Six reasons to back smaller companies as economies re-open
My American Express card is once again incentivising me to shop small and shop local. Available in-store only, I can get £5 back if I spend £15 or more up to five times until the end of June.
After more than a year of relying on the likes of the big companies like Amazon and Tesco for my goods and services, I’m more than happy to oblige.
And, as the economy re-opens, perhaps it’s not just my spending that should be focused on the UK’s smaller companies. Maybe my investments should too.
Small caps outperform large caps in a recovery
Looking back over the past 20 years, smaller companies around the world have - more often than not - quite considerably outperformed their larger peers after a recession and stock market correction. At worst they have kept pace.
Following the tech bubble at the start of the millennium, returns were 60-120 percentage points higher. After the global financial crisis, they were 40-50 percentage points higher and, since the lows of the pandemic, smaller companies around the world are currently 25-35 percentage points ahead*. Japanese smaller companies are the exception, having kept pace with their larger peers on two of these three occasions.
Why do small caps outperform?
There are several reasons why small caps tend to outperform in a recovery environment.
The first is that they also tend to sell-off the most as risk attitudes change in troubled markets – so they also have more ground to make up.
More positively, they are typically more sensitive to the economy, so should benefit from recovery tailwinds, better earnings and resumption in the broader economy, and have historically not been significantly impacted by interest rate rises. It’s only if inflation gets very high that cracks begin to show - wages tend to be a large part of smaller company costs, so if they rise significantly, margins come under pressure.
Another positive for smaller company investors in this environment is that merger and acquisitions tend to increase, and valuations are still attractive vs large caps. It is also an area that tends to be under-researched, so active managers have plenty of opportunity to add value.
Seven smaller company options
1. ASI Global Smaller Companies
This is a textbook fund from the Aberdeen Standard Investments equities team. Based around the screening tool 'Matrix', which co-manager Harry Nimmo helped create, it identifies smaller companies from all around the globe - including emerging markets - that the managers believe to have the best growth prospects.
2. Barings Europe Select
Barings Europe Select Trust invests in small and medium-sized companies and is run on what is known as a GARP (Growth at a Reasonable Price) basis. The four-strong management team has a detailed and thorough process, looking for four key company traits: strong growth prospects, good quality management, proof that the business is growing because of its own operations, and that it is valued below the market average.
3. Federated Hermes Emerging Market SMID Equity
This is a concentrated fund focusing on small and medium-sized companies across global emerging markets. The managers look for quality companies that are exhibiting compound growth and that earn more than their cost of capital over the long-term. Alongside this, they will want talented management, who act responsibly towards clients, stakeholders and minority shareholders.
4. Legg Mason IF Japan Equity
This out-and-out growth fund on the Chelsea Selection has a very experienced manager who has been investing in Japanese equities for more than 45 years. The fund will invest in companies of any size but ignores mega-caps and instead tends to be dominated by mid and small-cap stocks.
5. Liontrust UK Micro Cap
On the Chelsea Selection, this fund applies the team's proven ‘economic advantage’ investment process to micro-caps. Investing in Britain's smallest businesses, the alignment with management, focus on capital-light businesses which can scale quickly, and emphasis on company meetings are all very sensible. It follows in the footsteps of the successful Liontrust UK Smaller Companies and Liontrust Special Situations funds.
6. Matthews Pacific Tiger
This is the flagship fund of specialist Asian management group Matthews Asia. On the Chelsea Selection, it is a high conviction, low turnover portfolio with an emphasis on domestically or regionally oriented companies that stand to benefit from the long-term evolution and growth of the Asian consumer. Although the fund can invest across all market capitalisations, it does tend to favour mid- and small-cap companies.
7. T. Rowe Price US Smaller Companies Equity
This fund differs from the usual T. Rowe Price mould in that it is a more balanced core portfolio, with value names in addition to the usual growth focus. This approach has borne fruit, with considerable performance coming from stock selection. The manager will allow his winners to run if he still believes there is a return opportunity.
*Source: FE fundinfo, total returns in sterling, MSCI indices, 11 March 2003- 2 July 2007, 6 March 2009 to 4 March 2011 and 23 March 2020 to 19 May 2021.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and do not constitute financial advice.