Investment in Smaller Companies

Many of you know that I am a strong advocate of long term investment in smaller companies, not just in the UK but also in the US, Europe and Japan. The principal reasons for my view are that small companies are dynamic, fast growing and under-researched. The latter means great companies go under the radar and are often mis-priced. Owners of small businesses spearhead the company and often have large stakes of their own money invested in it. They are driven and entrepreneurial people with a big incentive for their businesses to succeed. Finally smaller companies are more likely beneficiaries of take-overs and mergers.

Not unexpectedly there is clear evidence that in the long term smaller companies outperform large companies and mega-caps. This is not to say they do not carry considerable risk. They are not diversified businesses and have limited markets, they can be damaged badly by earnings recessions and interest rate rises, whilst their balance sheets tend to be weaker than larger companies. Finally larger companies have scope to downsize or sell assets in a recession. Smaller companies are more prone to going bust and have a reputation for being more volatile.

Recently I have received some e-mails from Axa Investment Managers on the theme of investing in smaller companies. They highlighted some very interesting facts and figures, which I want to put to you for your consideration. You may be surprised at what you read.

1. Smaller companies have significantly outperformed large and mid-caps since 2000 – Source: MSCI based on index returns.

2. European smaller companies have only been 4% more volatile than larger companies since 2005 and less volatile than emerging market equities.

3. Whilst there is no single definition on what defines a small company according to Axa they can have a stock market value of up $10 billion. These are hardly tiddlers. In reality there is a vast spread from unlisted start-ups and fledgling companies to established businesses listed on the Alternative Investment Market (AIM) market or the FTSE All Share Index. Examples of small companies include ASOS, Majestic Wine, Flybe, Mothercare and Oxford Instruments.

4. Smaller companies make up 15% of the market capitalisation of global equities although 90% of all companies are considered small. Investors who avoid smaller companies are missing out on a huge tranche of the investment universe.

5. In the US the average larger company has 19 analysts compared to just two for smaller companies. I once recall hearing that in Japan some smaller companies have no dedicated analysts. Fund managers searching for mis-priced gems are likely to find them.

6. Smaller companies are masters of their own destinies. Axa Investment Managers explain:

Whereas Large Caps’ share price movements are predominantly driven by macro factors, Small Caps’ share prices are 60% correlated to stock-specific factors. So Small Caps can better shape their own growth trajectories.

Macro factors include the health of the global economy, political events, global commodity prices and currency movements. Large companies are more impacted as a high percentage of their earnings are global. In contrast smaller companies are domestically focused. Incidentally macro factors can be positive or negative.

7. In 23 out of the past 27 years smaller company earnings have outperformed those from larger earnings (Source JP Morgan – June 2015).

8. Smaller companies may be sharply impacted by an earnings recession but historically recover very quickly.

9. Data from the last 100 years shows smaller companies have historically posted better risk-adjusted returns over the long term. Axa conclude the longer you look the better they get.

In conclusion Axa Investment Managers believe there are myths surrounding investment in smaller companies i.e. that they are too risky. The evidence suggests small caps are misunderstood and have a place for many investors in balanced portfolios.

This blog post is my own assessment of investment in smaller companies, in part based on Axa Investment Managers’views. Nothing in this article should be construed as investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.