Investors in little companies could enjoy big returns.
The 'small cap effect' is one of the stock market's few enduring patterns. In the US, smaller companies have beaten the returns from larger companies for well over a century.
It's a similar story in the UK, albeit based on data that don't go back so far.
Research from Paul Marsh and Elroy Dimson at the London Business School has shown the compounded returns from investing in the FTSE All-Share in 1955 would have multiplied your money 541 times by now.
The same sum invested in smaller companies represented by the Hoare Govett Index would have multiplied 2,600 times -- a compound annual rate of return of 15.4%. And an investment focussed on the very smallest companies -- the HG1000 index -- would have multiplied nearly 6,000 times!
Galloping elephants and floundering fleas
If you're under 50 though, small cap outperformance may be news to you -- because this supposedly enduring affect hasn't done much enduring recently.
At the Growth Company Investor show last week, Adam McConkey from the small cap team at fund manager Gartmore (LSE: GRT) illustrated this by citing returns from four major slices of the UK stock market, from 1995 to now:
|FTSE Mid Cap||127%|
|FTSE Small Cap Index||11%|
|AIM Index||* -30%|
* Yes, that's minus 30%!
1995 was the year of AIM's launch. Anyone who celebrated its inauguration and anticipated fat profits from buying up its constituents would still be ruing the day.
As McConkey says rather laconically, "The rewards for investing in small caps as an asset class have obviously not been great." He has a few theories as to why:
- Professional investors have withdrawn capital from the asset class for a decade, as fund managers have increasingly 'index hugged' benchmarks like the FTSE 100.
- Private investors are pessimistic about the asset class, as shown by the typical discount of 15-20% on small cap investment trusts. When small caps are back in fashion, McConkey predicts, those trusts will trade at a premium.
- Too many small caps -- McConkey argues that too many low-quality companies came to the market, perhaps driven more by the desire of financiers to make a buck from flotations than by the suitability of a public listing. This proliferation stretched already thin investment in the asset class even further, making the market more inefficient and illiquid.
- Spread betting and other forms of leverage have turned private small cap investors into "one huge hedge fund" in McConkey's view. Small cap shares became even more volatile, which isn't attractive to professional investors.
As a result, McConkey sees a self-fulfilling spiral, with younger fund managers now believing what's important is timing when to move in and out of small caps, rather than investing for their long-term returns.
Things can only get better
As you might expect from a key employee at one of the leading small cap fund managers, Gartmore's McConkey went on to say why he thinks these negative headwinds for small caps are now easing.
Firstly, he thinks the over-supply of listed small cap companies is starting to clear, and says the number of stocks in AIM has already halved from its peak. This reduction is happening as companies are acquired on the cheap, or as managers or founding shareholders take their lowly rated companies private again (McConkey admits he "almost applauds" small cap company managers who "stick two fingers up at their depressed valuation"). It's also happening because of small caps going bust during the recession.
Yet rather against that trend, McConkey also argues that with bank debt being denied to smaller companies, the value of a public listing is being seen as more valuable, since it gives companies an alternative way to raise funds. He thinks indebted private businesses may even reverse into publicly quoted companies to get over a "hump" of upcoming debt refinancing.
Rather optimistically, McConkey thinks UK policymakers may look to tinker with stamp duty and Capital Gains Tax on small cap investments, to support the asset class on the grounds that it's good for the economy and job creation.
Finally, he believes small cap investing is attractive in today's choppy macro environment, since it enables stock pickers -- such as professional fund managers -- to add value by choosing the best investments.
According to research from Citi Group, 'macro' factors determine nearly 70% of the return from large companies, as opposed to just 11% from smaller companies. This means asset allocation decisions are most important with large companies.
In contrast, 89% of the return for small caps is down to stock specific issues, as opposed to just 29% for large companies. Clearly, small caps are where stock pickers should focus their time and effort when the macro economic picture is as unclear as today.
Small caps on the march
Like other fund managers, McConkey sees M&A activity as being good for small caps in the short term. He says it's effectively "Just In Time CAPEX and earnings growth" for larger companies, who can buy bolt-on revenues cheaply by picking up a small cap.
Beyond that, he looks for small companies who are big in their niche, who enjoy decent pricing power as a result, and where he feels confident he can invest for longer-term growth.
So when will we see small caps regain their old winning ways? McConkey thinks it's already happening. He points out that the FTSE Fledgling index is already "providing leadership", having beaten both the FTSE 250 and the FTSE 100 since May 2008.
I'd caution that small caps were massively beaten up in the bear market, so picking specific time periods that show outperformance could be disingenuous. But I'm also persuaded that small caps should do better again in the long-term.
To paraphrase Jim Slater, elephants can't gallop forever!
More from Owain Bennallack:
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