Five reasons to consider investing in smaller companies

17/02/2016

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How do we define UK smaller companies?


It's a broad definition, but generally businesses that are not in the FTSE 100 and worth less than £4bn. The Numis Smaller Companies Index, a key benchmark for smaller companies, includes those that are in the bottom 10% of the UK market by value, starting roughly half-way down the FTSE-250. 
 

When it comes to investing over the longer term Professors Elroy Dimson and Paul Marsh, the academic titans behind the FTSE-100 and Numis Smaller Companies Index (NSCI), certainly make a compelling case for smaller companies.
 
In their 2015 NSCI Annual Review they looked at the performance of a number of assets over a sizeable 60 year timeframe.  If you’d bought long-dated gilts your return would have been 23%; if it had been the FTSE All-Share, a handsome 821%; the NSCI? 4,946%. At an extra 3.4% per annum the outperformance of small over large-caps is eye-popping.
 
If we look at discrete 10-yr periods, i.e. 1955 to 1964, and so on, the evidence continues to be compelling: in the six periods to 2015 smaller companies outperformed in five of them. The exception was 85-94, coinciding with an explosion of easy credit which enabled larger companies to boost their growth, somewhat synthetically.
 
To put that into context, over the past 10 years, £100 invested in the average investment trust in the AIC UK All Companies sector – a grouping of investment trusts that invest in companies of all sizes - would have grown to £205, but if you’d invested it in the UK Smaller Companies sector it would be worth £278.
 
However, we must curb our enthusiasm - smaller companies are inherently more risky investments when compared with big companies, partly because they tend to be less well-established or broad-based and therefore have a higher chance of failing if things go wrong, but also because shares can become very much harder to sell when they fall out of favour. They also tend not to produce much in the way of dividends, because any spare cash is reinvested in the company.
 
As an idea of the potentially rough ride, the FTSE Alternative Investment Market (AIM) All Share index - an index for very small UK companies – rose 20% in 2013 only to retract 17% in 2014. Large near-term swings in value are usually not seen in larger companies.
 
But generally, taking a view of years rather than months, why is it that smaller companies tend to outperform?
 

1 Smaller company growth potential

 
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. It’s partly a matter of numbers: a firm earning £1 million one year could feasibly double that in the course of 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 inherently able to be more nimble, dynamic and innovative so they could expand into new parts of the country, launch a new product or service, or venture overseas – and 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.
 
And it’s a self-fulfilling prophecy – a company that repeatedly delivers on its earnings more than often warrants increasingly satisfied investors who then place a higher value on the business.


2 Lack of research means opportunity

Market analysts and fund managers typically spend much more time and effort crunching the numbers on the biggest stocks, because they cannot afford not to. Because big companies’ operations 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.
 
In contrast, small firms may be followed by only one or two analysts, so there’s much more opportunity for eagle-eyed fund managers to spot anomalies – mismatches between a company’s prospects or performance and its share price. Some refer to this as the ‘neglected effect’.
 
As James Henderson, manager of Lowland Investment Company (which currently holds a third of its portfolio in smaller companies) and Henderson Opportunities Trust (which holds around two thirds in smaller companies), puts it: ‘There remains value in what we see as under-researched, under-appreciated areas of the market such as AIM.’
 
Neil Hermon, Fund Manager of The Henderson Smaller Companies Investment Trust, usually holds around two-thirds of his portfolio in slightly larger, more established mid-cap businesses in the FTSE-250, but with a third in much smaller companies he agrees with the principal that there’s money to be made because smaller companies are more likely to be mispriced.


3 Opportunities for a growing dividend

Smaller companies are traditionally seen as an investment for capital growth – their cash tends to be allocated towards expanding business activities rather than rewarding shareholders. Equity funds that target income tend to harvest dividends from larger businesses of the FTSE-100. But in a world of low growth, it’s becoming increasingly hard for these businesses to keep up with the pace of dividend growth of the past 20 years.
 
