Growth at the right price, growth at a reasonable price

11/05/2017

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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:

Burford Capital

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

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

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.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

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.

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Important information

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

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), AlphaGen Capital Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no.2606646), (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. We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes.

Specific risks

  • Active management techniques that have worked well in normal market conditions could prove ineffective or detrimental at other times.
  • This trust is suitable to be used as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this trust.
  • The trust could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the trust.
  • If a trust's portfolio is concentrated towards a particular country or geographical region, the investment carries greater risk than a portfolio diversified across more countries.
  • Derivatives use exposes the trust to risks different from, and potentially greater than, the risks associated with investing directly in securities and may therefore result in additional loss, which could be significantly greater than the cost of the derivative.
  • The return on your investment is directly related to the prevailing market price of the trust’s shares, which will trade at a varying discount (or premium) relative to the value of the underlying assets of the trust. As a result losses (or gains) may be higher or lower than those of the trust’s assets.
  • Shares can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • The trust may use gearing as part of its investment strategy. If the trust utilises its ability to gear, the profits and losses incured by the trust can be greater than those of a trust that does not use gearing.
  • 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.

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