Is it time to ditch blue chip stocks for small caps?

published 26 November 2012

Income paying defensives; companies with global franchises; international firms with pricing power; brands with inbuilt inflation proofing; mega-caps with huge cash balances and dividend paying capacity: I'm bored with them all.

I've now been telling you to buy and hold these sorts of things for four years, maybe more. I've talked about them endlessly; I've reported on countless other people talking about them; and I've recommended all the funds that pick them as well. Now, one of the great truths of successful investing is that it is boring you have to choose good stocks at the right price and keep holding them until they aren't the right price any more. It is the fact that most flighty fund managers can't do this that keeps me in my carping-from-the-sidelines job and, mostly, your pension fund in the red.

But that doesn't mean that there aren't times when it might make sense to cash in some of your chips on the big-cap quality stuff and think about something else.

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Right now I'm looking at the big companies every fund manager I ever meet is clamouring to buy, and I'm worrying just a little bit. I'm worrying about their prices (not so cheap any more); I'm worrying about their margins (what goes up must come down); I'm worrying about just how long it will be until our comically broke governments find a way to tax the cash knocking about on their gargantuan balance sheets; and as a result I am allowing myself to be distracted by small caps.

Older readers will remember a time when it was commonly accepted that smaller companies always outperform big companies and that smaller companies should therefore trade at a good premium to big companies. Elephants don't gallop', people used to say (quoting small-cap investor Jim Slater): it's easier for a tiny company to double its size and your money than for a big one.

They don't say that so much any more. The search for value, diversification and, in particular, for yield has taken the UK's investors all over the place in the past couple of years into the mega caps we hear so much about; into Asian income funds; into all manner of bond funds; and into the quality investment trusts they spent the ten years before 2008 studiously ignoring.

But along the way the evidence of long-term outperformance of small caps has been forgotten (the Hoare Govett Smaller Companies Index now known as the Numis Smaller Companies index shows them outperforming large caps threefold between the early 1960s and 2010). The FTSE 100 trades on a price/earnings ratio of about 13.5 times. The FTSE Small Cap index is on more like 10-11 times.

Gervais Williams, manager of the newish small-company focused Diverse Income Trust (launched in April last year) thinks this gives us all something of an opportunity. As he sees it, the investors of the 1980s were right: small caps should trade at a premium to larger firms. They have growth potential (making them more likely to be the focus of government support than tax grabs); and they are woefully undercovered by analysts, meaning that managers who are good at their jobs should be able to dig out undervalued opportunities all over the place.

You might also argue that they also have the diversity some now find lacking in large companies, which are mostly exposed to the same global markets and all too often exposed to the remnants of the credit bubble via commodities and property.

Good news, then, that it looks like some investors might be beginning to expand their horizons closer to home and move down the size scale. The last few months have seen small caps start to outperform even the much-loved equity income sector very nicely, something that Williams says is partly just a cyclical move but also likely to be representative of a longer term shift back to the old normal of outperforming small caps (for more on Gervais's views on investing and the book he has written on the subject see www.slowfinance.com). The Diverse Income Trust has seen total returns of around 30% in the year to date, is raising new capital and is trading at a premium to its net asset valueof 2-3%.

Normally I don't suggest trusts trading much above net asset value it always feels better to buy at a discount. But this one also offers a yield of 4%, and Williams has a record of good discount management (preventing shares in trusts falling to big discounts to their net asset value). Still, if you want something that isn't on a premium you might consider the Aberforth Smaller Companies Trust its shares trade on a discount of 12% to its net asset value and it comes with a yield of 3.2%. Something for everyone.

Finally, a note on US housing. I have written here several times that as the financial crisis began with the US house price collapse there is no chance of it beginning to end until the crash is over. It looks like it is. US house prices have risen by 5% in the last year. If that keeps going, says Capital Economics, millions of Americans will finally start to leave negative equity behind them. That won't make things perfect, but it will certainly make them a lot better. The last time we wrote about US housing we suggested everybody bought some. I'm afraid I didn't get around to it. But I hope some of you did.

This article was first published in the Financial Times

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Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.