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

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.

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 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 value of 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

  • clive chafer

    As usual, an excellent and helpful article with useful investment recommendations.

    Thanks Merryn.

  • IJ

    I think it is and Merryn is right to be worried. If the biggest risk one takes in investment is to overpay for something, then many of these supposedly safe stocks may well be toxic. There are plenty of fallen angels already: take Intel, beloved by all not long ago, but which has lost 1/3 of its value since peaking earlier in the year; or Vodafone, -20% since its August high. Or the E.ON calamity. It’s not surprising when you look at the structural challenges some of these businesses face, but this crucial factor was all but forgotten in the “quality” mania. Don’t buy stocks commonly touted by fund managers. Beware of Nestle.

  • crazy tony

    Usually I like a fund with a track record that you can analyse, get a flavour of and comparison with others. 18 months is not very long really… perhaps hes just been lucky lately!

    Interesting stuff, but I dont think there is any rush, as the recovery from this debt laden recession is gonna be slow

  • Doug

    The wide range of contrasting views which well-informed MW contributors share with us is both healthy & welcome, enabling us to make personal decisions.
    However, we’ve recently received contradictory advice regarding equities. Last week MW sent an email about the need to protect our wealth. The reports “Supreme Income” & “Wealth Preservation” both gave the same advice – buy blue-chip shares for their dividends & buy gold & cheap overseas stocks.
    Bill Bonner recently stated in his Daily Reckoning that it’s time to be out of equities, contradicting 2 of the 3 steps in the reports. Now we have Merryn Somerset Webb asking if it is time to ditch blue chip stocks! Many readers will still be digesting last week’s report & must now be confused & concerned that she’s worried about their prices, margins, etc. What’s changed suddenly? Or, are the reports already out of date?
    We need the individual views, but please don’t let’s see out & out contradiction. We need confidence!

  • crinan

    I like it that there is no “party line” in Moneyweek, rather “let a thousand flowers bloom” as in China very briefly, so different views are a sign of strength, not weakness. there is no alternative to each investor making up their own mind!

  • Doug

    Crinan, I agree that different views are a sign of strength, not weakness – I implied that in my opening statement; however, I do not agree that there is no “party line.” Refer to “The alarming truth about Britain” a Right Side posting made yesterday by Tony Bray who continually refers to WE, meaning the MoneyWeek team. Bray states that the team has “called upon financial experts … to help us understand and respond to (the) threat” identified in a link to “the end of Britain” by “The MoneyWeek Team.” Again the term WE is constantly used in this link and it is stated that “We … show you precisely how we think you should position your wealth .. (in the) Wealth Preservation Report.” Merryn Somerset Webb is identified as one of the team. In my opinion she is casting doubt on how the team is “precisely” advising. Is she perhaps sitting on the fence?
    Yesterday’s Daily Reckoning refers to both Supreme Income & Wealth Preservation reports. A battle of wills? Team v Merryn? I wonder.

  • jimtaylor

    #4 Doug – and when it all comes together its known as “diversification”.

    These articles are generalisations even when they contain a small amount of detail. At any time there will be a blue chip worth buying and a small cap worth buying and many to leave alone (for the time being at least).

  • davy hulme

    Gervais Williams hasn’t just been lucky for 18 months – he has been lucky for over 20 years! Crazy Tony – check out his previous track record at Gartmore. He is also lead for MAM and you can also access his skills via a share in the asset manager. Slow Finance is well worth a read.