“Include better ingredients so your cake wins the bake-off” - Carbon's third Investment principle

Carbon advises clients to buy and hold shares in ‘small’ companies and ‘value’ companies as part of their portfolios.

The definition of what constitutes a ‘value’ company is more complicated to explain than that of a ‘small’ company, which is broadly still a big quoted company, but the smallest of the big companies listed on world’s stock exchanges. A ‘value’ company has an accounting valuation that is greater than the value of all the shares in issue, i.e. if the company was broken up today and all the assets like buildings, machinery, stock, etc, were sold, this would raise more than the market value of all the shares in issue; therefore, these companies are trading at a discount to their asset value. We target those companies whose share price represents the greatest ‘discount’ when compared to the assets of the company.

Why do we invest in small and value companies? Because they have a higher expected returns than large companies or ‘growth’ companies.

Intuitively this makes sense as it’s a risk and return story. If you were to lend money to a local independent retailer (a very small company), you would expect to receive a higher rate of interest to compensate for the risk you are taking compared to lending to, say, Marks & Spencer. And the principle applies if you invest in, rather than lend to, a small company – you deserve a higher return for the additional risk involved.

The same goes for companies whose share price has fallen, perhaps because their sector is unfashionable or they are going through a restructure, or the market does not like a new product – such a company is ‘riskier’ so investors demand a higher rate of return to compensate for that additional risk.

So small and value companies are riskier, but we view this as ‘good’ risk as we expect a higher return to compensate us. The same cannot be said for all risks.

At Carbon our investment approach is based on evidence. We seek to avoid unnecessary risks. One such risk would be to use actively-managed funds to deliver the required investment return. Active managers try to beat the market, but study after study proves that two-thirds to three-quarters of managers fail to do so over any meaningful time-frame.

Academic studies also show that over any meaningful time-frame, investing in small and value companies has delivered a better return than the broad market, so much so that your odds of success with this strategy are 75% or more, in direct contrast to the 75% chance of failure if actively-managed funds are chosen. For this reason we think the risks associated with small and value companies are well worth taking.

Tilting the odds of investment success in our clients’ favour might seem like an obvious thing to do, but it is one of the many things that make Carbon very different from our competition. Using small and value companies as part of the ingredients in our investment cake helps it rise to the occasion.

This blog post was written by Richard Wadsworth, financial planner at Carbon. You can view Richard’s profile here or contact him via email on richard.wadsworth@carbonfinancial.co.uk.