Big differences but still rich pickings

In the year to February 11 the Investment Association (IA) European, UK and Japanese Smaller Companies sectors all outperformed their large-cap peers, with the IA European Smaller Companies sector delivering the best performance of 3.5 per cent against the wider IA Europe ex UK sector average loss of 5.2 per cent.

The only outlier in the small-cap arena for the 12-month period was the IA North American Smaller Companies sector, which recorded an average loss of 12.9 per cent – more than four percentage points behind the average IA North America sector loss of 8.2 per cent.

So there can be a divergence in performance that could, at least in part, be attributed to geographical differences.

Julian Chillingworth, chief investment officer at Rathbones, notes that while small and mid caps in the UK are not dissimilar to those in Europe, there can be a structural difference as there are still “quite a lot of private companies in Europe, particularly in Germany, that would be quoted [firms] in the UK or US”.

As a result, there is more family ownership and family control in the European small- and mid-cap space. But does this potentially limit the universe for small- and mid-cap investors?

The MSCI Europe ex UK Small Cap index reports 691 constituents from 14 developed countries, compared with the MSCI UK Small Cap index, which alone is home to 239 companies.

But in terms of definition, David Walton, manager of the Marlborough European Multi-Cap fund, notes: “A small-cap company in Europe can have a market cap of up to £3bn and can therefore be almost twice the size of a UK small cap.

“As a consequence, the European small/mid-cap market is a very large one, with around 6,000 stocks. That includes the very smallest companies, which tend to be screened out by many fund investors because of their size, but can present attractive opportunities.”

But he says holding a blended portfolio of small and mid caps “significantly increases the number of potential opportunities, as well as providing important portfolio diversification benefits”.

Meanwhile Mr Chillingworth notes there is further differentiation between the UK and US small- and mid-cap sectors in terms of scale and market cap,

He explains: “If you look at the cross­over of the bottom of the FTSE [100] and start of the FTSE 250 index, companies cross between £3.5-4bn market cap. Then the bottom of the FTSE 250 is about £800m [market cap], then it goes into small cap [territory].

“In the US, effectively a small cap would be up to $2bn (£1.4bn), while a mid cap can range up to $10bn.”

Aside from size, another market difference is the sector make-up of these markets, with financials and consumer discretionary accounting for almost half the MSCI UK Small Cap index and almost 60 per cent of the FTSE 250 mid-cap index.

In contrast, the MSCI US Small Cap index sectors are dominated by financials and IT, which account for just over 40 per cent of the index, while the MSCI US Mid Cap index is closer to the FTSE 250, with 40 per cent in financials and consumer discretionary.

Mr Chillingworth adds: “The US mid cap and small cap arena is quite US-centric, so if you want to play the US economy, you’re better off in the mid-cap arena than the large-cap arena. And biotech and technology is vastly greater in the US.”

This domestic focus does have its benefits, though, with Chris Berrier, manager of the Brown Advisory US Smaller Companies fund and co-manager of the US Small-Cap Blend fund, saying US small caps are more insulated from the effect of a strong US dollar and weakening global demand.

“Over the past five years we have seen a highly correlated market with low volatility, thanks in part to quantitative easing.

“The difference in performance between established, quality businesses and those which are currently unprofitable but have positive long-term earnings forecasts, has been blurred.”

But he continues: “The market has once again started to discriminate between companies on the basis of ‘quality’.

“As valuations are somewhat richer and growth less pronounced, we expect the market to continue with a more discriminate attitude to company ratings.”

Nyree Stewart is features editor at Investment Adviser