Thirty-eight years in the asset management industry undoubtedly provides many ‘lessons learnt’. Although I have tried to learn from previous mistakes, human nature occasionally gets in the way. Companies, economies, business sectors and markets are dynamic, always in a state of flux, changing for better or worse. So, we must work out how to navigate this as best we can.

The ‘top down’ macro outlook is essentially trying to predict the future. Legend has it that Nathan Rothschild made a fortune by bond buying when he had early information about the outcome of the battle of Waterloo, but the speed of modern communications makes being ahead of the market almost impossible.

Instead, we’ve long focused on the ‘bottom up’ approach, especially when it comes to smaller companies, where a system of back-testing can be harnessed to produce a relatively simple set of rules for investing. Our abrdn UK Smaller Companies Growth Trust, has been managed with the same investment process for 25 years. No process can work all of the time, but it just needs to work about 70% of the time.

Really, nothing about what we do is original and, over the years, investors have in fact moved in our direction as ‘behavioural’ approaches have largely superseded the ‘random walk’ and ‘efficient markets’ approach. So, without further ado, here are the rules that we have so successfully adhered to.

1. A stable and back-tested investment process is vital to success. Stepping away from your process can lead to a fatal loss of confidence, but even when things aren’t going so well, investors will remain loyal if they understand and trust your process.
2. We use a proprietary research tool to screen the 700 companies in our universe down to 100 potential investments. We use it on the investments we hold too, to make sure they continue to meet our criteria.
3. We have to be long term – when you own 50 or more 5% holdings in individual companies, selling can become complex.
4. One important factor is earnings forecast revisions. A company displaying earnings upgrade momentum may continue to do so for extended periods. Our job is to get on board and hold. We believe in running our winners and cutting our losers. Deteriorating earnings forecasts can last for extended periods and in smaller companies, this can go all the way to bankruptcy. Edwin Lefebre in his Reminiscences of a Stock Operator advised against ‘fighting the tape’ back in 1923. We prefer to join the virtuous cycle and avoid the vicious one. We look for the ‘multi-baggers’, the stocks that go up hundreds of percent, as a few of these will counteract the inevitable lemons. When we consider a stock to be in a virtuous circle, we go large.
5. A stock with a low valuation, in our opinion, is often one that will go on to deliver negative returns. Low valuation usually means the company involved has a high chance of disappointing. But, unfortunately, the idea of ‘good value’ is ingrained in investor psychology.
6. The quality, visibility and predictability of earnings is most important – we look for long-term contracts, recurring revenue and predictable cashflows.
7. We want to find the growth companies that can still grow when times are tough. A company successful in the UK can go global, and even a small niche can be huge if it goes global. However, ‘blue sky’, high-concept stocks can be dangerous.
8. Generally, pursuing solely an acquisition-led plan for growth can encounter problems for small-caps so bolt-ons and organic growth are preferable.
9. Founder-run businesses are mainly a good thing. A founder that can grow a business from nothing to making millions, employing thousands of people is a special wealth creator.
10. Finally, what are the warning signs that all is not going well at a company? The finance director should always be a qualified chartered accountant. If margins seem out of kilter, it’s time to sniff out why.

Important information

Risk factors you should consider prior to investing:

• The value of investments and the income from them can go down as well as up and you may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment trusts are specialised investments and may not be appropriate for all investors.
• There is no guarantee that the market price of a Trust’s shares will fully reflect its underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Alternative Investment Market (AIM) is a flexible, international market that offers small and growing companies the benefits of trading on a world-class public market within a regulatory environment designed specifically for them. AIM is owned and operated by the London Stock Exchange. Companies that trade on AIM may be harder to buy and sell than larger companies and their share prices may move up and down very sharply because they have lower trading volumes and also because of the nature of the companies themselves. In times of economic difficulty, companies listed on AIM could fail altogether and you could lose all your money.
• Certain Companies treat the generation of income as a higher priority than capital growth; such Companies may deduct part or all of their management charge from capital. This will increase the amount of income available but at the expense of capital growth.
• Shares of smaller companies may be more difficult to buy and sell than those of larger companies. This means that the Investment Manager may not be able to buy and sell at the best time or may suffer losses. This could reduce your returns.
• Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

Other important information:

Issued by abrdn Investments Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419.

Find out more at www.abrdnuksmallercompaniesgrowthtrust.co.uk and www.abrdnsmallercompaniesincome.co.uk. You can also register for updates or follow us on Twitter and LinkedIn.