Put your trust in small companies

Wheel of fortune © Getty
Smaller companies can turn their fortunes around, generating spectacular returns

Despite a dire 2018, the long-term trends in the small companies sector are encouraging.

Last year was one to forget for investors in smaller companies, says Professor Paul Marsh of the London Business School. The Numis Smaller Companies Index (NSCI), the bottom 10% of the UK market, returned -11%, 2.3% behind the FTSE 100. However, if investment companies are excluded, the gap increases to 6.6%, and if companies listed on Aim are included, to 7.1%.

The NSCI is made up of all 707 stocks (of which 348 are investment companies) with a market value below £1.33bn, and has a combined value of £231bn. Including Aim, it comprises 1,617 companies worth a total of  £307bn. This compares with the £1,814bn value of the FTSE 100 index.

Small-cap managers have many more companies to research than their large-cap counterparts, each with far less research coverage, less accessible management and more risk. It wouldn’t be worth bothering unless smaller companies outperformed larger companies over the long term.

Small but mighty

The research by professors Marsh and Elroy Dimson calculates the scale of this outperformance of the NSCI (excluding investment companies) as 3.3% compounded over the 64 years since 1955: 9.7% per year versus 6.4% for the All-Share Index. This means the NSCI has multiplied eight-fold relative to the overall market. While the FTSE 100 is barely higher than it was at the start of the millennium, the NSCI has multiplied 4.2 times. Moreover, this outperformance is replicated worldwide: in most countries, small-cap outperformance has actually been higher than in the UK.

So is this a good time to invest in smaller companies both for a shorter-term catch-up and for the longer term? Probably, but there are some caveats. While smaller companies look cheap in absolute terms on a price/earnings multiple of 10.9, below the long-term average of 12.7, this is only a little below the 11.2 multiple for the All-Share Index. Outperformance by smaller companies in 2019 will require better earnings growth (this is despite evidence from the longer term that value outperforms growth).

Other factors which help outperformance are a focus on lower-risk stocks, a sceptical approach to new issues and, above all, a strategy of running winners and selling losers. Companies can turn their fortunes around, generating spectacular returns for investors, but it is much harder in the small-cap arena than for larger companies. Aim’s performance last year was disappointing, but Marsh is encouraged by some longer-term trends. The proportion of foreign companies has fallen, while the avalanche of new issues has abated. By number, 45% of Aim companies are profitable, and 75% by value, while 32% and 63% respectively pay dividends. In 2000, just 25% by value were profitable. Unsurprisingly, smaller-companies fund managers have been increasing their allocation in recent years.

Why trusts are better

While the odds of UK smaller companies outperforming in 2019 are good, those of investment trusts specialising in them are better. Small-cap trusts have, on average, outperformed the NSCI by 14% over five years and trade on a discount to net asset value of over 10%. On average, trusts in the “UK all companies” sector have underperformed the All-Share Index by 10% and trade at a discount of 7%, while trusts in the “UK equity income sector” have equalled its performance, and trade at a discount of 4%.

Small-cap trusts such as BlackRock (LSE: BRSC), Throgmorton (LSE: THRG), Henderson (LSE: HSL), Invesco Perpetual (LSE: IPU), JP Morgan (LSE: JMI) and Standard Life (LSE: SLS), each ahead of the average over almost all time periods, are well worth backing.