Would you like that in a small, medium or large, Sir?
UK based 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, generally well established in their sectors, and tend to have strong governance and long histories of creating shareholder value.
But history lends us evidence of investments with even stronger returns: in the UK’s smaller companies. These are firms in the bottom 30% of the UK stock market by market capitalisation – so the FTSE 250 and smaller, or less than around £4bn.
The volatility for investors likely contributes greatly to small-cap reluctance – their share prices tend to swing more wildly, setting nerves affray, and they’ve been known to disappear from time-to-time on account of poor management.
Source: Janus Henderson Investors
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, more ambitious companies, with profits in the millions rather than billions of pounds, 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 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 more nimble, dynamic and innovative, and so are more able to expand into new parts of the country, launch new products or services, 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 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. The price is informed by the work of analysts. Big companies tend to be followed by lots of analysts: it averages 24 per firm for those over £10bn. Because their 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, 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. It means there’s more opportunity to spot mispricing. Academics call this the ‘neglected effect’.
3) Mergers & 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 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 following the financial crisis, having been reluctant to commit to major investments in such an uncertain environment – but as economic confidence has recovered they’ve been spending. According to Dealogic, records were broken in 2015, with $4.7trn of deals. 2016 still proved high at $3.8trn.
A rich history
The Henderson Smaller Companies Investment Trust has not always been in the business of smaller companies. It was founded in 1887 as the Trustees Executors and Securities Insurance Corporation, aiming to beat UK government bonds. Its original Chairman branched out into accountancy services and eventually formed Touche Ross, now a key part of Deloitte – one of the biggest accountancy firms in the world.
It was not until 1992 that it started investing in smaller companies, and in 2000 only in those from the UK. It makes it one of the oldest investment trusts there is: surviving, adapting and evolving over many years.
In 2002, in the wake if the dotcom crash, I became the Trust’s fund manager. Much has happened since: 4 prime ministers; various polarising US presidents; oil prices bucking between $30 and $140 a barrel; Harry Potter and his famous scar; a Middle-Eastern melt-down; a searing global financial crisis; and the explosion of social media, smartphones and apps.
Throughout these twists and turns markets have gyrated yet we’ve has delivered an average annual return of 17.9%, outperforming the benchmark in 13 of the last 14 years. We know the past doesn’t predict the future, but this would’ve transformed £1,000 of your cash into over £12,000.
We’ve done it through consistency, consistency….you get the idea - the method has never changed. Now supported by Indriatti van Hien, our focus is on finding exceptional management teams and good quality businesses, buying them at prices we think are value for money (other small-cap managers care less about firms priced expensively against history or otherwise, but we think this is a key mistake). With Brexit-this and interest rate-that, the UK market seems on a more cautious footing: probably now has never been a better time for stock picking.