February 2022

How investments in smaller companies can be a useful addition to your portfolio

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When investing, it can be easy to become hung-up on buying big names – or so-called “blue chip” stocks – to generate returns in your portfolio.

Indeed, this is no bad thing; bigger companies listed on main indexes such as the FTSE 100 are generally the most established, and so are typically more likely to perform well, create profit, and serve you with investment returns as a result.

Even so, there’s still room for investments in smaller companies to bolster your portfolio.

Unlisted companies not on a main index, or companies listed on the Alternative Investment Market (AIM) Index, can still provide valuable benefits to your portfolio.

In particular, Venture Capital Trusts (VCTs) and the Enterprise Investment Scheme (EIS) offer an accessible route into such companies.

However, as you can probably imagine, that doesn’t mean smaller companies are always the right choice.

So, here are a few things to consider when thinking about investments in smaller companies.

Small businesses can grow to become household names

All businesses have to start somewhere. That’s why the first thing that’s worth knowing is that many household names have started out as smaller businesses seeking investment.

Two huge online businesses that benefited from VCT funding include fashion platform Depop and car retailer Cazoo.

Similarly, meal kit subscription service Gousto is an alumnus of the EIS, having outgrown the scheme with its success.

Early investment in these businesses would have provided great growth potential, particularly at the stage when these businesses were scaling up.

Indeed, a commonly quoted figure when discussing smaller companies is the Apple share price. According to CNBC, a $1,000 investment in Apple at the company’s IPO in 1980 would have been worth around $430,000 in 2018.

That means careful investments in smaller businesses could have greater growth potential than in larger, established businesses.

Of course, just because this has happened in the past does not mean it will happen in the future. Past performance is not indicative of future performance.

Adaptable and away from the market

Alongside this growth potential, smaller companies can even fare better than bigger ones in the market.

The share price of a smaller business will likely be more closely aligned to the underlying value, rather than market sentiment and conditions.

Of course, that still means you face additional volatility as the underlying value can fluctuate more. Even so, it may offer some protection from market movements.

Similarly, owing to their size, smaller businesses can be more adaptable to changing conditions than larger corporations, which must do a lot more to keep up.

This could mean that they’re able to be more resilient in difficult circumstances and volatile markets.

It could be tax-efficient

As well as the returns they can provide, investing in smaller companies can be a tax-efficient way to invest, particularly through the EIS and in VCTs.

For example, investments in the EIS offer 30% Income Tax relief on up to £1 million of investment in a single tax year.

That means, provided that the business remains EIS-qualifying for three years and you hold your shares for at least three years, you could reduce your Income Tax bill by up to £300,000.

You also benefit from tax-free growth on your shares, and you can even defer a Capital Gains Tax (CGT) bill on other assets if you reinvest the profit in EIS shares.

Similarly, VCTs also offer 30% Income Tax relief on up to £200,000 of investment. That gives you the potential to reduce your tax bill by up to £60,000.

There’s no CGT to pay if you sell your shares for a profit, and some VCTs also pay tax-free dividends to their investors.

That means, if you have a large amount of capital to invest, you could use these two options to mitigate Income Tax or CGT.

Downsides to investments in smaller companies

While all these advantages do sound promising, there are two downsides to bear in mind when investing in smaller companies. These are the greater risk you take on, and the illiquidity of your shares.

  1. Greater risk

The biggest issue with investing in smaller companies is that, while there is great potential for growth, that also means taking on additional risk.

A smaller business’s share value will likely fluctuate more, as the underlying value of the company is more variable while it’s growing.

So, you’ll need to be comfortable with potentially seeing the value of your investment rise and fall dramatically over time.

Aside from fluctuations in price, small businesses are more likely to fail entirely. Indeed, according to the Telegraph, 20% of new businesses fail within 12 months, rising to 60% after three years.

That means there’s a chance of you losing your entire investment in the time that it takes to be eligible for tax relief from a VCT or the EIS.

You must be prepared to take on this extra risk, including losing your entire investment, before you put your money in smaller businesses.

  1. Liquidity

Another issue that comes with smaller businesses is a lack of liquidity.

You may find it difficult to sell your shares as it would require another buyer to be willing to take them on.

This could make it difficult to access the value in your shares, even if they have grown in value.

Another issue is that, for EIS and VCT investments specifically, you must hold your investment for at least three and five years respectively to qualify for tax relief.

All in all, this means you’ll likely be unable to access the value in your investments quickly if you need to.

Make sure you take financial advice first

All investments carry risk, and smaller companies are no exception. However, these specific issues mean that you must be prepared to deal with additional risk and illiquidity in your portfolio.

Realistically, you should only include these companies in your portfolio if you can afford to lose your entire investment.

If you have any doubt as to whether investments in smaller companies are appropriate for you, you should take professional advice from a financial planner.

Please speak to us at Holborn Financial if you’d like to find out how we can help you to design a portfolio that’s well-balanced and appropriate for your needs.

Email info@holbornfinancial.com or call 020 8946 8186 to speak to one of our experienced advisers.

Please note

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

Enterprise Investment Schemes (EIS) and Venture Capital Trusts (VCT) are higher-risk investments. They are typically suitable for UK-resident taxpayers who are able to tolerate increased levels of risk and are looking to invest for five years or more. Historical or current yields should not be considered a reliable indicator of future returns as they cannot be guaranteed.

Share values and income generated by the investments could go down as well as up, and you may get back less than you originally invested. These investments are highly illiquid, which means investors could find it difficult to, or be unable to, realise their shares at a value that’s close to the value of the underlying assets.

Tax levels and reliefs could change and the availability of tax reliefs will depend on individual circumstances.