Smaller companies – bigger returns?
By Liz Rees, Head of Research
In the UK the Smaller Companies universe is usually defined as listed companies outside the FTSE 100 and FTSE 250. This comprises the FTSE Small Cap index (roughly the bottom 2% of the FTSE All Share by value), the FTSE Fledgling Index (those listed on the main market but too small for the FTSE All Share) and the constituents of the Alternative Investment Market (AIM).
AIM is a sub-market of the London stock exchange but has lighter regulation and may attract more speculative companies. However, it does include well known names such as ASOS (the online retailer) and Fevertree (the producer of upmarket mixer drinks). Around 1,000 companies are listed on AIM making a total pool of around 1,400 companies.
Most UK Smaller Companies Funds use as their benchmark either the FTSE Small Cap or the Numis Smaller Companies index. The latter encompasses the bottom 10% of the UK market including AIM.
Funds which invest in Smaller Companies in other regions tend to be wider in their scope; for example, in the US such Funds often contain stocks as large as $5bn in size or even higher.
The attractions of holding Smaller Companies Funds
The main advantage is the opportunity to invest in tomorrow’s leaders at an earlier stage of their development. In reality it is easier for a company to grow from a turnover of £100m to £1bn than from £1bn to £10bn and it is often in this phase that the strongest share price advances are delivered.
Smaller Companies can be more flexible; taking advantage of trends and adapting to change. They are more likely to be run by talented entrepreneurs with large personal stakes in their success.
In some sectors the UK has recognised expertise and knowledge and also has a good record of developing world leading brands. Another appeal is that a lot of Initial Public Offerings(IPOs) take place in this part of the market. In some instances they are not easy to access by the general public so institutional investors effectively get first refusal.
Are they more risky?
Without doubt there are risks involved and you should choose your Fund carefully. Some may take big positions in ‘blue sky’ companies yet plenty of Funds will focus on more mature, profitable businesses which they consider to be undervalued. Funds are unlikely to invest in unlisted companies although they may invest in vehicles which have stakes in them.
Smaller businesses can be dependent on the performance of key individuals so it is important that a company has the depth of resources to cope with anticipated growth and has a succession plan in place.
The sector is generally under-researched which presents both a risk and an opportunity. It allows skilled managers to uncover undervalued stocks whose potential has not yet been recognised. On the other hand, if a company fails to meet targets or investors are misled then share price falls can be significant.
What makes a good Smaller Companies Fund Manager?
As in any sector, a solid track record through different market cycles will demonstrate a manager’s ability to deal with changing market conditions. Managers must be capable of weeding out those companies which have lost their way, including former ‘Blue Chips’ whose industry or products have fallen out of favour.
Less analyst research means managers must do more of the ground work and visit the operations. The key is to be a good all rounder with knowledge of a wide range of sectors as well as being capable of carrying out detailed financial analysis.
How have they performed?
Smaller companies have handsomely outperformed their larger counterparts over the past year and indeed over the longer term. After a short wobble following the EU referendum they have reasserted their leadership. In hindsight it was a great buying opportunity which many managers seized and the return on the FTSE Small cap index since the referendum is an impressive 30%1 compared to 26% for the FTSE 100.
The sell off after the Brexit vote was attributed to fears of a slowdown in s investment and consumer spending which would affect Smaller Companies due to their greater domestic presence. In addition, sterling weakness favoured larger Blue Chip stocks.
However, the UK economic backdrop has remained fairly supportive and there has been solid growth from some of our key trading partners in the US and Europe.
What types of Funds are available to choose from?
It is particularly important when researching Small Cap Funds to look at the Manager’s strategy as composition can vary considerably. If you don’t want pure Small Cap exposure there are a number of Funds which source their ideas from across the market cap spectrum.
Some of the larger Funds in the sector may, for liquidity reasons focus on the top end of the Small Cap index. If they find their size is restricting ideas they may soft close for a limited period. At the other end of the spectrum you will find the microcap funds- they focus on the very smallest companies which often require a great deal of due diligence.
The characteristics that make smaller companies attractive extend to other countries and small stocks in Europe, Japan and Asia have also delivered stellar returns. To capture this growth you could consider a regional or Global Small Cap Fund.
Conclusions and outlook
The FTSE Small Cap is trading on a valuation discount to the FTSE All Share of around 10%, slightly below the long term average2. While the valuation discount has narrowed considerably from circa 25% post Brexit, some analysts believe the sector should trade on a premium to the wider market at this stage in the cycle.
News flow has been reasonably positive in terms of corporate earnings. Furthermore, any rebound in the Pound would give smaller companies a boost. It is of course necessary to keep an eye on potential negatives such as Brexit upheaval, levels of household debt and pressure on real wages leading to a slowdown in consumer spending.
Nevertheless, with such a diverse range of companies to choose from it should be quite possible for a proactive Fund Manager to construct a portfolio which is suitable for any prevailing economic conditions.
1Small cap (ex IT) Index, total return basis, 24/6/2016-16/08/2017
2Figures quoted at 21/7/2017