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Part 1: Buy smaller companies – the history and the opportunity today

Posted by: Brian Dennehy
Membership level: Free
 
There is a perpetual debate about whether you can outperform the indices, and we always highlight the four well-researched ways in which you can do so. Here we look at one of those, investing into smaller companies, particularly UK smaller companies in the wake of the UK election result. 
 
In this first of two articles, I look at how this has worked out to date, and why there is an opportunity today in particular.
 
The reason why small companies should outperform the rest of the stock market is obvious. A small company can grow much faster than a larger company….
 
Elephants can’t gallop.
 
They also tend to be more volatile than the rest of the stock market, particularly in a severe recession, and are less liquid e.g. you cannot invest with very large sums, and selling might not always be easy. The former should not be a problem for typical retail investors, and the latter is mostly dealt with by buying a well spread fund, rather than punting into individual stocks.
 
Because they are not as easily invested into by large institutions, it also means they are less well researched, which makes it easier to uncover some gems – because everyone else isn’t digging in the same place.
 
The small cap performance edge
 
In chart 1 below you can see how the mainstream UK stock market (the FTSE 100 index) has performed vs the smaller companies index, 133% vs 203%, about 2.8% extra growth per annum.
 
Out of interest we choose to show the action from December 1999 as this was a terrible time to start investing, as it was followed by a 3-year bear market and the stock market fell by 50%. So, if a strategy works from that date, it is reasonably robust.
 
 
The small cap performance chasm
 
The latter was just comparing index to index.
 
If you can select the best of the UK smaller company funds (there are currently 44, and the size and quality vary considerably) that performance edge becomes a chasm.
 
This is easy to highlight with the benefit of hindsight, of course. The power comes in being able to identify a fund with outstanding potential at the time you invest.
 
Our process (built into our Dynamic Fund Ratings) transforms the extra performance of smaller companies, as you can see in chart 2 below. 
 
For example, the funds selected by applying our Dynamic Fund Ratings grew by 1,273% over those 19 years, 9.6 times more than the main stock market. An extra 14.2% per annum of growth!
 
In part 2, we review the individual fund selections now, both for unit trusts and investment trusts.
 
 
Is now a good time to be buying UK smaller companies?
 
Smaller companies can have years when they underperform larger companies – do be aware of that.
 
Nonetheless, the recent UK election result triggered some improved confidence in the outlook for the domestic economy. The commitment to increased government spending is obviously very helpful, and we should expect this spending to be broadly based (reflecting new Tory voters, and their expectations), again helping confidence, which is vital for a robust domestic economy.
 
Overseas investors are probably under-invested in the UK since 2016, so they will also have increased confidence in the UK as a destination for their money.
 
Also, look out for “Thatcherite” initiatives on a 12-month view – providing benefits for the largest number of people, not just the few. That might well be (must be?) a mantra over this electoral cycle, or Boris will not go down in history, he will just go down.
 
And valuations are undemanding amongst small caps; there are pockets which are cheap – a little buying will drive prices higher due to less liquidity in this area of the market.
 
In part 2, we consider the selection process and funds selections for both investment trusts and unit trusts.
 
FURTHER READING
Topic: Sector analysis


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