This may be sensible as a rule of thumb, according to Standard Life Investments’ Harry Nimmo, who points to the spectacular returns seen by smaller companies as they came out of the bottom of a number of bear market phases – sparked by the Asian, Gulf War, banking and eurozone sovereign debt crises.
But David Coombs of Rathbone Unit Trust Management thinks, even as a rule of thumb, it’s too simplistic. The head of multi-asset, who also runs the multi-asset portfolios and Global Alpha fund, points to several factors driving company performance, regardless of size.
In terms of operational performance, companies tend to be more efficient due to cost-cutting put in place during any preceding recessionary period, which he says is often a tailwind for earnings.
“Interest rates also tend to be lower coming out of a recessionary period and, therefore, companies can finance themselves more cheaply. Typically, sales also pick up during periods of economic growth.”
But he stresses these benefits are not exclusive to small caps.
Giles Hargreave, manager of several Marlborough portfolios focusing further down the market-cap spectrum, including the newly launched Nano-Cap Growth, Special Situations, MicroCap Growth and Multi Cap Income funds, takes the long-held view that smaller companies’ relative outperformance is irrespective of timing.
“You can’t really predict a point in the market cycle [when smaller caps will do better or worse]. The past 10-15 years have shown significant outperformance, in spite of a 12-year flight to safety being included in that, where people have been moving out of equities and out of small caps.”
Gervais Williams, managing director at Miton Group, says that since the start of the smaller companies index in the mid 80s, they have seen a prolonged period of outperformance, averaging roughly 40 per cent per year. But, he says, in the past few years, growth came from everywhere, with market-cap size irrelevant.
Mr Hargreave says 2013 is the first time in 15 years that people are switching back from bonds into equities, and is convinced small caps’ success shows no signs of waning. Mr Nimmo on the other hand is more bearish. He says the number of recent new issues is encouraging but believes after such a strong run, it might be time for investors to exercise a bit more caution.
“But I’m not fearful of that, because my portfolios are positioned at the more defensive end of my universe,” he adds.
Mr Coombs says that, regarding share price performance, smaller companies tend to be more depressed during recessionary periods due to their relatively higher risk profile – generally newer companies operating in rather niche sectors.
“Small companies also tend to be in a weaker negotiating position compared with larger companies when dealing with customers and suppliers, which also means they may get squeezed on the price of their inputs from suppliers, or may have less resource to chase up on missed payments by clients. When the economic outlook improves, these risks reduce and this is then reflected in share prices.”
On AIM stocks, which make up roughly 80 per cent of his Smaller Companies fund and more than a third each of his Multi Cap Income fund and Diverse Income Trust, Mr Williams says their stronger returns come with challenges. “People always love to hate AIM stocks because they see them as speculative and therefore are pretty much expected to disappoint.”
Mr Hargreave puts the current popularity of AIM down to more recent tax breaks around Isa investing and IHT allowances. He says their poor reputation is often unjustified and believes many of them are underestimated. The veteran manager does however stress the point across AIM, and small caps in general, that their breath of focus is such that generalisation is almost impossible.
Rob Harley, senior research analyst at Bestinvest, says while small caps do – given reasons aforementioned – rally during risk-on periods, he says that much of the performance is relative given the qualities of the larger-cap indices.
“You had the eurozone crisis of 2011, [Mario] Draghi’s comments in 2012, where small caps saw a massive rally. But, at the same time, some of the big sectors struggled. Miners struggled in the face of a China slowdown, the oil and gas sector saw earnings downgrades – so the smaller-cap index saw relative outperformance because they didn’t suffer the same drag.”
That said, Mr Harley agrees with Mr Nimmo that higher earnings growth has led to a rerating of the sector – with industrials and consumer services making up over half of the Numis Smaller Companies index. Small caps are now trading at a premium, he says, and anyone looking at the space now, might have arrived too late.
Sam Shaw is a freelance journalist
WHAT THE EXPERTS SAY
James Calder, research director, City Asset Management
We took a positive view on UK small caps earlier this year, focusing upon Gervais Williams’ CF Miton UK Smaller Companies fund. Smaller company funds will benefit from the recovery of the UK as they tend to be more domestically orientated than large cap. While the asset class should be considered higher risk than large cap, we believe the improving economic outlook and the return potential will reward investors for taking the additional risk.
Ian Cooper, fund analyst, Brewin Dolphin
The significant levels of small-cap outperformance investing has re-accelerated still further since 2012. This is a rational response to improvements in the economic cycle, to which smaller companies have a higher sensitivity than their larger counterparts. The business cycle can, therefore, be a useful tailwind for small-cap investors. However, the fundamentals of UK small caps is also currently supportive, with many companies well capitalised, exhibiting decent top-line growth – sourced increasingly from overseas – and well-placed to benefit from M&A.
Richard Larner, head of offshore research, Brooks Macdonald Asset Management
Although the FTSE SmallCap index has outperformed the FTSE 100 in the past 12 months, we still feel the outlook remains supportive. With domestic economic conditions improving, their high beta characteristics imply greater sensitivity to improving fundamentals. However, being selective and focusing on quality is crucial to benefit from the next stage of the market rally. In addition to the momentum of the recovery now taking hold, we would expect bank lending conditions specifically for smaller companies to improve over time, enabling management of these businesses to increase capital expenditure and position themselves for future growth.
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