads the market. Furthermore, the £1.5 billion in assets (across all accounts) that McCombie runs in this style is a concern given the liquidity constraints inherent in small-cap investing and the potential for increased trading costs that can damage returns. Still, given the fund’s low level of turnover we’re willing to give McCombie the benefit of the doubt for now. Any significant changes to his style or portfolio construction, however, would cause us to re-evaluate that position.
Despite those caveats, and assuming that asset-growth isn’t permitted to proceed unchecked, we believe that McCombie’s style is sensible, and capable of delivering strong long-term results relative to other UK small-cap offerings. Therefore, for small-cap investors who are prepared to wait out some lean spells, we believe the fund is a good choice.
