Many groups have reduced their exposure to small caps recently but investors shouldn't forget that they tend to perform better than larger companies during times of economic growth or recovery
A number of funds have recently been reducing their exposure to small companies. To us this looks like a questionable strategy.
Small companies tend to outperform large companies during times of economic growth or recovery, and underperform during periods of decline. Consequently, indicators of economic growth are frequently used as a guide to prospective small company relative performance. A customary indicator is the slope of the UK yield curve. Small companies tend to outperform as short rates decline relative to long rates because the relative strength of long rates is seen as anticipating acceleration in economic growth. General economic forecasts and economic leading indicators are also employed.
At present the message from these indicators is ambiguous (see chart above right). If anything, both the yield curve and consensus economic forecasts, currently for GDP growth of 2% in 2003 and 2.4% in 2004, point to a period of subdued growth, albeit not decline. Does this mean that small companies should be avoided for the time being? We think not.
It is dangerous to generalise about UK small companies. Although they tend to be treated as an asset class in their own right, size is not of itself a determinant of company fortunes. The business model and market in which a company operates are more important. Consequently the appeal of small companies as an asset class varies not just with macro-economic outlook, but also as a consequence of the mix of companies present in the small companies universe.
For example, during 1999 the preponderance of technology, media and telecom shares in the FTSE SmallCap index resulted in out performance of the market as a whole, although underlying economic growth was slowing. It may be that indicators which appear, with the benefit of hindsight, to have been accurate guides to the performance of small companies are only valid when the sector profile of the small company universe remains unchanged.
UK small companies' sensitivity to the domestic economy reflects high weightings of domestically exposed cyclical businesses compared with the FTSE 100, which is internationally biased and has low cyclical exposure.
Over 60% of the FTSE 100 consists of banks, oil & gas, pharmaceuticals and telecoms. The top five sectors of the FTSE SmallCap are support services, general retailers, real estate, software and computer services, and construction and building materials. These sectors account for only 35% of the FTSE 100 index.
The FTSE 100 is also very concentrated, with the top 10 companies which represent 55% of the index. These same 10 companies make up 47% of the FTSE All-Share index. Consequently small company funds are advantageous for investors both for diversification and in order to build direct exposure to growth or recovery in the UK economy.
Small companies also benefit from the size effect. Extensively researched by Elroy Dimson and Paul Marsh at the London Business School, the size effect is the tendency of small companies to provide a return premium over long periods of time. Dimson & Marsh have estimated that, between 1955 and 2002, the average arithmetic size premium (defined as the difference between the returns on the HGSC and FTSE All-Share) was 3.5% per annum.
The broader range of small company activities allows active fund managers, regardless of the overall trend in GDP, to focus on where there are returns to be made. Increasing demand might result from the ageing UK population, growth in the use of technology, the phenomenal growth in Chinese manufacturing activity, or large pharmaceutical companies' shortage of a pipeline of new drugs. All these themes can be directly accessed via targeted investment in UK small companies.
The main disadvantages of small company investment are poor liquidity and inadequate research coverage. The perception that small companies are more risky stems largely from these factors. At cyclical bottoms the discount for poor liquidity tends to become exaggerated and offers opportunities for enhanced returns during recovery. In some respects small companies may be less risky than large companies in the same field. For instance, they are less likely to carry detrimental legacies such as large pension deficits. In recent times, these pension deficits have been damaging to FTSE 100 share prices but have affected small companies to a much lesser extent.
That small companies are under researched, and/or the independence of the research available is open to question, creates an opportunity for active managers to add value. Frequently, only the broker paid a retainer by the company can justify devoting research effort to an individual company. In such cases the broker provides a valuable function but the independence of the research is questionable.
Very small, illiquid or corporately inactive companies may not be researched in any meaningful way at all. The inefficient market resulting from the poor research coverage creates value anomalies. Active small companies fund managers are able to add value by carrying out and acting on the analyses brokers fail to provide.
The combination of a risky commercial environment and low economic growth currently dictates a risk averse approach to investment in small companies. This does not preclude growth situations, but it does mean that we spend a lot of time seeking to identify and avoid risk.
How does the business behave if activity halves? Does it haemorrhage cash or does it simply suffer a reduction in profits? Are revenues received as cash or accruals? Long-term visibility offered by contracted revenues may seem attractive, but who are the customers?
Might diverse customer bases with established and symbiotic relationships with the company be more valuable than large long-term contracts with empowered customers such as the Government? All the time we are trying to establish the behaviour and security of cashflows and ensure we establish appropriate discount rates. If we take on a higher level of risk, we must be amply compensated for doing so. Quite simply, if the market has been declining for over three years, the easiest way to increase the co-variance of the historic returns with those of the market is to buy shares that have declined more than most.
As our unitholders hope to make money from our investment decisions, providing them with 'high beta' via a portfolio of shares verging on bankruptcy would not be well received. As statistical risk measures can be misleading, we assess the risk of each investment for ourselves.
As an example, we wanted to access the demand for construction created by public spending on infrastructure and the strong demand for affordable housing.
Seeking to control risk we decided rather than endure specific contractual risks, having to absorb bid costs, which might not even result in winning contracts etc we would not invest in contractors but would invest in companies like Speedy Hire which supply tools or services to the contractors. The cashflows they benefit from may not be as great as might be available to the most successful contractors, but the business model risk is lower and we are more certain of receiving our return than we would be if we invested in an unsuccessful contractor.
UK equities appeared to be bottoming recently after dividend and gilt yields crossed over. Capital spending constraints are having a cleansing effect, and share buy-backs and directors' dealing indicate the insiders' view of value. Small companies as an asset class tend to lag recovery in larger companies, but also tend to provide excess returns in cyclical upturns. Despite the subdued economic outlook, investors would be wise not to ignore them.
he ageing UK population and growth in the use of technology could boost demand for sectors in which smaller companies are active.
Small company funds can be used for diversification and to build exposure to growth or recovery in the UK economy.
Smaller companies tend to provide a return premium over long periods of time.
Interest rate outlook unchaged
FCA made demands last week
'Unsung' part of FSCS work