Patience is a virtue with this Aim pair as the market continues to ostracise smaller companies

These two holdings have yet to deliver on their potential in share price terms, but sooner or later sentiment will turn in their favour

‘Smaller companies have become extremely unpopular since Aim shares hit a 20-year high in 2021’

Investing in shares is at times a very frustrating experience. An investor can do all of the right things, such as buying high-quality companies that go on to deliver strong financial performance, but still fail to generate large profits on their holdings for sustained periods.

This situation is likely to resonate with investors in British shares, and especially those who own stakes in smaller companies, which have become extremely unpopular since the FTSE Aim All-share index soared to a 20-year high in September 2021.

The index has subsequently fallen by about 43pc. Judging by the downbeat outlook currently adopted by most investors, a return to the heady days of plentiful capital growth seems highly unlikely in the short run.

In Questor’s view, investors in smaller companies must accept their limitations. There is little they can do except ensure that their current holdings are financially sound, performing well and still offer fair value for money, as well as force themselves to be patient. After all, history suggests that underperforming high-quality stocks are only ever a temporary phenomenon.

For example, Gamma Communications, a holding in our Inheritance Tax Portfolio, trades at the same level as in May 2019. Although the telecoms company’s shares are 87pc higher since their addition to our IHT portfolio in January 2018, and have therefore vastly outperformed the FTSE Aim All-share index’s 30pc decline, all of their capital growth essentially came in the first 16 months of our notional ownership.

Gamma’s latest trading update, last month, showed that it was performing in line with financial guidance that was upgraded at the time of its interim results in September. Those results showed a 9pc rise in revenue and a 12pc rise in pre-tax profits. Since then, it has made two acquisitions and has the financial strength to engage in further M&A activity.

It has net cash of £135m and strong cash flow further enhances its capacity to make purchases at a time when asset prices are depressed. It has also sought to improve efficiency by undertaking a restructuring that involves a combined management team for its Dutch and German businesses. And with its operations in Britain successfully mitigating high inflation through price rises, profit margins are relatively unchanged relative to the first half of the financial year.

Trading at about 16 times forecast earnings, Gamma’s shares are by no means cheap. There are countless smaller businesses whose lower valuations could tempt bargain-seekers. But a sound balance sheet and encouraging financial performance make it worthy of a premium valuation compared with riskier small-company rivals.

While its share price in recent years has undoubtedly been frustrating, this column remains upbeat about its capacity to generate further capital growth over the long run. Hold.

Update: Judges Scientific

One of our more recent IHT additions, Judges Scientific also has yet to fulfil its potential amid downbeat investor sentiment towards smaller stocks. The highly acquisitive designer and producer of scientific instruments has produced modest share price growth of 4pc since our notional purchase in July last year, although it has still outperformed the FTSE Aim All-share index by five percentage points.

Its latest trading update last month showed that it continued to make encouraging progress amid a challenging environment. Organic revenues for the full year grew by 15pc and it said it remained on track to post a rise in operating profits in line with previous guidance. On a post-tax basis, though, the rise in corporation tax from 19pc to 25pc in April 2023 is sure to dilute profit growth.

Its net debt of 63pc of assets at the time of its half-year results, and the fact that its interest bill was covered more than 10 times by profits in the first half of the year, showed that it had the financial flexibility to make further acquisitions. And while it trades at a rather heady 26 times forecast earnings, this is little changed from its valuation at the time of our purchase.

So Judges Scientific continues to offer significant long-term capital growth potential. Like many London-quoted smaller companies, it is poised to benefit from an improving economic outlook that prompts a more upbeat mood among investors. Yet when that will take place is unknown. Patience, therefore, will continue to be required in abundance. Hold.