Is it time to invest in smaller companies?

27 July 2009

Smaller companies, also called small caps, are like the little girl with the curl in the middle of her forehead: when they’re good, they’re very, very good, but when they’re bad, they’re horrid.

They have a reputation for being more volatile than larger companies – producing great returns when the market’s booming, and then being particularly hard-hit when times get tough. So, like the unpredictable little girl, you need to understand something of their psychology and the reasons for those temper tantrums.

There are several reasons for smaller companies’ disappointing performance in downturns. For a start, they don’t generally have the cash reserves or infrastructure to get them through the hard times, so they’re more likely to go bust if their market dries up. They’re also often more dependent on home sales, so they’re heavily influenced by the domestic economic cycle (whereas larger companies often have a more international spread).

Worse, because smaller companies are less well-known, their shares can be hard to trade, particularly when the market is falling. Such drawbacks make investors nervous when there’s a slowdown, so they tend to sell out early – as happened this time.

The credit crisis of the past two years has made things even more difficult, as small-cap companies are generally dependent on borrowing to keep going, but banks have cut back massively on lending.

In fact, all things considered, it’s perhaps surprising that the difference in recent performance between smaller and larger companies is not greater. The UK Smaller Companies sector lost an average 24% over the year to 23 June, compared with the UK All Companies, which fell 21%. And over three years, the Smaller Companies sector has averaged -21% and All Companies -16%, according to Morningstar figures. 

But as Richard Wiseman, manager of Insight Investment’s European Smaller Companies fund, points out: “Small companies have just performed true to type over that time, whereas larger caps have been particularly badly affected, because of the unprecedented circumstances.”

The flip side of this is that when recovery finally happens, smaller companies are likely to enjoy the biggest bounce-back. Ben Yearsley, investment manager at Hargreaves Lansdown, explains: “They’re more dynamic and there’s potential for quicker growth when the tide turns.

For example, it’s very unlikely that Vodafone, with a market capitalisation of £62 billion, will double in value as markets recover, but a company with a market capitalisation of £10 million could grow by a big percentage because it’s starting from a low level.”

They also tend to outperform over the long term. That’s very evident in the Morningstar performance figures for the recent bull market. From March 2003 to November 2007, the average fund in the UK All Companies sector grew in value by 130% – but the average UK Smaller Companies fund increased by over 190%.

The same broad trend of outperformance from small companies as markets rally can be seen in the US. According to Royce Associates, a US affiliate of fund company Legg Mason specialising in US smaller company investment, in the recoveries that followed major downturns (where the market fell more than 20%), the smaller company index gained an average of more than 90% over three years, compared with an increase averaging 65% for the main S&P 500 index.

Time to invest?

So what’s the outlook for small caps? Sector performance has picked up over recent months, though there have been ups and downs: small caps in the UK have outperformed the FTSE 100 by 7% over the past six months, says Yearsley.

But although everyone agrees that markets will recover in due course, few experts are prepared to stick their necks out on whether or not we have reached the stage of ‘real recovery’.

Wiseman says: “It seems that the market has got ahead of itself and we’re treading water at present. And looking to the months ahead, the signs are not good. Usually, companies’ earnings forecasts improve as share prices rise, which helps boost investor confidence, but that hasn’t happened this time; the market won’t be able to sustain a higher level unless company earnings improve to support it.”

But he’s expecting a more ‘normal’ recovery to set in during 2010.

In the meantime, Wiseman is upbeat about the opportunities for shrewd bargain hunters in the small-cap sector. Traditionally, small cap funds have looked for high-quality growth companies, often in specialist niches such as healthcare, retail and biotech. Not only is there tremendous value in these established small-cap areas as a result of the sell-off by investors, he says, but “smaller companies tend to be less well-researched, so there’s even more chance of finding unloved bargains”.

In addition, the choice of businesses qualifying as small cap is much greater than 12 months ago, because so many larger companies have shrunk in value, especially financial companies.

Wiseman says: “Our fund [at Insight] is allowed to invest in companies with market capitalisations of up to €3 billion, which is big for a small-cap fund, but two years ago we would have struggled to find any European banks we could invest in; now the market is littered with them.”

Wiseman bought a lot of financial stocks in the first three months of this year, including Bank of Ireland and the insurance company Irish Life. “These holdings have gone up 500% in value since we bought them,” he says. “It’s an unprecedented opportunity to invest in companies we couldn’t normally consider, and benefit from them as they recover.”

Gervais Williams, head of UK smaller companies at Gartmore, is also positive about prospects for small-cap investors, although he’s very negative on the wider market’s prospects for the future, maintaining that the bull phase will peter out and there will be “disappointing returns from markets”. 

In that kind of stagnant environment, the main reason for investors to choose equities is for a decent and growing income, which they cannot get now from cash, bonds or property. It’s here that Williams sees great potential in small caps. “Around 80% of companies listed on the

Alternative Investment Market [where most smaller companies are listed] don’t produce any income, but a lot could. The share price of many is around four times the earnings per share. If they distributed all their earnings they’d pay dividends of 25% of their share price. We’re suggesting to companies that they start paying dividends – maybe just 5-10% this year, but increasing in coming years.”

Williams believes that those that do will attract new income-seeking investors, which will push up their share price. Of course, these are early days for the Gartmore plan, but a few companies have already agreed to the idea, and Williams reports “good interest” from many.

Marina Bond, manager of the smaller companies side of Rathbones Recovery fund (a merger of Rathbones’ smaller companies and special situations funds), is also keen on companies paying decent dividends. “High yields can be a warning sign, but if the business is being restructured, then they may be very attractive,” she says.

Indeed, many small companies have been bringing in new management teams. “Many are decent businesses producing good products – they haven’t been well managed in the past, but that can change very rapidly,” she says.

What about small caps in other markets? Philip Pearson, partner at Southampton-based P&P Invest, believes that Europe still has a way to go before any real recovery takes place, but “there’s a good chance that the US will lead out of recession in the West, and there is now plenty of value available in small caps”.

Chuck Royce, chief investment officer at Royce & Associates, expects smaller companies to lead any wider US market recovery: “Stronger, more conservatively capitalised smaller companies have advantages in being more nimble than most of their larger cohorts, and more stable than their smaller peers.” 

Clearly, dangers such as cash-flow troubles and liquidity problems will remain for smaller companies until a recovery, but if you’re taking a medium to long-term view, there are great opportunities to be exploited.


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