DIY Investor Magazine
| Oct 2017
46
WOULD YOU LIKE THAT IN A SMALL, MEDIUM OR LARGE, SIR?
Three pretty compelling reasons why investing in
smaller firms can be more lucrative than large – Neil
Hermon, Henderson Smaller Companies Investment
Trust.
UK investors have tended to fill their portfolios with
funds investing in the large, liquid firms of the FTSE 100.
They are easy to buy in large amounts, well established
in their sectors, have strong governance and long
histories of creating shareholder value.
But history points to even stronger returns in the UK’s
smaller companies; firms in the bottom 30% of the UK
stock market by market capitalisation – the FTSE 250
and smaller, or less than around £4bn.
Their volatility likely contributes greatly to small-cap
reluctance – share prices tend to swing more wildly, and
they’ve been known to disappear from time-to-time on
account of poor management.
But the long-term numbers - where investors should be
focused - speak for themselves: if you’d put £100 in the
FTSE all-share in 1955, by 2016 you would’ve received
£96,792; for the FTSE-Small-Cap it would’ve been
£597,433. The latter is quite remarkable at six times the
former.
WHY IS SMALL - MIGHTY?
Professors’ Elroy Dimson and Paul Marsh of London
Business School developed the theory behind why
small-cap firms outperform larger ones.
1) Organic growth – The growth potential tends to be
greater because it’s much easier for small, ambitious
companies, with profits in the millions rather than billions
of pounds, to double their business; a firm earning £1
million one year could feasibly double that the following
year, but one that earned £1 billion would have to
generate an additional billion pounds over that time to
achieve the same growth rate.
Small companies also have more options for increasing
business; they are more nimble, dynamic and
innovative, are able to expand into new parts of the
country or overseas, and can more easily, launch new
products or services. In contrast, new initiatives for
giant multinationals are likely to affect only one of many
subsidiaries or product lines. And it’s a self-fulfilling
prophecy – a company that repeatedly delivers on
its earnings increasingly satisfies investors who then
place a higher value on the business. This is known a
momentum.
2) Lack of research – The stock market is a pricing
mechanism that takes into account all of the publicly
available information there is regarding a firm’s
finances and its operations, interpreted by analysts.
Big companies tend to be followed by lots of analysts:
it averages 24 per firm for those over £10bn. Because
they are so extensively scrutinised it’s very unlikely any
great corporate initiatives or managerial shake-ups will
pass under the radar, so the share price tends to reflect
the business realities fairly accurately, making it harder
for fund managers to find pricing anomalies.
In contrast smaller firms have fewer analysts following
them, with those under £500m averaging only 2, so
there’s more opportunity to spot mispricing. Academics
call this the ‘neglected effect’.
3) Mergers & Acquisitions - A big attraction of investing
in smaller companies is the likelihood of a corporate
action, usually when a larger firm snaps them up. For
large, slow-growing companies, taking over an attractive
small firm is the easiest way to expand the business in a
lucrative new direction.
Source: Janus Henderson Investors
