Small companies for a big world

However, many believe that during uncertain market and economic conditions large-cap multinational defensives are the place to be for equity investors. It is argued that these companies are more likely to weather economic storms and, while you may not get much growth, you'll at least get some dividends, so you don't end up totally empty-handed.

But others disagree. "As a sweeping generalisation this is probably true," says Guido Bicocchi, co-manager of the McInroy & Wood Smaller Companies Fund. "But there are also good smaller companies out there with defensive profit margins and a global reach, which in their niche are very important. The right company and the right sector can grow regardless of the downturn. Small caps are also good value right now because their share price has been hit."

There is also scope for merger and acquisition (M&A) activity to pick up. "I would expect to see a meaningful impact on M&A as larger companies seek to buy up cutting-edge or leading technologies," says Peter Walls, manager of Unicorn Mastertrust, a fund of funds. "In most markets, over time smaller companies outperform larger ones – there is lots of academic research that demonstrates that."

Asset manager Invesco Perpetual has recently highlighted the findings of two academic studies, one of which (International Diversification with Large- and Small-Cap stocks by CS Eun, CS; W Huang, and S Lai, Journal of Financial & Quant Analysis in June 2008) argues that global smaller company investing can benefit portfolios from a risk and return perspective, offering diversification benefits and equity return premium potential over the long term. "The perception is that investing in smaller companies is intolerably risky, but we believe – as is often the case – that the perception is far from reality," says Nick Hamilton, head of global equity products at Invesco Perpetual. "As your holding time increases, your price volatility equalises with larger companies but your average return is higher. We have not had a small-cap bubble for a while but in the last 20 years where this has happened – in technology, media and telecoms (TMT), and financials – it has involved large-caps."

Invesco also cites a Brown University 2010, study (Optimal Portfolios for Different Holding Periods by Choi, BP & Mukherji), which finds that on average smaller companies had the highest returns between 1926 and 2007 compared with other asset classes, including government bonds, corporate bonds and large-cap stocks. Interestingly, the study concluded that, on average, the long-term expected volatility for smaller companies was exactly the same as it was for larger companies.

It is also easier for small-caps to grow strongly than large-caps, as the latter may have reached their peak. What is a smaller company now might be a large-cap in future, and they sometimes offer exposure to up-and-coming leading technology or the development of products and services. In developed markets, smaller companies can offer exposure to more entrepreneurial and dynamic ideas.

Smaller companies indices are less dominated by particular sectors or stocks. The FTSE All-World Index is heavily weighted to banks, oil & gas and pharmaceuticals, which account for 27.5 per cent of it. Over the past 10 years, technology and financial stocks have had a negative effect on wider company equity performance. But the three largest sectors of the FTSE Global Small Cap Index come to 16.2 per cent of the total, with real-estate investment trusts, technology and general retailers representing around 5 per cent each.

In emerging markets, smaller companies capture gross domestic product growth (GDP) more closely. Large-caps in emerging economies tend to be resource-focused or multinationals swayed by influences other than strong emerging market economic growth.

The managers of smaller companies tend to hold a significant amount of their companies' own shares and so have a stronger incentive to succeed, adds Invesco.

UK investors tend to have significant underexposure to global smaller companies, despite the fact that small caps represent 15 per cent of global stock markets. However, Adrian Lowcock, senior investment adviser at wealth adviser Bestinvest, says: "As a UK investor you should have a higher weighting to your domestic market. But if you have a large enough portfolio you could add areas to this, such as the US. It is best to start with global and UK funds – core smaller company exposure – and then add to this. Overall it is probably better to have more exposure to large-cap defensives at the moment because smaller companies have had a good run, but the key is to still have exposure to both."

It is also important not to be overexposed, as some more general funds may include an element of exposure to small-caps, for example recovery and special situations funds.

Domestic exposure?

Another reason some investment specialists say you shouldn't invest in small-caps at the moment is because they are more exposed to their domestic economies than large-caps, which can avoid economic trouble spots because they sell around the world.

"I disagree quite forcefully because our smaller companies exposure is very overweight to companies that get most of their earnings from overseas," says Mr Walls. "You should not assume that smaller companies are not exposed, for example, to emerging markets GDP."

Meanwhile, Robert Siddles, manager of the F&C US Smaller Companies investment trust, adds that only 25 per cent of his portfolio has solely domestic earnings. Read the full interview here.

An important part of the globalisation process has been the emergence of the internet and the growth of online businesses. "Technology and communications improvements have dramatically reduced the costs and investment required to operate in multiple countries and regions," says Harry Nimmo, manager of the Standard Life UK Smaller Companies investment trust. "This has been augmented by an ongoing erosion of trade barriers as governments look to support their companies' efforts to grow overseas."

This is common in the industrial sector. Examples include Austrian turbine manufacturer Andritz and US pumps and compressor manufacturer Gardner Denver, which benefit from strong overseas demand. Online retailer Asos, meanwhile, makes 55 per cent of its sales outside the UK.

Rough ride

As with all higher-return investments, smaller companies also incur more risk. They are generally less able to weather downturns because they are not as financially strong. They may only rely on one product or service, in only one sector and, with fewer customers, may be more vulnerable if a significant one stops purchasing.

The share prices of smaller companies are more volatile, especially as their shares are less easy to buy and sell.

Another problem with smaller companies is their need for credit, according to Rob Burgeman, divisional director at Brewin Dolphin. He says: "Many rely on the availability of banking facilities and at the moment this is shrinking. Large-caps find it easier to get bank loans, tend to have more cash than smaller companies and can go to the bond market."

If you invest in this area you should have a long-term time horizon of at least five years, and ideally longer.

Global smaller companies funds

Source: Morningstar as at 31 October 2011

Global smaller companies investment trusts

Source: Morningstar as at 31 October 2011

Regional smaller companies investment trusts

Source: Morningstar as at 31 October 2011