Investors are increasingly turning to smaller companies as a source of growing dividends. As with capital growth, a low base is fertile ground for quick dividend progression, and with many businesses not having paid dividends in the past, and our fund managers looking for those with strong balance sheets and a history of delivering reliable earnings, there’s potential for them to start making payments and grow them thereafter.
 
Neil Hermon began managing the Henderson Smaller Companies Trust in 2003; though not a guide to the future, if you’d invested £1000 at the beginning of his tenure, setting aside capital growth, you would have received £692 in cumulative income – a surprise perhaps.


4 Tricky trading

Share liquidity – the ease in which fund managers can trade their stocks in the open market – can be something of an issue the smaller the company is. Buyers might be few and far between and market makers may charge a lot of money to transact the deal.
 
Theory suggests the market gives investors a discount for taking such risk, rewarding them as the company grows and liquidity improves, closing the discount. But it’s a double edged sword: if the market goes belly-up, fund managers may find themselves unable to exit positions easily, compounding loses.
 


Big open-ended funds, aware that if investors baulk they may need to sell positions to raise cash, also tend to avoid smaller stocks - as do passive strategies due to the mismatch between expensive trading (in large numbers of illiquid stocks) and their philosophically cheap design. This leads to a market less crowded with investors, and a fertile hunting ground for opportunities.


5 Merger and acquisition (M&A) targets

One of the big attractions of investing in smaller companies is the likelihood of corporate action, usually when a larger one snaps them up. For large, slow-growing companies, taking over an attractive small firm is probably the easiest way to expand the business in a lucrative new direction.
 
M&A 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 or shares in the acquiring company, or a mixture.
 
Many companies had built up a war-chest of cash in the years since the financial crisis, having been reluctant to commit to major investments in such an uncertain environment – but as economic confidence recovered they started spending. Globally, $3.5 trillion of deals were done in 2014, and in 2015 - for the first time ever on record - the volume of deals passed the $5trn mark, according to Dealogic.
 
Neil Hermon notes: ‘The past 18 months have been an extremely strong period for M&A activity and we’ve seen a number of bids for companies in the portfolio, particularly from the US. It’s a trend we expect to continue in 2016.’

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.

The information in this article does not qualify as an investment recommendation.


Important information

Please read the following important information regarding funds related to this article.

Henderson Opportunities Trust plc

Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial 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. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change.

Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

Issued in the UK by Janus Henderson Investors. Janus Henderson Investors is the name under which Henderson Global Investors Limited (reg. no. 906355), 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. Telephone calls may be recorded and monitored.

Specific risks

  • If a fund is a specialist country-specific or geographic regional fund, the investment carries greater risk than a more internationally diversified portfolio
  • Some of the investments in this portfolio are in smaller companies shares. They may be more difficult to buy and sell and their share price may fluctuate more than that of larger companies

Risk rating

Lowland Investment Company plc

Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial 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. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change.

Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

Issued in the UK by Janus Henderson Investors. Janus Henderson Investors is the name under which Henderson Global Investors Limited (reg. no. 906355), 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. Telephone calls may be recorded and monitored.

Specific risks

  • Some of the investments in this portfolio are in smaller companies shares. They may be more difficult to buy and sell and their share price may fluctuate more than that of larger companies

Risk rating

The Henderson Smaller Companies Investment Trust plc

Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial 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. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change.

Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

Issued in the UK by Janus Henderson Investors. Janus Henderson Investors is the name under which Henderson Global Investors Limited (reg. no. 906355), 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. Telephone calls may be recorded and monitored.

Specific risks

  • If a fund is a specialist country-specific or geographic regional fund, the investment carries greater risk than a more internationally diversified portfolio
  • Most of the investments in this portfolio are in smaller companies shares. They may be more difficult to buy and sell and their share price may fluctuate more than that of larger companies

Risk rating

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