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The basic case for investment in larger companies is well known: with the onset of globalisation and the reduction of tariffs, a number of global companies are emerging in each industry whose unrivalled resources, market position and competitive advantages will ensure their future success. A successful equity investment strategy must focus on these leaders. Their market dominance, coupled with relative stability of earnings, should produce higher risk adjusted returns over the long term.

Changes in the asset management industry have also benefited large cap companies such as the development of pan-European investment and its requirement of a collection of big, liquid stocks. Analysis of relative equity performance appears to bear this out. Investor attention over the last decade has focused on larger cap stocks in the FTSE 100, which have outperformed the FTSE Small Cap Index in six out of the last 10 years. Between 1 January 1990 and 1 January 2000, the FTSE 100 rose 186% against 94% for the FTSE Small Cap. Large cap stocks in the pharmaceutical, banking and telecoms sectors have been principal beneficiaries of the recent UK equity market bull-run.

It is not easy to place UK smaller cap stocks in this context. The traditional image is of a collection of dull but worthy competitors, driven principally by cyclical changes in the domestic economy. Taken at face value, it seems that the investment case for smaller companies is weak.

The case for smaller companies

The FTSE defines small cap as any company in the FTSE All-Share that is not large enough to be included in the FTSE 350. This definition includes companies with a market capitalistion of up to £458m as at July 2000. Alternatively, the Hoare Govett Smaller Companies Index (HGSCI) includes all companies whose market cap equates to the bottom 10% of the total equity market. This definition includes companies with a market cap of up to £740 million as at December 1999. The HGSCI provides a universe of 1433 stocks.

At its most basic level, the case for smaller companies rests on the fact that they are faster growing and, individually, higher risk investments. Classical investment theory states that higher returns should ensue.

The life cycle of a company starts with a period of rapid growth from a small base, when most of the value is generated, before maturing as growth rates slow. Smaller companies are often more dynamic and able to carve out niches, unlike their larger competitors. Furthermore, a good product or 'contract win' is more likely to have a greater impact on the business due to the base effect.

Small caps are also able to operate closer to their customers and, with the advent of information technology, can benefit from operating efficiencies without high levels of capital expenditure. The UK has a large pool of entrepreneurial talent that can be tapped through investment into smaller firms.

Managers of smaller companies are often highly motivated individuals with a significant stake in their businesses. A key issue for larger companies is the ability to hire and maintain quality staff. We have recently seen many high profile departures by people starting up small businesses, particularly in the dot.com sector.

Risk and diversification

Individual small companies are higher risk investments than their large cap counterparts. They are more likely to go bankrupt and may be dependent on one particular market or product. As a result, individual company earnings and share prices are more volatile.

From another perspective, however, exposure to small caps can reduce risk in a UK portfolio by increasing diversification. In the FTSE All-Share, the five largest stocks account for almost 30% of the total index, with one stock, Vodafone, larger than the total value of all 1433 stocks in the HGSCI. In the FTSE 100, the five largest stocks account for 36% of the total. The ever-increasing concentration of assets in fewer companies further increases risk.

A fund which allocated 4% of its UK equity portfolio to small caps via an active manager, would be gaining exposure to between 100-200 companies in a greater number of sectors.

Smaller companies also provide funds with a means of diversification on a relative basis. According to work carried out by Merrill Lynch in the US, the correlation coefficient between large and small caps has fallen from 0.96 in the 1940s to 0.85 during the last 10 years.

To put this into perspective, the correlation between stocks and bonds is around 0.2. The increasing divergence of large and small caps provides a further incentive to invest in small companies, thereby producing a more efficient portfolio with higher returns and less variability.

High growth

Central to the myth of smaller companies is the image of the asset class as a group of cyclical stocks dependent on interest rate cuts to kick-start share price performance. In fact, smaller companies are increasingly focused in the high growth sectors of the economy and deserve to be re-rated.

An analysis of the HGSCI at the beginning of 1999 compared with its composition today highlights these changes. Whereas in 1998 the largest new issues joining the index were Express Dairies, Selfridges and Informa Group, the largest arrivals in 1999 were eXchange Holdings, Knutsford Group, 365 Corporation, Morse Holdings and Affinity Internet, all high growth stocks.

At the beginning of 1995, the general industrials and services' sectors (both skewed towards cyclical stocks) represented 57% of the total value of the index.

By the start of 2000, cyclical services and cyclical consumer goods combined accounted for only 28% of the total index whilst information technology accounted for over 7%. Technology is clearly shifting the focus of smaller caps towards high growth sectors.

Despite the shift of UK smaller companies towards emerging growth sectors, these firms on balance remain

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