Large and mid-cap companies can only dream of achieving the earnings growth expected of their smaller cousins
In these unsettled times, there is supposed to be a flight to quality, with the understanding that only big, stable companies offer it. But this time round, investors are distinctly ambivalent about things that are big or global. Many are realising that testosterone-driven M&A activity, the glory of the 1990s, rarely adds value and often destroys it. They are downsizing, in all respects.
Once again, small is beautiful. Portfolios too are beginning to reflect the attraction of small caps. Small firms still have an image of homespun solidity. Often locked into the national economy, they are probably patriotic. Like loving families, the directors know the name of your second child's teddy bear and invest all their own savings in the business.
The great investing public now associates blue chips with fat cat salaries, aggressive accounting and raids on workers' pension funds. Besides, big companies are these days quite keen to shrink their public profiles. Relegation from the FTSE 100 index is a positive relief to many CEO's battered by the hostile scrutiny membership of that club attracts.
On a more commercial note, small caps are expected to outstrip large caps by big margins. According to a survey from Merrill Lynch, FTSE 100 companies are projected to show 10% growth in earnings this year, while the mid caps are tipped for 17% growth, and small caps an exhilarating 30% growth. All the things that fund managers traditionally don't like about small caps have been obliterated by those blazing figures, and the marketing departments are in overdrive.
Small cap valuations are certainly more attractive than those for headline companies, but then they always were, for the good reason that they are often less successful businesses. Small companies are supposed to be more vulnerable to recessions. But, say the sector's bulls, if you stick to those with a big cash buffer, you'll be OK. Well of course you will. Anything with a cushion against tough times is a screaming buy right now. While you may be able to buy easily, selling might be trickier. Liquidity was never the strong suits of the small cap sector. But never mind, you won't be tempted to ditch prematurely the stock that turns out to be the next Microsoft. In 10 years time you will be glad you couldn't sell in 2002.
And the best non sequitur of them all: small companies are more simple and transparent than big corporates. That must come from someone who has never worked for or with one. Small companies are always under the gun. As a result, the management is invariably ruthless and tyrannical. It is excellent training for the moment when they graduate to the big league. Which brings us to the final anomaly. Small companies, as an asset class, is not exactly small. It is not the same as investing in your friend's newly floated film production company. The average market capitalisation of the 359 companies in the FTSE 350 index (sic) is £104m. The average market cap of those in the Russell 2000 index, the benchmark most commonly used in the US, is $530m.
Good reasons to invest in small caps include competitive advantage of some sort, high barriers to entry and sound management. But that goes for any target, surely? The only really gripping thing about small caps is the possibility that they just might grow because expansion from a low base is easier to achieve than from a high one. But you had better find a wizard small cap fund manager, because coverage of the sector among mainstream brokers is plunging.
Partner Insight: For Blackfinch, the arrival of its IHT portfolio services was a 'natural evolution' in the group's offering and points to an established track record of returning cash to investors.
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