Small companies are ready to step ahead
21st May 2015 10:09
by Cherry Reynard from interactive investor
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As benchmark indices hit all-time highs, including the breaching the 7000 mark for the first time, smaller companies have seen a rather different trajectory.
They have suffered from not being defensive enough when security was investors' greatest concern. With blue-chip prices looking high, there is an argument for revisiting smaller companies as the global economic environment starts tentatively to improve.
UK smaller companies delivered some astonishing returns in the recovery period from 2009 to 2013 - 28.8% on average in 2012 and another 44.7% in 2013 - and almost every other market showed a similar performance. For example, investors who took a chance on European smaller companies also fared well.
Taking a pause
Perhaps unsurprisingly after such a strong run, smaller companies took a pause in 2014. Fears over deflation, the crisis in Europe, weakening global growth and interest-rate rises sent investors scurrying towards the apparent safety of blue chips. UK smaller company trusts slid 5.5% in 2014 on average. The only brighter spot was the relatively limited global smaller companies sector, which continued to rise.
Some of those fears that dogged smaller companies last year are now diminishing - economic data from Europe is improving, for example; and for many countries, deflation appears to be a function of lower oil prices rather than a symptom of something more sinister.
Also, many defensive blue-chip stocks now appear to be extremely expensive: has a market capitalisation of 26 times its annual earnings, while is similarly expensive by historic norms. Smaller company valuations look lower by comparison. As a result, investors may be pondering whether the time has arrived to revisit smaller companies and if so, how it should be done.
While market timing is often seen as a fool's game, it has historically proved more important for investors in smaller companies, and particularly smaller company investment trusts. If the market turns, investors can lose on the discount, the gearing and the underlying companies, and this can be painful. On the other hand, it can be extremely remunerative if it works the other way.
The academic evidence backs up the long-term outperformance of smaller companies, but also suggests that investors need to be careful about when and what they buy. The main academic backing for a long-term allocation to smaller companies was Rolf Banz's article The Relationship between Return and Market Value of Common Stocks in the Journal of Financial Economics.
Among his findings was this observation: "In the 1936-1975 period, the common stock of small firms had, on average, higher risk-adjusted returns than the common stock of larger firms."
However, his work was called into question by a number of commentators who pointed out that returns on smaller companies had come from periods of extremely good performance, but that investors also suffered periods of significant weakness. This seems to be supported by investors' experience in the technology bust of 2000 and the aftermath of the credit crisis in 2008.
Equally, more up-to-date research by AQR Capital Management suggests that by introducing a 'quality' bias to stock selection, investors can weed out the weaker small companies and those most likely to go bust, producing a stronger and more compelling return over time. This is the thinking behind the current vogue for smaller company trusts focused on dividends.
The academic research naturally leads investors to two conclusions: it is worth giving at least some attention to market timing when investing in smaller companies; and it is worth paying attention to the strategy of the manager.
Market timing
On whether this is a good time to buy smaller companies, most agree that it is certainly a better time than a year ago, and some go as far as to say it is a good time to invest.
Gervais Williams, manager of the , which can invest across the market capitalisation spectrum, says: "At the moment, we have around 10-12% in the FTSE 100, 25% in the FTSE Mid 250 and the remainder in small cap. This is the lowest the weighting has been in larger companies. We are very excited by the prospects for some of the companies outside the mainstream indices.
"The valuation difference between mid/large and small companies has never been as large as it is now. The Alternative Investment Market (AIM) has come down quite hard and there are now some extraordinary valuations." He points out that a lot of smaller companies, far from being riskier, have more cash to pay their dividends and better balance sheets, leaving them with greater growth potential.
James Baker, fund manager at smaller companies specialist Chelverton Asset Management, agrees that valuations look more compelling in the smaller companies sector: "The mid-caps are trading on a slight premium to the FTSE 100, and if oil and financial services companies are stripped out, stocks in the FTSE 100 are on higher valuations."
He adds: "Last year, smaller companies needed to deliver strong earnings to keep their run of good performance going. They didn't, in many cases, despite the strength of the UK economy. This year, expectations are much lower. There have been some outflows from the sector and valuations look reasonably attractive. The companies we talk to are confident on the outlook and that their earnings forecasts are sustainable, if not beatable."
James Henderson, manager of , admits that there is perhaps more momentum in the mid-sized and large companies at the moment, as investors are reluctant to abandon their safety-first approach. However, he believes that once there has been a year or two of solid economic recovery, investors will turn back to these smaller companies.
