John Baron: Why I’m buying smaller companies

An overweight exposure to smaller companies has been one of the more reliable investment strategies in generating higher returns over time, relative to the wider market. Recent figures suggest that, since 1955, the Numis Smaller Companies Index excluding Investment Companies (NSCI), which represents the bottom 10 per cent of the UK market, has beaten the FTSE All-Share on average by over 3 per cent a year on a total return basis. Small figures compound over time. While the FTSE 100 has made little progress since 2000, the NSCI has risen over two-and-a-half times.

There is an inherent logic to this. Elephants do not gallop. Many smaller companies operate in niche and growing markets, are nimble and exhibit faster growth in part because they are benefiting from the advance of technology. This is not just helping to reduce costs and open new markets, but is better enabling them to embrace the disruptive practices needed to compete with their larger brethren. There is no reason to suggest this will not continue over time.

Indeed, the absence of genuine entrepreneurship in many of our larger companies and adherence to a financial system too focused on the short term have contributed to their relative underperformance (my article ‘Where are our pioneering giants?’ (IC, 8 Feb 2019)) touches on this theme in more detail. However, as with investments generally, investors need to be invested for the long term to capture this smaller company outperformance. The fact they exhibit greater volatility can then be embraced as an opportunity.

This is such a moment. Both in the UK and globally, smaller companies again underperformed their larger brethren over the year. Indeed, their historical record of outperformance has largely been working in reverse for the past decade. This has not happened since the 1990s. Valuations have returned to levels not seen since the financial crisis – some measures suggesting price/earnings ratios being close to the all-time lows seen in 1992, 2003 and 2009. Sentiment is very poor.

Yet the fundamentals continue to look strong. These companies continue to exhibit the characteristics highlighted above, which have largely accounted for their outperformance over time. Many have robust balance sheets, strong management and markets offering huge potential. It is perhaps no coincidence that good quality smaller companies have resurfaced on the radar of trade buyers and private equity fund managers alike. The extent of M&A activity is on the rise. History may also be part of the reasoning.

Recent analysis by MSCI of US equity returns over the past 70 years show smaller companies usually perform strongly immediately after a recession. On each occasion, they have performed better than larger ones by a margin on average of over 15 per cent during the following year – again reflecting their ‘nimbleness’ when responding to the changing economic environment. Although global economies have tended to avoid recessions, slowing growth rates and perhaps modest ‘technical recessions’ of two negative quarters of growth should usher in something of a rebound from which these companies should particularly benefit.

These companies’ dividend levels may also account for a resumption in outperformance. Poor relative returns have ushered in yields towards the upper end of ranges in recent decades. At a time diversification regarding income generation remains important, there has been a greater propensity for equity income managers to look to smaller companies in both domestic and overseas markets. This looks set to continue.