Thursday, 5th August 2021 10:11 - by Andrew Craig

Smaller Companies (AKA “small caps”)…

One asset class that I have written about before and that has a long track record of producing average annual returns quite some way north of 10% is smaller companies. Long-time readers may recall me having written in the past about a London Business School study published by Professors Elroy Dimson and Paul Marsh that showed how UK smaller companies achieved no less than 15.3% average annual returns in the sixty years from 1955 to 2015 (when the study was published)!

Those are extraordinary returns. If you max your ISA each year and make an average return of 15.3% per annum – you will have over £1 million in just over 15 years. A couple could get there in less than 12 years! Amazing stuff really.

When you think about it – it is quite logical that smaller companies might perform better than big companies. Growth is one of the most important drivers of share prices. It should be intuitively obvious that it is a great deal easier for a company with, say £10m of sales to multiply their sales tenfold than it is for one with £10 billion of sales (although Apple and Amazon have been doing their best to disprove this in recent years!).

For what it is worth – this isn’t just the case in the UK. That London Business School study noted that:

“…during the period of 2000 to 2014, smaller companies outperformed larger ones in 85% of worldwide markets. Small is bountiful.”

1,000 True Fans and the joys of Secular Growth

One of my favourite ideas in investment (and, in life more generally) is to focus on YOUR economy rather than THE economy. I think people waste far too much time tying themselves up in knots worrying about what THE economy may or may not do. Ultimately, it needn’t have that much of an impact on your life if you run things the right way - big picture at least. Too few people think like this – much to their detriment if you ask me.

Business author, renowned futurologist and founder of Wired magazine, Kevin Kelly, captured the essence of this idea rather brilliantly in a 2008 article he called “1,000 True Fans”.

The basic idea is that any individual or (small) business can make a perfectly decent living with only “1,000 true fans”. That is - 1,000 customers who love what you do enough such that they will repeatedly buy something from you. As an individual - if you can get 1,000 customers to pay you, say, £100 a year each (net of the costs of delivering your product or service), this is obviously £100,000 a year of income. Or perhaps you can charge them a £20 a month subscription for something – that’s actually £240,000 a year – and so on.

Different businesses have different price points, margins and dynamics but the broad idea behind “1,000 fans” is that anyone should be able to reach enough of a market to make a living and this has never been easier than to do than it is today thanks to the power of the internet to access the "long tail". (It is worth reading the article in full given what an extraordinarily uplifting and empowering idea this is by the way).

This phenomenon is broadly relevant for smaller companies too – in that they only need a tiny percentage of the world’s population as customers to make decent revenues and profits. My point here is that there is something economists and professional investors call “secular growth”. Basically - if you are small enough – and have a great product, service and or brand and a strong enough following as a result, you can grow a great deal and be a great investment, essentially no matter what the economy is doing.

A small company that can achieve “secular growth” doesn’t need to care as much as a massive company does about what THE economy is doing – they only need care about THEIR economy. As with everything – this isn’t black and white and every company will be affected by the economy to some degree or other – but a small company with a really fantastic product may “only” grow 20-30% in a difficult year for the economy at large versus, say, 50% for the previous ten years of their existence and versus large companies who could well be going backwards at such times. Quality companies will also ensure they have a strong enough balance sheet to cope when economic tailwinds might turn into headwinds for reasons outside of their control. By putting by in the good years and being very careful how they use debt in particular – they should be able to fund the more difficult ones if they arise.

Goblins, Dragons, Cocktails, Fashion and Property

As a percentage of the entire population, there are really very few people in the world who like painting little lead models of orcs, dragons and goblins. Such things are generally reserved for gauche 10-year-old boys (I know, since I used to be one of them). This hasn’t stopped Games Workshop (LSE:GAW) from becoming a £2.2 billion value company – more than 25 times the value it was a decade ago by the way. There are enough gauche 10-year-olds in the world for Games Workshop to have been able to achieve many years of “secular growth”.

Similarly - lots of people in the world prefer beer and wine to gin and tonic – but that didn’t stop Fever-Tree (LSE:FEVR) finding enough people willing to buy a “trendy” tonic water to become a £1.7 billion value company (admittedly they used to be a lot bigger than that at peak – but lots of value has been created here, nevertheless). The same can be said about online fashion retailer – ASOS (LSE:ASC) (As Seen On Screen) – currently valued at £2.5bn. I met the management team in 2004 when they were valued at about £30m (from memory).

Or look at online property company Rightmove (LSE:RMV) or leading takeaway app business Just Eat (LSE:JET). They’re both valued at not far off £6 billion as I write. They were founded in 2000 and 2001 respectively. That is a great deal of growth in only twenty years.

I’ve been working with smaller companies for more than twenty years and have seen so many of these sorts of examples in that time. Of course, there are also plenty of companies that have failed spectacularly – but that hasn’t stopped smaller companies from creating strong double digit returns for patient investors – on average - as evidenced by the London Business School piece I provided above.

