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September 27, 2013 6:48 pm
Small is beautiful. Elephants don’t gallop. A flea can jump 200 times its own height. There’s no shortage of appropriate metaphors for the tendency of small-cap shares to outperform their larger brethren – and in recent years, no shortage of examples of them doing so.
Shares in companies outside the top echelon of the market have been on a tear this year. The FTSE Fledgling index is up 27 per cent this year to date, while the FTSE Small-cap is up 25 per cent and the Numis Smaller Companies index has risen 21 per cent – more if the investment trusts are stripped out. That compares with a gain of 11 per cent for the FTSE 100, which tracks the biggest companies.
Why? The customary explanation is that they have been among the chief beneficiaries of the “risk-on” trade; with central banks effectively backstopping financial markets, investors have been prepared to take greater risks and have rushed to buy the kind of cyclical companies that litter the lower echelons of the market – housebuilders, retailers, recruiters and engineers among them. Many of these companies had near-death experiences in 2008 and 2009, but have recovered spectacularly. A good example is housebuilder Taylor Wimpey, whose shares crashed as low as 4p in November 2008. They’re now over 100p.
But small-caps’ record of outperformance predates the latest round of central bank stimulus. The Numis Smaller Companies Index (NSCI) has been backdated to 1955 and cumulative returns since that date have soundly beaten larger-cap indices. An investment of £1,000 in the index in 1955 would have been worth £236,574 by the end of 2012. With dividends reinvested, the real return is £161,768. The performance of the NSCI 1000, which tracks tiny companies, has been even more startling.
Most investors don’t have the luxury of hanging around for 58 years. But returns in individual years have tended to be strong, too, as the chart shows – although there have been some lean times too. “There have been some fairly dismal periods. You could easily get 10 years of underperformance,” notes Paul Marsh, professor emeritus of finance at the London Business School, who first compiled the Numis index in 1987 along with LBS colleague Elroy Dimson. He points out that the 1990s were just such a grim period – small-caps underperformed large ones for eight years out of 10 – and that the noughties have generally been very good for small-caps. That mirrors the experience – until recently at least – of emerging markets.
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The conventional explanation for small-caps’ higher returns – as with emerging markets – is that they carry higher risks. But Harry Nimmo, who has managed the Standard Life UK Small Companies Trust since 2003, is disdainful of the idea that small-cap shares are inherently more risky than larger ones. “All equities are risky . . . just look at the banks, or when BP halved after the Macondo spill,” he says. “The trick is to construct a low-risk portfolio that gets the dynamism of smaller companies without additional risk.”
Prof Marsh agrees. “The margin of outperformance is greater than one would expect from the risk premium alone,” he says. “The average small-cap company is more volatile than the average large-cap one. But what matters is how much additional risk they add to a portfolio – and the answer is not very much.” The volatility of the Numis index is greater than that of the All-share, but not by a large margin, he notes.
There are other possible explanations for the consistent outperformance. One is a so-called “neglect effect” – the fact that smaller companies generally don’t attract as much attention from the media and analysts. “They are an under-researched sector. Many investors, such as big pension funds, don’t regard them as an asset class at all,” says Mr Nimmo. Another explanation is liquidity. Small shares can be illiquid and hard to trade in large volumes – not an issue for individual investors, but a red flag for institutions that need to be sure they can sell quickly if needed. Trading costs are also higher because bid-offer spreads are wider, which is an issue for open-ended funds in particular.
The higher trading costs, potential periods of underperformance and high levels of stock-specific risk mean that small-cap investing is a long-term business. Almost all the fund managers in the sector say they believe in running winners for as long as possible. Mr Nimmo says this explains the presence of Hargreaves Lansdown, a FTSE 100 stock, in his fund. “We bought that when it was £2. It’s now £10. I’m not out there buying more but if something is working I’m reluctant to sell it.”
Although small-cap companies tend to be thought of as growth stocks (and most small-cap funds have a growth mandate), there is plenty of evidence that value is the better strategy over the long term. Prof Marsh says that crunching the numbers in the LBS database suggests that over the long term, small-cap value shares have been among the best performers and small-cap growth among the worst.
There’s one area of the small-cap market where the increased risk hasn’t translated into superior rewards: Aim. The stock exchange’s market for smaller companies was established in 1995, and in terms of the number of companies listed, reached a peak in the mid-noughties – 387 companies floated on it in 2005 alone.
However, the record of the Aim 100 (left) and the Aim All share indices is miserable, both in absolute terms and relative to other small-cap indices. From inception to the end of 2012, the Aim All-share index returned an average of minus 1.9 per cent a year, compared to an average 8.2 per cent gain for the NSCI.
Several explanations have been advanced for this. One is that it now contains a sizeable contingent of speculative resources companies, whose shares have performed poorly over the past two years amid concerns about slowing demand for commodities in China. But when Dimson and Marsh stripped out the resources sector, they found that Aim still underperformed other indices. Another possibility is that the tax advantages of Aim – shares in most companies qualify for business property relief, and are exempt from inheritance tax if held for two years – may have encouraged investors to buy companies they may otherwise have avoided.