He argues that selectivity is perhaps more important than worrying about the relative price of smaller companies. He says that while Aim companies have been out of favour - largely thanks to some high-profile corporate governance issues and the weakness of the mining sector - only some of the companies have unique characteristics that will enable them to grow over the longer term.
Perhaps unsurprisingly, all the managers believe that smaller companies tend to be a better choice for the long term. Henderson says: "It is simply easier to grow a £100 million company to a £1 billion company than it is to grow a £1 billion company to a £10 billion company."
Baker agrees: "Smaller companies can grow faster than the wider market simply because they are starting from a smaller base. New sub-sectors are emerging in the higher-growth parts of the economy, so the smaller companies sector keeps refreshing. Last year the market may have been paying up for security, but usually it pays up for growth and this is to be found in smaller companies."
Williams believes that smaller companies have generally made better use of their resources than larger companies. They operate within a niche and can therefore be more targeted in the type of company they buy or merge with, and any mergers and acquisitions activity tend to be more successful.
This all contributes to better dividend growth. He adds: "Even in this settled environment, large companies seem to be struggling to find capex [capital expenditure] projects."
If they are convinced about the case for the inclusion of smaller companies within a portfolio, investors also have to make a choice on where they invest, particularly whether they plump for an investment trust or an open-ended fund.
Structure counts
Investment trusts have certain structural advantages in the management of smaller companies. History is littered with open-ended smaller companies managers whose funds have suffered, whether they admit it or not, from taking too much money. The funds became unwieldy to run and the managers could no longer invest in the type of companies that had generated their longer-term returns, so performance suffered.
Trusts avoid this problem by having a fixed pool of assets to invest. Managers do not have to sell relatively illiquid companies to meet redemptions. Equally, they do not have to compromise their style by investing in companies in which they have less conviction, simply because they have inflows that they need to invest.
Williams took the decision to launch the Diverse Income trust as a closed-ended structure in part for this reason. "Small-cap funds can get swamped with inflows and outflows. Also there is leverage. In general we don't use it unless we see a 2009-type situation, when markets were perfectly priced for recovery. Then, having gearing can help fund managers participate more fully in the upside."
Gavin Haynes, investment director at Whitechurch Securities, agrees that the investment trust structure can be advantageous for smaller companies managers: 'When you are investing at the smaller end, liquidity is one of the key issues.
"Not having inflows and having the size of assets fixed make it more attractive to run money in a closed-ended structure. Smaller companies tend to be in under-researched areas, and finding the right manager with the ability to sniff out the right opportunities is particularly important."
However, there are downsides to using investment trusts. Baker points out that investors will experience greater volatility. Also, while discounts - at around 10% across the sector - look superficially attractive, they have remained at this level for some time.
Vive la difference
Stephen Peters, research manager at Charles Stanley, believes that many smaller companies investment trust managers do not use the flexibility of the structure sufficiently. He says: "In general, managers are not as different as they could be, and they could make wider use of the flexibility provided by the investment trust structure; but there are still some good trusts."
Peters points out that there has also been plenty of rationalisation in the smaller companies investment trust sector, which has helped performance overall and means that the sector now looks stronger and more robust.
Equally, a number of high-profile managers have had a rough ride recently, which has opened up the discount. The has had a difficult few years, which has seen the discount to net asset value widen out.
This has largely been as a result of manager Harry Nimmo's growth style, which has been out of favour, rather than any inherent weakness in the fund. Haynes says: "Investors can buy some good managers at a discount to NAV and it is certainly a better time to buy than it was a year ago."
Investment trust picks
R&M UK Microcap
"The fund invests in companies with a market capitalisation of less than £100 million. It is managed by Philip Rodrigs, who has built a good track record. The discount has drifted out in recent months."
Kieran Drake, analyst, Winterfloods
Aberforth Smaller Companies
"Aberforth is a specialist investment boutique. It only does smaller companies and has a good track record. It looks for undervalued and overlooked companies. This is on quite an attractive discount at the moment - around 15% - having been as low as 4%."
Scottish Oriental Smaller Companies
"Outside the UK, we like this , managed by First State's team of Angus Tulloch and Martin Lam. They focus on the less-researched stocks and this market is a good one for them to exercise their stock-picking skills."
Gavin Haynes, investment director, Whitechurch Securities
Strategic Equity Capital
"We believe that trusts should really be doing something different. And some certainly do. For example, we like this , which is managed by GVO Investment Management and uses private equity techniques to help struggling public companies"
Henderson Smaller Companies
"We also like the , managed by Neil Hermon, who has a strong long-term track record."
Stephen Peters, research manager, Charles Stanley
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.