In the UK, smaller companies have outperformed their larger counterparts in three out of the past fi...
In the UK, smaller companies have outperformed their larger counterparts in three out of the past five calendar years. The large capitalisation companies are represented by the FTSE 100 index, where valuations range between £3bn and £130bn. Smaller companies, as represented by the FTSE Small Cap index (FTSC), have upper market valuations of about £500m, with more than 400 companies within the index.
On a five-year compound basis, the two indices provided similar returns, with an 89.2% gain from the FTSC as opposed to 92.8% on the FTSE 100.
The similar returns provided over a five-year period hide the differences between the two asset classes and especially the increasingly dynamic nature of the indices.
The performance divergence between the two groups of companies can be startling, with a low correlation over the past four years. For example, over the two-year period of 1997 and 1998, the FTSC had a lacklustre return of 0.3%, while the FTSE 100 continued to perform strongly with a return of 50.6%.
Towards the end of this period, there was great debate on the usefulness of the smaller company asset class as an area of investment. The poor performance of smaller companies over this period led to some large name investment houses disposing of entire smaller company portfolios in an attempt to turn around performance. This proved to be costly when the FTSC, starting from a low base, had a strong technology rally returning 62.3% over the past two years, as opposed to only 10.6% for the FTSE 100 index. About 53.8% of that performance came in 1999 alone.
Because of the perception of higher risk levels and poor liquidity among smaller companies, many people believe such organisations tend to trade at discounts to larger companies on a P/E basis. But in reality, the FTSC index trades at a premium to the FTSE 100.
This can be attributed to the number of highly valued companies recently entering the index from the FTSE 250.
A number of these companies would originally have started in the FTSC index, where many recently floated technology stocks participated in the 1999 technology rally and were subsequently promoted to the FTSE 250.
The recent turmoil in the market and the revaluation of technology stocks has seen the demotion of many of these stocks back to the FTSC.
The multiples at which the indices trade will also reflect their bias towards specific sectors of the economy. The FTSC index has historically had a strong bias towards low multiple sectors such as basic and general industrials, although there is enough weighting in highly rated areas such as information technology and hardware to keep the index multiple high. Nearly half of all flotations in 2000 were in highly rated technology stocks. With such volatile valuations for whole sectors, we must remind ourselves that the indices are dynamic in nature and need to be monitored with care. The more lowly rated sectors also saw high levels of corporate activity in 2000, which supported the index against the backdrop of a poor wider market.
These low valuations in certain areas such as property look attractive to management buyout teams, as well as making them vulnerable to bids. The current environment of falling interest rates will reduce the borrowing costs of such management buyouts.
Don't restrict yourself
Limiting your investment horizons to solely smaller companies would restrict your top-down management abilities, and gaining exposure to some important sectors would prove difficult. A smaller company fund would not be able to provide you with exposure to key areas of the economy such as banking, telecoms and oil, for example. Small or indirect exposure could be obtained but not to the levels provided by the FTSE 100 or indicative of their importance within the economy.
With this restriction on an investor's ability to tilt sector weightings, stock-picking becomes vital. With more than 400 stocks in the FTSC index, and many other smaller listed companies, this requires large resources and high levels of expertise.
As well as having to contend with a large investment universe, smaller companies also receive far less analysis than their larger counterparts. This lack of secondary information on smaller organisations will mean that investors need to rely more on their own ability to obtain and analyse primary information. This requires specialist skills and resources that are not usually available to the average private investor. Specialist funds can therefore play a big role in this area of an investor's portfolio.
As smaller company investment is predominantly a stock-picking environment, the choice of manager will be crucial to the risk and return profile of the fund.
With the top-down approach more commonly adopted by large-cap funds, it would be fair for an investor to expect similar characteristics and performance as that of the general market or their chosen benchmark. Extreme variations in performance would not be commonplace at least. With smaller company funds, however, performance is more likely to deviate from the benchmark index.
There can be advantages for the skilled private investor to make direct investments into smaller companies, though. The lack of liquidity attributed to smaller companies can be used to the investor's advantage. Small companies can easily become subject to extreme valuations, which a specialist fund may not be able to take advantage of in the short term.
Watch out for risk
Specialist fund managers can provide the stock-picking skills but will still face the liquidity problem and so tend to be restricted to a medium to long-term holding strategy. The shrewd private investor can, however, take advantage of this by trading at extreme valuations. Obviously, this is where the risk comes in.
Would the average private investor be aware that these are extreme valuations and, also, if a private investor were a forced seller, would they be able to obtain a fair price? Such extremities are not so likely to occur in the FTSE 100, where there is a wider investment audience to participate in the pricing of a security. The lack of information on smaller companies makes valuation more difficult. Despite large and small companies posting similar returns over the past five years, further analysis of these figures has shown that care needs to be taken in the timing of investment. With the sector weightings of these indices changing quickly in recent times, old views of the smaller companies index maybe misplaced. The index now contains a range of value and growth stocks, providing the opportunity for good performance in inflationary and deflationary environments.
With equity markets currently in decline, smaller companies could continue to prove to be defensive investments, benefiting from their bias towards domestic and European revenue streams.
The low correlation between the two investment groups should benefit all investors.
Keeping some exposure to companies at an earlier stage in their life cycle should be a prudent long-term strategy. Additionally, with recent constituent changes the opportunity to perform in different economic environments has improved.
The multinational nature of the large capitalisation stocks can provide the investor with quick access to regional and global growth rates. With world growth rates proving to be a concern, exposure to the domestic economy via a carefully selected smaller company fund would seem sensible.
Larger firms should, however, be the first to benefit from any sharp improvement on the markets.
Matthew Grange is a fund manager at BFS Investment
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