If you would like some more evidence, I would encourage you to spend a little time having a look at this ranking of UK smaller company unit trusts from the Citywire website. There are clearly winners and losers, but you can see that the average return from all 46 funds over the last ten years is 234.3% - with the very best ones doing more than 400% (check out folks like Merian, Liontrust, Jupiter, Marlborough and AXA Framlington, to name just a few from the table).

You might also have a look at the performance of the 17 UK smaller company investment trusts. The top seven of these have grown their Net Asset Value per share by more than 300% in the last ten years (both BlackRock small cap ITs have done this for example).

Volatility!

As I said above – those sorts of returns could make you an ISA millionaire in a few years. BUT (and it is a reasonably big BUT) - there is a problem with this type of investment – volatility! Although the performance track record of smaller companies over no less than sixty years is amazing (and almost entirely unknown by the vast majority of people other than a small minority of folks in the City), those returns didn’t come smoothly every year. Some years smaller companies powered ahead by 30% or even 40% or more. On several occasions between 1955 and the present day, however, they fell by more than 50%.

It is a very rare person indeed, psychologically, who can see their ISA or pension account 50% in the red, stick to their guns, ignore the noise and carry on investing regardless – confident that it will all be fine in the end. For most people, these sorts of falls will cause them to give up in fear, crystallise a big loss and then never invest in the space again. This is terrible for two reasons: First, it means that they have locked in that large loss and secondly, even worse, they will then not enjoy the amazing returns they would have got by sticking to their guns over many years because having suffered that huge loss, they will almost certainly avoid the stock market from that point onwards.

This is why you need a PLAN and you need to stick to it! Small caps are great – but you need to be very clear about how and when you use them. “100 minus your age” can obviously help with that in that you can work out a sensible allocation to them based on your age.

Active vs. Passive

By the way – in terms of the SPECIFICS of how someone might go about investing in small caps – there are broadly two ways to do it: First, to invest in an active fund of some kind (either a unit trust or investment trust like those in the links I’ve provided above). Alternatively, you might buy a passive smaller companies ETF (Exchange Traded Fund) - that is to say a fund that automatically tracks a small cap index of some kind.

There is a great deal of debate these days about the relative merits of passive versus active investing. (If you want a reminder of what passive vs. active means, please refer to page 177 of my book).

The fashionable opinion nowadays seems to be that active funds are invariably the work of the devil and an expensive con-trick and you should only ever use passive (tracker) funds unless you’re a clueless moron. My own view here (after more than twenty years working at the coal face with stock-market-listed smaller companies for what it is worth) is that this is a rather unhelpful and simplistic stance and particularly when it comes to investing in small caps.

A full discussion of active vs. passive is well beyond the scope of today (but certainly a topic for another one in the near future). All I will say is that there are a number of structural (that is to say, inherent) reasons why passive ETFs don’t work as well when it comes to smaller companies as they do for tracking massive companies like those in the FTSE 100 or S&P 500. For very small companies, passive ETFs can’t actually work at all.

This is primarily to do with something called "liquidity". It is very easy to buy and sell many millions of pounds worth of a large FTSE 100 or S&P 500 company whenever you like (within reason). Such companies are said to be “liquid”. The same cannot be said about small companies. Very small companies (often called “micro-caps”) – can be very hard indeed to transact in. It could take a skilled specialist smaller company trader several days to buy or sell a decent quantity of shares in a given small or micro-cap company and they will have to have a pretty clear idea of specific people to call in order to get the trade done. This means that it essentially impossible to include such companies in a passive ETF product which needs to be able to automate such deals. At the small end of the market, a computer just can’t do the job of a human being.

As a result - those small cap ETFs that do exist simply can’t capture the very smallest companies in a stock market – the ones where all that growth might come from perhaps.

I would also argue that the role played by qualitative factors - such as the quality of a management team or board of directors or an intuitive feel for whether or not a given product will be able to find a market – are far more important in small cap investment than for larger caps – which are more driven by quantitative factors (the financial numbers basically and, perhaps more importantly, what the rest of the market makes of those quantitative factors).

I’m all for using inexpensive passive tracker funds where appropriate - we use them in our fund after all - but you might consider an actively managed fund for small caps and particularly if you really want to swing for the fences and go for micro-caps for example.

Long-term readers will know that I can’t make specific investment recommendations as we are an FCA regulated company with our own fund. What I can say, however, is that you might simply have a trawl through the two links I provided, see which of those funds have the best long term track records and then do your own research.

So that is it for today - small caps can provide exceptional returns for the patient investor as long as you are mindful that they can also have pretty aggressive down years along the way.

If you are confident in your allocation thanks to using an idea like “100 minus your age” perhaps, then they could be a strong candidate for the “aggressive” portion of your investments.

This blog post was taken from Andrew Craig's site Plain English Finance. Andrew is the author of How to Own the World: A Plain English Guide to Thinking Globally and Investing Wisely.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.