Aiming too high
I know Gervais. He is a super-smart, highly successful investor and eloquent proselytiser for UK small companies. He has also written here an admirably clear book. Its contention is: “Aim will be the world’s best market.”
Now, as Gervais admits, Aim has been a fiasco for investors since 1996, so, reasonably, it may be due a bounce. However, I am dubious about Aim’s long-term appeal, or indeed any other small company index.
This is because the three strategic arguments he adduces for small caps are, in my opinion, dubious too: they “have significantly outperformed larger quoted companies over the years”; this outperformance derives from “notable advantages over their larger competitors” and, in particular, faster growth – “the bigger a business, the less scope there is for it to grow”; and recent macro-economic developments have created an unprecedented opportunity for small caps.
For decades, academic studies have indicated superior returns from small companies. The crucial word though, is “academic”, because in practice no one can replicate them. The calculation of small-cap index returns assumes costless annual portfolio rebalancing and reinvestment of dividends – all into and out of tiny companies. It just cannot be done, as Gervais admits when he notes there are no Aim tracker funds, for precisely this reason.
An anomaly in capital markets is only of value if it is exploitable, and the so-called small company effect is not exploitable – effectively it does not exist. Remember, the performance of companies hand-picked from a universe cannot be tabled as evidence for or against the claimed superiority of the whole.
Next, it seems intuitive that small companies should have better investment potential than large. Elephants cannot dance, can they? However, most battle-scarred investors have tested this proposition to destruction and found it not so. The blunt truth is that most quoted small companies are small for a very good reason. This is that they are mediocre businesses and, regrettably, likely to remain so. Of course you will unearth individual winners among them, but no more so than across all market capitalisation bands.
Finally, I argue contra Gervais that recent micro-economic trends are unprecedentedly favourable for larger companies and that my micro-economic trends out-trump his credit cycle-based macro-economic ones. Mine relate to technology. Technology favours large in two ways. First, it creates gigantic companies – Facebook, Google – that were never “small”, at least as quoted entities, but still with fantastic growth opportunities. Next it brings new efficiencies to established industries, engendering greater economies of scale and encouraging the big to get bigger.
I could be wrong – so please read the book yourselves. And I would go further and say, consider investing with Gervais. He will make you money, but that is because he is an outstanding stock-picker, not because of any inherent superiority in small companies.
Nick Train is investment manager of the Finsbury Growth and Income Trust
