UK-based investors have tended to fill their portfolios with funds investing in the large, liquid firms in the FTSE 100 index. These firms are easy to buy in large amounts, they are generally well-established in their sectors, and they tend to have strong governance and long histories of creating shareholder value.
However, history offers us evidence of investments with even stronger returns: in UK smaller companies. Smaller companies are those in the bottom 30 per cent of the UK stock market by market capitalisation – members of the FTSE 250 index and smaller, valued at less than around £4 billion.
The volatility (the rate and extent at which the price of a portfolio, security or index, moves up and down - it is used as a measure of the riskiness of an investment) of small caps probably contributes greatly to investors’ resistance to the asset class. Share prices tend to swing wildly and fray nerves, and small companies have been known to disappear on occasion, because of poor management.
But the long-term numbers – where investors should be focused – speak for themselves: a £100 investment in a FTSE All-Share tracker in 1955 would have grown in value to £96,792 by 2016, but £100 put into a FTSE Small Cap index tracker would have been worth £597,433. The latter return is quite remarkable: six times greater than the former.
Why is small mighty?
Professors Elroy Dimson and Paul Marsh at London Business School developed the theory behind why small-cap firms outperform larger ones. They identified three key factors:
1) Organic growth
The growth potential tends to be greater because it’s much easier for small, but ambitious companies, with profits in the millions of pounds rather than billions, to double their business. It’s partly a law of numbers: a firm earning £1 million one year could feasibly double that over the course of the following year, but one earning £1 billion would have to generate an additional £1 billion pounds over that time to achieve the same growth rate.
Small companies also have more options for increasing business. They are inherently more nimble, dynamic and innovative, so they are better able to expand into new parts of the country, launch new products or services, or venture overseas – and thereby make a huge difference to the bottom line. In contrast, new initiatives for giant multinationals are likely to affect only one of many subsidiaries or product lines.
Furthermore, 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 as momentum.
2) Lack of research
The stock market is a pricing mechanism that takes into account all the information publicly available regarding a firm’s finances and operations. The price is informed by the work of analysts. Big companies tend to be followed by lots of analysts: 24 per firm on average for a company worth more than £10 billion. Because their operations are so extensively scrutinised, it’s highly unlikely that any great corporate initiatives or managerial shake-ups will slip under the radar, so the share price tends to reflect business realities fairly accurately, making it hard for fund managers to find pricing anomalies.
In contrast, smaller firms have fewer analysts following them: those worth less than £500 million are only followed by two on average. This means there’s more opportunity to spot mispricing. Academics call this the ‘neglected effect’.
3) Mergers and acquisitions
One of the big attractions 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 probably the easiest way to expand their business in a lucrative new direction.
Mergers and acquisitions deals are usually viewed as good news for shareholders in the acquired company because, as owners of the business, they will receive payment, usually in the form of cash and/or shares in the acquiring company. Many companies built up a war chest of cash in the years following the financial crisis, having been reluctant to commit to major investments in such an uncertain environment, but as economic confidence has recovered they have been spending. According to Dealogic, records were broken in 2015, when deals worth $4.7 trillion (£3.5 trillion) were completed. The value of deals done in 2016 was also high, at $3.8 trillion.
The Henderson Smaller Companies Investment Trust has not always been invested in smaller companies. It was founded in 1887 as the Trustees Executors and Securities Insurance Corporation, with the aim of beating UK government bonds. Its original chairman branched out into accountancy services and formed Touche Ross, now a key part of Deloitte – one of the biggest accountancy firms in the world.
It was not until 1992 that the trust started investing in smaller companies. This makes it one of the oldest investment trusts: surviving, adapting and evolving over many years.
In 2002, in the wake of the dotcom crash, I became the trust’s fund manager. Much has happened since: four prime ministers, various polarising US presidents, oil prices bucking between $30 and $140 a barrel, a meltdown in the Middle East, a global financial crisis, and an explosion of social media, smartphones and apps.
Throughout these twists and turns, markets have gyrated, yet we have delivered an average annual return of 17.9 per cent, outperforming the benchmark in 13 of the past 14 years. We know the past doesn’t predict the future, but this would have transformed £1,000 of your cash into more than £12,000.
We’ve done it through consistency – our method has not changed. Now supported by Indriatti van Hien, our focus is on finding exceptional management teams and good-quality businesses, and buying them at prices we think offer value for money. Brexit and interest rate uncertainty have made the UK market a more cautious place; but as a consequence there has probably never been a better time for stockpicking.
Sponsored content: This article appeared in Money Observer’s View From The Top supplement, which was contained inside the December 2017 issue of Money Observer.
RISK WARNING The information should not be construed as investment advice. Before entering into an investment agreement, please consult a professional investment adviser. Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Issued in the UK by Janus Henderson Investors. Janus Henderson Investors is the name under which Henderson Global Investors Limited (reg. no. 906355), Henderson Fund Management Limited (reg. no. 2607112), Henderson Investment Funds Limited (reg. no. 2678531), Henderson Investment Management Limited (reg. no. 1795354), AlphaGen Capital Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no.2606646), Gartmore Investment Limited (reg. no. 1508030), (each incorporated and registered in England and Wales with registered office at 201 Bishopsgate, London EC2M 3AE) are authorised and regulated by the Financial Conduct Authority to provide investment products and services.