Whether an individual share turns out to be a good investment can depend on the performance of a company’s business, economic fundamentals, valuation, geography, dividend policy, currency, politics, regulation, disruption, and many more variables. And in terms of risk, there is always the possibility that a company can go bust. (Naturally, we take the risk of permanent loss of capital very seriously.)

This complexity has led, over the years, to the emergence of many different equity portfolio management strategies, including:

• Active or passive equity portfolio management (seeking to generate better returns than an index – such as the FTSE All-Share Index – or simply to match them)
• Value or growth (buying shares based on low valuations or on underlying growth)
• Quality (buying companies based on the solidity and superiority of their financial structure and business model)
• Quantitative (using mathematical approaches)
• Technical (making investments based on share price charts).

 

Identifying specific sector investment opportunities

If we can identify specific sectors or areas that systematically do better than the whole market over the long term, and if we can do so without adopting too much risk, it makes sense to have a bias towards them.

‘Quality’ investing is often cited as one way to identify high performing sectors, using the MSCI Quality Index and defined by high return on equity, stable earnings growth and low financial gearing.

Another widely employed way of capturing the superior returns available from distinct sub-asset classes in equities is to use smaller companies, which we explore here.

 

Comparing indices of small, medium and large companies

Within the FTSE All-Share Index, the FTSE 100 (which comprises the top 100 of the FTSE All-Share Index’s 636 companies) makes up just over 80% of the total market capitalisation, with the balancing 20% made up of medium-sized and smaller companies.

Despite the 80/20 split, JP Morgan has estimated that the average generalist UK equity fund has over 40% exposure to stocks outside the FTSE 100 – a very significant bet against the underlying index. However, it is also a very rational position to take. Since the end of 1985, when comparative records began, the FTSE 250 Index (which is made up of the 250 largest companies after the FTSE 100) has risen at an annualised rate of 11.1%, compared with 8.3% for the FTSE 100. This has generated a return of just over 2,800%, compared with a little under 1,160% for the larger index.

The effect is equally marked in other countries as well. In each case, when you compare the Russell 2000 with the S&P 500 in the US, the MDAX with the DAX in Germany and the CAC Mid 60 with the CAC 40 in France over the last 15 years, the smaller company index has outperformed the larger. The stars of the show overall have been the French and German mid/smaller company indices.

 

Why are smaller companies able to generate superior returns?

1. Small companies benefit from the law of large numbers. It’s easier to multiply the size of a company valued at £100m by ten than to grow a £100bn company to a £1trn company. At the very large end of the scale, the addressable market simply may not exist for the product the company makes.
2. Large, sunset industries are more likely to be represented in the big indices, while smaller, innovative companies usually form part of the smaller indices.
3. Smaller companies are more likely to be taken over, as their size makes them more digestible.
4. The composition of the smaller index is very different from the larger. In the UK, for example, the FTSE 250, excluding investment trusts, has a 3% weighting to oil and 3% to banks. In the FTSE 100 the respective weightings are 15% and 13%. Perversely, even though smaller companies are seen as higher risk (and they do go bust more frequently) a higher sectoral concentration in the larger index can mean greater risk, as sectors tend to move together in the same direction.
5. Small companies tend to be under-researched, and diligent investors can often discover hidden gems.

 

And what are the downsides of investing in smaller companies?

1. Just as with the ‘quality’ style, there have been periods of as long as five years when they have underperformed their larger brethren
2. They can be illiquid and tend to fall further than the wider market when equities suffer from serious corrections
3. In general they are more financially fragile
4. They are more highly valued
5. Particularly pertinent to the UK, they are more exposed to the domestic economy, which may prove a headwind in the event of a hard Brexit
6. For the smallest companies, such as the AIM market in the UK, the performance track record has been much patchier.

 

Our conclusion

We believe equity markets should have a solid year in 2018. In this case, having a meaningful exposure to smaller company equities continues to make good sense, and we try to ensure that well balanced portfolios have a proper allocation to them.