Get Set For The Small Cap Resurgence

Published in Company Comment on 4 October 2010

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:

MarketReturn
FTSE 10041%
FTSE Mid Cap127%
FTSE Small Cap Index11%
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  • Professional investors have withdrawn capital from the asset class for a decade, as fund managers have increasingly 'index hugged' benchmarks like the FTSE 100.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:

> Try The Motley Fool's Share Dealing Service. You can buy and sell shares in real time for a flat rate of just £10. Click here for more details or to open an account.

Share & subscribe

Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

theRealGrinch 04 Oct 2010 , 3:09pm

I have read this many time son fool this year, but Jim Slater, never actually created the words "elephants can't gallop". In fact, in his autobiography he attributed its creation to a journalist he had read.

JeremyBosk 05 Oct 2010 , 3:27pm

The other reason for not investing in AIM is the inability to put AIM stocks in an ISA. This has frustrated my intentions many times. There are stocks on aim plainly superior to some on the main market.

TMFFlaneur 05 Oct 2010 , 4:51pm

@Jeremy - Agreed. Apparently this is under review now, in the light of the CGT benefits going for AIM stocks.

@Grinch - Thanks for the feedback. I'm sure you're right, but I'll try to remember to check my Zulu Principle tonight! ;)

Dozey1 05 Oct 2010 , 6:52pm

Not only do I agree wholeheartedly with Jeremy above, I would go further. It would make good sense if only AIM and Plus quoted shares were ISAble. Or perhaps an upper capitalization limit of, say, £100m at the time of investment would be more practicable.

This would give a fantastic boost to smaller more entreprenerial companies which are the future hope of Great Britain Limited, but also considerably boost revenues to the taxman. I filch several thousands from him each year by sheltering many shareholdings, and I cannot see logically why I should have this priviledge.

Doze

MDW1954 06 Oct 2010 , 12:17pm

Hello Grinch (and Owain),

It's in there, I assure you! I too will check my copy, and hopefully provide a page reference.

Malcolm Wheatley

Moi747 06 Oct 2010 , 11:00pm

The third problem with some small caps and AIM shares if you buy them outside a fund is liquidity. There are often only small packets of shares to trade and a punter coming in or going out with even £5k can move the market significantly.

MDW1954 07 Oct 2010 , 10:02am

Hello again Grich & Owain,

Page 21!

Malcolm

TMFFlaneur 07 Oct 2010 , 1:50pm

@Malcolm - Thanks, I checked too. No sign I can see of the putative journalist he pinched the quote from. Maybe that's in another source?

ksteinbach 09 Oct 2010 , 7:30pm

"The other reason for not investing in AIM is the inability to put AIM stocks in an ISA"

That statement is incorrect. There are a multitude of AIM stocks can go into an ISA. Fair enough not them all but the do exist. I have 3 of them in my stocks and shares ISA as we speak and has the potential to blow any FTSE company out the water in terms of potential return

browntrout74 10 Oct 2010 , 8:56pm

Given that certain AIM stocks are not eligible for an ISA and the with volatility and risk involved in small caps would the reatil investor not be better served with unit trust funds and investment trusts focussed on small caps, what are some of these funds?

Presumably these would eligible for an ISA?

Say you got a compound annual rate of return to match the Hoare Govett index of 15.4% (quoted above since 1955) then paying 1.5% annual charges would be money well spent.

Join the conversation

Please take note - some tags have changed.

Line breaks are converted automatically.

You may use the following tags in your post: [b]bolded text[/b], [i]italicised text[/i]. All other tags will be removed from your post.

If you want to add a link, please ensure you type it as http://www.fool.co.uk as opposed to www.fool.co.uk.

Hello stranger

To add your own comment, please login.

Not yet registered? Register now.