Eustace Santa Barbara, co-manager of the IFSL Marlborough Special Situations, UK Micro-Cap Growth and Nano-Cap Growth Funds, explains why investors should resist abandoning proven investment processes during periods of market uncertainty, and why the long-term case for UK smaller companies remains compelling.
Cast your mind back a couple of months to the World Snooker Championship and the nail-biting semi-final between Mark Allen and Wu Yize. The defining moment of a genuinely epic clash came in what would turn out to be the penultimate frame.
Allen needed only to pot the black off its spot to advance to the final. It was a shot he would usually make a hundred times out of a hundred. Incredibly, he instead rattled the ball in the jaws of the pocket.
This presented his suitably stunned opponent with the opportunity he needed. Wu went on to win the match and, subsequently, the title.
Yet why did Allen miss? Perhaps the most likely explanation lies in process – or, to be more accurate, in the sudden absence of it.
It is in this respect, I believe, that the episode offers a valuable investment lesson – not least with regard to the long-term attractions of UK smaller companies.
Responding to anomalies
Poring over the miss in the BBC Sport studio, former champs Steve Davis and Kyren Wilson highlighted how Allen had played the fateful shot with his bridge hand resting on the cushion and therefore some distance from the white.
He would normally place his bridge hand on the baize, within just a few inches of the cueball.
The peculiarity was likely to have been decisive, Davis and Wilson argued. The enormous tension, the possibility of a sensational victory, the heat of the moment – something had suckered Allen into abandoning a tried and trusted routine.
It is easy enough to find a parallel in investing. There are countless instances when, either consciously or subconsciously, we might be tempted to radically revise our approach in the face of extraordinary circumstances.
By way of illustration, imagine a stock, a fund or an asset class enjoys a spell of notable outperformance. Showered with unpredicted gains, should we rest on our laurels and exercise less rigour in our efforts to identify the brightest investment opportunities?
Conversely, imagine a stock, a fund or an asset class enjoys a spell of notable underperformance. Rocked by unpredicted losses, should we dismiss everything we think we have learnt and adopt a conspicuously different way of making sense of the investment universe?
The bigger picture
Something akin to the latter scenario has characterised the plight of UK smaller companies in recent years. Amid the fallout from disruptive dynamics such as the vote for Brexit, the COVID-19 pandemic, soaring inflation and the apparent normalisation of political instability, this is an arena whose investment appeal is widely perceived to have dimmed.
As a result, many investors have turned their backs. Just as significantly, many fund managers have questioned the merits of exploring this space.
In doing so, these market participants seem content to forget that UK smaller companies have an impressive track record over time. For example, Deutsche Numis 2025 Annual Review data stretching back to 1955 shows they outshone not just the FTSE 100 but US equities and Treasuries over the course of the ensuing 70 years.
In my view, this is where the importance of process enters the reckoning. Regardless of the backdrop, there is likely much to be said for resisting the urge to dramatically change tack.
It is true that notable, unpredicted outperformance can make us look like fortune tellers. It is also true that notable, unpredicted underperformance can make us look like fools.
Yet neither of these anomalies – for that is what they ultimately tend to be – demands the rejection of a process that has been shown to work time and time again over the longer run.
The bigger picture should carry more weight than the relatively fleeting aberrations that sporadically punctuate it.
Staying focused on what works
So what might constitute an effective process for investing in UK smaller companies? In our experience, broadly speaking, the basic goal is to find businesses that have impressive growth potential and which are undervalued in relation to their prospects.
This requires in-depth research – not something for which this corner of the investment realm is especially renowned.
The number of sell-side analysts monitoring a given UK smaller company frequently falls somewhere between low single figures and zero, which is why funds like ours prefer to rely on in-house expertise.
It is useful to operate a “watch list”. A deeper dive – including direct engagement with senior management and a comprehensive risk/reward analysis – can then be conducted whenever a specific business piques interest.
Since the lower end of the market-capitalisation spectrum can be volatile, portfolio diversification should be sensible. We build positions gently and do not allow any one holding to account for more than 3% of a fund. Equally, sell decisions must be rooted in a disciplined framework.
This kind of methodology has held up over extended periods. With a sprinkling of eye-popping exceptions, the same might be said of Mark Allen’s cue action. So why cast it aside?
Although investment professionals are forever obliged to stress the past should not be taken as a guide to the future, history strongly suggests it is unwise to black-ball UK smaller companies.
Crucially, it also suggests investment processes that have served investors well previously can serve them well again now.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The writer’s views are their own and do not constitute financial advice.
This information should not be relied upon by retail clients or investment professionals. Reference to any particular investment does not constitute a recommendation to buy or sell the investment.
Main image: focus, eye, lens, perspective, alex-perez-VibKgg3aUd0-unsplash
