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Smaller returns

John Baron reminds readers why smaller companies remain favoured by the portfolios
Smaller returns

With markets hitting new highs despite a host of issues concerning investors, the consensus trade has been to gravitate towards the perceived safety of big companies when investing in equities. However, in looking to the long term, smaller companies should continue to benefit not only from their natural advantages, but also from more secular changes not yet fully appreciated by the market - changes that will enhance the already healthy rewards in prospect for appropriately positioned portfolios.


Natural advantages

The long-term performance figures continue to remind us of the merits of smaller companies. Recent statistics confirm that money invested on a total return basis in the bottom 10 per cent of the UK market in 1955 would be worth more than five times as much as the returns available from UK shares generally. Portfolios have had to endure volatility to access these gains - the FTSE Small Cap index dropping 43.9 per cent in 2008, only to bounce 54.3 per cent the following year - and this volatility has at times discouraged investors.

However, smaller companies continue to boast a host of natural advantages that investors often forget. Being ignored by the large institutional fund managers because of liquidity, and hardly touched by index funds, the sector is under-researched - providing a rich hunting ground for active fund managers. In these uncertain times, many investors are failing to recognise the increasing breadth of choice in smaller companies, and that fund managers factor in these uncertainties when selecting.

Many smaller companies possess quality management and strong balance sheets, operate in niche and growing markets, are more nimble and offer faster growth, in part because they are better harnessing technology - a resource that has become more affordable. Indeed, an increasing number is able to grow regardless of the economy. At a time when the move into large-caps has become the consensus trade, and may therefore have run its course, there are many hidden gems in the small-cap sector waiting to be discovered.

Smaller companies are also becoming more important to those seeking income. Many FTSE 100 companies in recent years have instigated dividend cuts, while their dividend cover has deteriorated and certain company pension liabilities are causing concern. By contrast, many smaller companies offer sound balance sheets, good yields and growing dividends that are better covered. Such exposure benefits our portfolios, and also assists my website's Dividend and Winter portfolios achieve yields of 5.0 per cent and 6.0 per cent, respectively.

Valuations suggest smaller companies should do well in relative terms. The Numis Smaller Companies index (NSCI), comprising the smallest 10 per cent of the main equity market by size, underperformed the broader market in 2016 in part because the fall in the pound favoured FTSE 100 companies with their larger overseas exposure. In anticipation of higher earnings, the FTSE All-Share was re-rated and the NSCI de-rated to the point that the latter's discount has hardly been higher in recent decades. This bodes well for the NSCI in coming years.




Secular changes

But there are other, more secular changes that bode well for the smaller company sector - for it is important to address the relative, as well as the absolute, when assessing merits. Because of globalisation, the internet and the harnessing of technology, smaller companies are better able to search for growth opportunities abroad. Recent research suggests that over 40 per cent of sales of the NSCI now occur overseas. As this figure increases, so will investor interest.

Meanwhile, technology has also helped smaller companies both to reduce costs and embrace disruptive practices, and so level the playing field somewhat with their larger brethren. The extent of this has not been fully acknowledged by the markets. In this world of pedestrian growth and high debt, those portfolios taking refuge in larger companies need to recognise that many of these companies are going to struggle by past standards as increased competition erodes margins.

As suggested in previous columns, a few genuine growth stories, predominantly in the technology and biotechnology sectors, and those with wide moats, will thrive and command lofty ratings because of their liquidity and scarcity value. However, many will be slow to respond to this changing environment. And some will wither on the vine at a rate faster than first imagined, as organic growth becomes increasingly elusive - note the increase in recent years in M&A activity and share buybacks relative to longer-term investment.

By contrast, smaller companies tend to be lean, nimble and adaptable when meeting the challenges of the market place. This is where the productivity gains of the future will be anchored. It is where innovation and enterprise will thrive. The market will gradually recognise their growing resilience and enterprise value relative to the economy and their larger brethren. Lower volatility may also help to improve sentiment. This process will not be smooth, but it will be inexorable.



But there is a further reason why smaller companies may be set to do well in relative terms. In this high debt world, governments will increase efforts to seek revenue from where it is due. Despite the UK's recent progress relative to others, still not enough is being done to clamp down on aggressive tax avoidance - and some large multinational companies are key culprits, particularly when 'profits' are transferred to lower tax regimes. Pressure is growing to put right this wrong.

Last year there were reports that nearly 150 large US companies had to alert their investors that a worldwide tax avoidance crackdown would impact their profits. The UK government has recently introduced a 25 per cent diverted profits tax on various practices that allowed companies to avoid paying corporation tax owed here. Add in various international initiatives, such as the OECD's plan to stop what is commonly referred to as the 'double Irish' method of tax avoidance, and the direction of travel is clear.



We are seeing a shift toward greater accountability and transparency when it comes to corporate tax arrangements. But this goes further. When government revenue still trails expenditure, large companies in particular are vulnerable. Rises in the minimum wage are helping to end the era of cheap labour from which they have disproportionately benefited, while reducing the government's benefits bill. The ending of various tax breaks is also bringing in extra billions of pounds, and more measures are set to follow.

Times are changing for the large multinationals - smaller returns may be in prospect. Many of these perceived 'paragons of safety' could become more like 'sitting ducks' over time, both because of market developments and greater government scrutiny - something to reflect on for those portfolios still underweight smaller companies.

Otherwise, there were no changes to either portfolio during May.