Professors Elroy Dimson and Paul Marsh, the academics behind the FTSE 100 and Numis Smaller Companies Index (NSCI) , make a compelling case for investing in smaller companies over the long-term.
In their 2017 NSCI Annual Review, Dimson and Marsh looked at the performance of a number of equity asset classes since 1955: If you’d bought the FTSE All-Share you would’ve gained a handsome 968%; the MSCI mid-cap index would’ve handed back 2,870%; and the NSCI? 6,067%. Needless to say, the stark outperformance of small-caps over large-caps is undeniable.
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 easily available credit that enabled larger companies to boost their growth, somewhat synthetically.
So why do smaller companies outperform over the long term?
There are a number of theories. Aside the more obvious factors of strong earnings growth and greater corporate emphasis on innovation, which engenders the ability to capitalise on market opportunities more effectively, there is also the ‘neglected effect’.
The complex operations of larger companies are usually covered by a suite of analysts. It means the market - as a pricing mechanism that represents all of a company’s publicly available information – tends to be well served, reflecting the corporate’s fundamental worth with relative accuracy. Smaller companies usually have far fewer analysts covering their operations, meaning there are greater opportunities for a fund manager to spot anomalies - mismatches between a company’s prospects or performance and its share price. Our ability to then choose the strongest companies draws from the team’s extensive experience in picking stocks, at over 74 years collectively.
But simply allocating to smaller companies or even picking great stocks is insufficient – our belief is that you need to buy them at an attractive entry price to generate strong returns over the long term. It was Benjamin Graham, a man often referred to as the ‘Father of value investing’, who said:
“Buy not on optimism but on arithmetic.”
We are growth investors but we apply value principals so as not overpay for the above-average growth of earnings we are seeking to find. This investment style is known as growth-at-the-right-price, or GARP.
As we have written on before, structural or ‘secular’ growth stories also remain an important part of our portfolios. In a world where economic growth is low and fragile we have been looking to firms that are exposed to isolated growth trends - where the drivers of their returns isn’t correlated, or at least very lowly correlated, to the wider macro-economic cycle. Brexit uncertainties and others abound, this has proved a sensible strategy in recent years.
To highlight some of our structural growth names:
Litigation can be a long and expensive game. For law firms, with many cases likely running at any one time, cash can get tied up and be prevented for use in the growth of new business. The accounting treatment in the recognition of this cash-flow is not favourable either, and traditional finance doesn’t like litigation assets so bank lending is often hard to obtain. Burford specialise in bridging this gap.
Structural returns come from their low correlation to the market or business cycle. They are also very picky in selecting assets – usually around 10% of cases offered – and yet they have managed to generate very strong rates of return on their investments.
Sanne is an outsourced provider of back-office functions to the asset management industry. It has been a challenging environment for active managers more recently: the much-reported downward pressure on fees on account of the growth in passive investment products; increasing costs in areas of regulation such as MiFID II and the Retail Distribution Review (RDR); industry consolidation; and the growth of alternative investments, has all led bosses to strategically redirect firms towards trimmed-down operations. These favourable market conditions for Sanne are propelling its organic growth to excesses of 15%.
Accesso is a disruptor in queue management for theme parks, primarily operating in the US and UK. Their proposition lies in making the experience more fun for the ‘thrill seeker’, while generating greater revenues in the process - hand held systems notify you when to queue for your desired rides and it’s tech encourages spending.
Interestingly they allow their customers to access the technology themselves so that they can build their own solutions, with cloud based delivery of products enabling real-time updates. Disruption stems from the fact they cut just 2% from the ticket price whereas larger competitors can charge in the 20%+ bracket. Its structural growth comes from increasing penetration in online ticket purchasing and new customers.
Calling all investors: smaller companies for structural growth!
Amid rising import costs for many companies from weak sterling and the pressure this is creating for domestic names, our investment thesis remains to try and identify firms that generate revenues somewhat protected from macro-economic pressure and poised to structurally continue growing into the future. We also believe that by identifying names in the smaller market-cap area of the market the exposure to this positive trends is only concentrated, which should enable us to continue delivering strong performance in a range of market conditions.