Big returns from smaller companies

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Big returns from smaller companies

So, what are the advantages of investing in global smaller companies that are enticing investors to choose them as part of their equity allocation?

Investment returns are obviously key. One of the main attractions of investing in global smaller companies is that they tend to be a consistently outperforming asset class. That is because most smaller companies are in the earlier stages of their development, so they typically have higher growth potential than their larger peers. This helps drive superior price performance over long periods, as illustrated in the chart. 

This is not a flash in the pan. Several academic studies have demonstrated a consistent small-cap effect over many decades and in most countries around the world. The potential to maintain their record looks promising: economic indicators are improving with PMI figures rising in China, the Eurozone, Japan and the UK. Furthermore, markets are on an upwards trend, which creates a positive environment for global small caps to thrive.

Another significant attraction of global smaller companies is the diversification benefits they offer, helping investors improve the risk and return profile of their portfolios. 

There are 6,000 companies in the MSCI AC World Small Cap Index, but they fall outside the usual benchmark for global equity funds, the MSCI AC World Index. As a result, they are often ignored and under-researched. This is a mistake as despite being just the bottom 15 per cent of world market cap, they represent 70 per cent of the world’s listed companies and contain many high-quality, established businesses that are often market leaders in their field.

But what about risk? It is fair to say there is a common perception that smaller businesses are not quite as safe an investment prospect as bigger, global names. However, they are not as risky as you might think, especially when you focus on the higher quality ones.

It is true that the small-cap asset class overall is slightly more volatile, but this is mostly due to the greater proportion of lower quality, often loss-making, businesses than we would find in the large-cap universe. If you avoid these and focus on high-quality smaller companies, you reduce the volatility substantially. Moreover, a focus on quality also improves your returns, which is contrary to the idea that the only way to improve returns is to take on more risk. In my experience, it is lower risk smaller companies that deliver the highest returns and what long-term investors should concentrate on.

How do we define a high-quality smaller company? Factors they can be identified by include their strong balance sheets, high margins, low debt, capable and seasoned management teams, profitable growth, impressive records, high standards of corporate governance and solid returns on capital.

They tend to have a more resilient earnings stream and suffer less when the market goes down, providing a degree of stability for investors’ portfolios. They are also often characterised by tremendous innovation, which drives higher earnings growth. It is also a good sign if the founder of the company is still actively involved in running the business: arguably no one has a bigger stake in the company achieving its goals.

Perhaps the most important definition of a high-quality business, however, is one that has a sustainable competitive advantage and barriers to entry that will enable it to maintain and grow its profits. For instance, those with rock-solid client relationships, unshakeable brand loyalty or patent protection of a key technology are more likely to see strong returns and continuing profits.

So, what are examples of small-cap stocks I believe are exhibiting these characteristics? It may not be a globally recognisable household name, but Sunny Optical, a Hong Kong-listed Chinese manufacturer of camera lenses for smartphones and cars, closely fits the definition. It is benefiting from the trend for dual cameras on the back of smartphones for improved picture quality and the increasing use of cameras on cars. The company also has the advantage of in-depth technical expertise, which creates a high barrier to entry in this market. 

US-based technology company Alarm.com, which offers interactive home security through a smartphone app, is another standout stock. Alarm.com is the market leader, but it is the strength of its relationship with global home security company ADT that is key. It has an exclusive arrangement with ADT as the supplier of such services, enabling it to penetrate ADT’s customer base of 6m, thereby enhancing its likely growth trajectory. In addition, interactive home security is a secular growth market. 

Another global small-cap stock currently delivering strong performance is Pigeon, a market-leading Japanese company offering baby products. Its success stems from its reputation as a trusted brand and it is doing particularly well in China, where parents do not trust local Chinese products due to a history of safety scares.  

To sum up, global small caps’ performance indicates that they are continuing to give large caps a run for their money and offer investors the opportunity to enhance their portfolio. 

Alan Rowsell is investment director, smaller companies, for Standard Life Investments

Key points

Smaller companies are offering promising returns.

There are 6,000 companies in the MSCI AC World Small Cap Index.

Smaller companies tend to have a more resilient earnings stream when the market goes down.