Markets are generally jittery and the sceptics are roaming the plains. My column last month (‘The UK market: darkest before the dawn?’, 7 September 2018) highlighted the extent to which this nervousness had affected the UK market, in part because of misplaced concerns about a possible ‘no deal’ Brexit. Good outperformance dawns relative to overseas markets. And within those overall returns, smaller companies will feature strongly as they have been unduly affected by this negative sentiment.
With markets climbing the wall of worry, the consensus trade has been to gravitate towards the perceived safety of big companies. Yet smaller companies should continue to benefit not only from their usual advantages, but also from a more profound seismic change as technology helps them better challenge their larger brethren across swathes of industries – a development not yet fully appreciated by markets. Once again, long-term investors will be well rewarded for defying the consensus.
Elephants don’t gallop!
The long-term case for outperformance is well established. As long as 30 years ago, the London Business School calculated that UK small companies (the bottom 10 per cent of the FTSE All-Share index, now the Numis Smaller Companies index) had outperformed the FTSE All-Share by 3.4 per cent a year since 1955. This has broadly continued to date – and across most other markets, with the overseas outperformance being somewhat higher at over 5 per cent a year. In 2017, the Numis index produced a return of 18.8 per cent compared with 13.1 per cent for the wider market.
There are a number of reasons for this. Putting aside for a moment the unusual phenomenon that is today’s large technology companies, the function of size usually prevails – it is easier to grow when smaller. As Jim Slater once said, elephants don’t gallop. Smaller companies also tend to be ignored by the large institutional fund managers because of liquidity – a factor which contributes to them being shunned by index funds. The sector is therefore under-researched and provides a host of opportunities for fund managers.
Indeed, it is now generally accepted that a smaller company bias is one of the more reliable investment strategies in generating higher returns relative to the wider market. At present, the valuation of the Numis index is at a modest premium to its long-term average. However, over the past four decades, this premium was only ever lower relative to the wider market during the late-1990s. Smaller companies look well placed to outperform larger companies, particularly given the current economic environment.
Many smaller companies operate in niche and growing markets, are more nimble and offer faster growth in part because they are particularly benefiting from technology – a resource which has become more affordable. Indeed, an increasing number are able to grow regardless of the domestic economy, in part because of their increasing global reach. They are also becoming more important to those investors seeking income, given the number of large high-profile companies have had to cut their dividends in recent years.
This helps to explain why all eight ‘real’ investment trust portfolios run in real time on my company’s website (www.johnbaronportfolios.co.uk), including the two covered by this monthly column, are overweight the sector. And why, we are looking to add to their positions – while always maintaining portfolio balance relative to remit. The proviso for readers is that these portfolios invest for the long-term, and therefore accept the volatility that accompanies the sector’s outperformance.
Seismic changes
But there is another, perhaps more profound, reason why the portfolios are overweight smaller companies. As highlighted in previous columns, the technology that is disproportionately helping these smaller companies to reduce costs and grow markets is also helping them to embrace disruptive practices and therefore better compete with their larger brethren. Technology will continue to favour the small. The entrepreneurs are at the gates. And markets will be surprised by their audacity and success.
In this world of pedestrian growth and high debt, those investors 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. A few genuine growth stories, predominantly in the technology and biotechnology sectors, and those with ‘wide moats’, will continue to command lofty ratings.
However, many will be slow to respond to this changing environment. Some will wither at a rate faster than first imagined, as organic growth becomes ever more elusive – note the increase in recent years in merger and acquisition (M&A) activity and share buy-backs, relative to investment. The assumption that ‘big’ is ‘strong’ will come to be increasingly tested across large swathes of the stock market.
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 both the economy and their larger brethren. This process will not be smooth but it will be inexorable.
Then there is the effect of government priorities and policies – direct and indirect, intended and unintended. With debt high and rising, governments generally are looking to raise revenue. Still more needs to be done to clamp down on aggressive tax avoidance – some large multinational companies are key culprits. Corporate tax arrangements are now in the spotlight.
Meanwhile, rises in the minimum wage are disproportionately affecting larger companies, while reducing the government’s benefits bill. And, as Lord Rose testified to the Treasury Select Committee just before the EU referendum, Brexit could result in wages rising faster as a fair and controlled immigration system is introduced.
Times are ‘a changing’ for the large multinationals. We are witness to a pivotal moment in the investment cycle. Key shifts in the broad sweep of history are of particular importance to the long-term investor. The future is indeed small – and portfolios need to be positioned accordingly.
Portfolio changes
The only change during September saw the Autumn portfolio add to its existing position in Montanaro UK Smaller Companies (MTU) at a price of £1.21, for the reasons highlighted in last month’s column when explaining why MTU had been introduced to both portfolios at a price of £1.17. The search for good quality smaller company investment trusts at attractive prices goes on.