Both Mr Marsh and Mr Nimmo point out that the ease with which companies can float on Aim – as a junior market, it has less stringent rules for listing, liquidity and supervision – makes it prone to short-term fads. “As a rule I don’t go for blue-sky companies with no revenues or profits, and a good third of Aim is in that category,” says Mr Nimmo. “But it’s unwise to write off the whole market. There’s nothing like it anywhere else in the world and it’s where I’ve had some of my best ideas.” He cites Asos, the online fashion retailer, which is still on the junior market despite a near-£4bn valuation that would easily put it in the FTSE 100 if it were on the Official List.
The conclusions are pretty clear. Smaller shares can indeed deliver fabulous profits, especially if they are held for long periods. But it’s an area of the market where active stockpicking is the best strategy – and that requires patience, discipline, legwork and a willingness to absorb the occasional disaster.
Funds that keep it small
The liquidity constraints of smaller shares mean that there are no index-tracking products that replicate their performance (although there are several such funds for the mid-cap FTSE 250 index).
However, this is one area where a good manager can add real value and there are several small-cap funds with outstanding long-term performance records.
Bestinvest recommends Old Mutual’s UK Smaller Companies and the Marlborough UK MicroCap Growth run by Giles Hargreave, which focuses on companies with a market value of less than £100m. Chelsea Financial Services also recommends the Marlborough fund, along with Cazenove UK Smaller Companies.
Many “special situations” and equity growth funds are also biased towards mid- and small-cap shares and in some cases – Marlborough and BlackRock among them – share the same management team.
Those wanting to venture into overseas markets will find small-cap offerings in the US market (although the American idea of a “small-cap” is anything under $5bn), in Japan and even in emerging markets.
Dominic Johnson, chief executive of Somerset Capital Management, says that small-caps in emerging markets are often established companies with high levels of home-market ownership, meaning they are less vulnerable to flows of foreign money. “They tend to be very consumer-focused, and they are certainly under-researched.”
Debenhams is probably not most people’s idea of a “small company”. The department store group employs 29,000 people, operates more than 170 stores and has a stock market value of £1.25bn.
It is also a constituent of the Numis Small-Cap Index – along with brewer and pub owner Greene King (£1.77bn) and support services group Carillion (£1.4bn). All three companies are also in the mid-cap FTSE 250 index.
The Numis index, which until 2012 was called the Hoare Govett index, is the benchmark for many small-cap funds and accounts for the lowest 10 per cent of the main market in terms of capitalisation. It contains 751 companies and is rebalanced at the start of each year.
The shrinkage in the number of quoted companies on the Official List, and an increasing bias towards mega-cap stocks, has resulted in a gradual increase in the upper limit for inclusion. In January 2000 – when the blue-chip index had just set an all-time high – the largest company in the Numis index was worth £740m.
However, the NSCI is not the only index for smaller companies; the others are shown below.
|Index||What it is||Companies|
|NSCI||Lowest 10% of main market||751|
|NSCI 1000||Lowest 2% excluding investment trusts||593|
|FTSE Small-cap||Companies too small for FTSE350||208|
|FTSE Fledgling||Companies too small for Small-cap||116|
|FTSE All Small||Small-cap plus Fledgling||324|
|FTSE Aim 100||Top 100 companies on Aim||100|
|FTSE Aim All share||All companies on Aim||814|
|Source: Numis/FTSE International|
‘A happy hunting ground’
I believe that there are two key prerequisites for successful investment: common sense and above all patience, writes John Lee.
When stock selecting, I seek six additional characteristics: a stable, experienced board with significant directors’ shareholdings; cash positive or low levels of debt, and preferably good asset backing; profitable companies with a record of paying a dividend; companies registered in the UK and thus with UK governance and audit standards, but with a global turnover; a trading activity that I can understand; and optimistic recent comments made by the chairman or chief executive.
I am frequently asked how I make my investment selections: I avidly read City columns, Investors Chronicle, and my bible, Company Refs; this latter tome comes out quarterly and is divided into two sections – main market and Aim [Alternative Investment Market]. There is a page on each quoted company showing the board and advisers, shareholdings, turnover, profits and cash position, etc. Brokers’ forecasts of future profits and dividends are also shown for many companies.
I personally favour investment in small-caps which are less well researched and covered by analysts, thus providing a happy hunting ground for me – discovering a new gem is exciting and satisfying. I have invested in PLCs with capitalisations of less than £10m, but the average capitalisation of my current 40 stocks is probably just over £200m, although most have shown significant appreciation from much lower original base figures.
It is obviously easier for a small-cap to grow substantially and, provided one strictly adheres to the aforementioned criteria, downside risks are limited. Small-caps such as software specialist Delcam, soft drinks Nichols and flavours/fragrances Treatt have been stellar performers for me. I bought Anpario (see left), a manufacturing company in natural animal feed additives sold globally, a couple of years ago at less than £1 when it was capitalised at £16m: today, following excellent interims, it has doubled. My 2013 purchase, safe storage Lok’NStore, was capitalised at £33m when first bought and is now nicely appreciating on south-eastern prosperity.
Takeovers are a particular feature of “small-cap” investing and over the years I have been on the receiving end of approximately 50 takeovers. Usually they occur after I have been a holder for some time, but recently I was lucky with Fiberweb which I bought mid-August and received a bid within a fortnight!
Lord Lee of Trafford is a Liberal Democrat peer and an active private investor. He is the author of “How to Make a Million – Slowly”, due to be published in December
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