The rise of a neglected asset class

In the past, smaller companies were overlooked and undervalued, but is it time for investors to reconsider this less-favoured sector?

THEY MAY NOT have the allure of a Google or Coca-Cola, and while smaller companies may not be household names, they are beating the odds to provide decent returns. So is it time for investors to reconsider this less-favoured sector?

Patrick Lawless, managing director of Appian Asset Management certainly thinks so. His company has just launched its first smaller company fund, the Small Companies Opportunities Fund, and he is forecasting growth of 10 per cent a year.

“Our view is that smaller companies are overlooked, under-owned and now undervalued,” he says.

Fund manager Ken Nicholson, who runs Standard Life’s European Smaller Companies fund, agrees, noting that small caps are quite a “neglected asset class”.

The reason of course, is that investors perceive investing in smaller companies as a riskier proposition than sticking to household names and tend to stay away. But ignoring small caps might be to their detriment. In the UK, small caps have outperformed bigger companies almost persistently for nearly 60 years, according to research from the London Business School, while other studies suggest that over the long term, smaller companies have outperformed larger companies by the order of about 5 per cent a year.

In the UK, there is a whole movement emerging behind smaller-company investing, led by manager Gervais Williams. He is a proponent of the “slow finance” approach which, much like the “slow food” movement, advocates looking for investment opportunities – as opposed to strawberries – close to home. This means opting to put your money into small, local companies and he has even built an app to help you identify potential investments in your area, although it is limited to the UK.

And while the term “small” might put off some investors, it doesn’t mean that you’re betting your money on pre-revenue start-ups. Typically, small-cap companies span the spectrum from a market capitalisation of about €100 million all the way up to about €4 billion.

“We’re not really into investing in start-ups. We look for more established companies that have proven track records,” says Nicholson.

To mitigate the risks posed by investing in smaller companies, which because of their scale and their focus on a particular sector, can be a riskier prospect than a large, diversified global organisation whose business spans the globe, stock-picking is key. “You can find riskier smaller companies, but the secret of our success is to invest in sustainable ones that produce a strong return every year,” says Nicholson. And his fund’s results don’t lie. Over the past three years to September 30th, the European Smaller Companies Fund has returned more than 11 per cent a year on an annualised basis, surpassing 20 per cent over the past 12 months.

So how do they do it?

“We look for companies with strong balance sheets, low debt, strong cash flows and the ability to not only pay a dividend but also to grow it,” Nicholson says, adding that they favour family-run businesses, such as the French pen company, Société Bic, “as they’re the kind of companies that are in it for the long term”.

So, while you might not be investing in the next Google, sometimes it is the “boring” companies that can offer the most comfort. As Nicholson notes, the tag-line for Standard Life’s smaller company fund is “Proudly investing in boring companies since 2007”.

Given the pre-eminence of German companies in the mid-size tier, through the Mittelstand Germany accounts for about 30 per cent of Standard Life’s European fund, with notable successes through companies such as Fuchs Petrolab, a world leader in industrial lubricants. It has grown its earnings every year by 25 per cent since 1999.

Appian’s fund takes a more international approach, investing in companies across north America and Europe. One company that takes its fancy is Stanley Gibbons, which has benefited from a growing interest in stamp collecting in emerging economies such as China.

But Ireland’s small- and mid-cap companies also have a role to play. One of Standard Life’s better picks has been Paddy Power, which it first bought into back in 2004. It now owns 7 per cent of the company,

“It’s a classic case of a compounder and has solidly sailed through the crisis,” notes Nicholson, recalling that when the fund manager first bought the stock, people thought they were crazy because the company was “just an Irish bookmaker”. Now it’s having the last laugh given the stock price has soared from about €8 in 2004 up to almost €60.

So why have some smaller companies performed so strongly despite the global crisis?

In Europe, the EuroStoxx small index is up by 8 per cent in the year to October 8th, marginally ahead of the broader EuroStoxx 50 index, while across the Atlantic the SP 600 is up by about 14 per cent year to date, although this is lagging its larger company counterpart, the SP 500.

“We’re in a very low growth world at the moment because of all the debt, and the companies that are able to grow tend to be smaller companies,” says Nicholson.

For Lawless, the opportunity lies in the fact that while the share prices of smaller companies have been impacted by the macro environment, “smaller businesses tend to react much quicker than larger companies”. He also likes the fact that chief executives of smaller firms tend to run them like owner managers, and can act more quickly and more flexibly in times of challenges.

Another reason why smaller company funds have tended to beat their larger counterparts of late is because the troublesome banks would have been too large to meet the benchmark criteria.

While Appian’s fund will seek to identify potential takeover targets, for Nicholson, it’s all about the compounding effect of regular returns.

“The worst thing that can happen is if you lose one of your companies to a takeover. For us it’s a disaster – you get a 30 per cent premium on one day, or instant gratification, but what you lose is a company that’s capable of compounding those returns every year,” he says.

But how big of an allocation to smaller companies should you consider? Nicholson notes that wealth advisers tend to favour putting as little as 2-3 per cent in smaller companies. However, he is a lot more bullish and recommends investing up to 25 per cent. “That will allow investors to capture the growth potential,” he says.

Smaller-company investing should also be a long-term play. As Lawless notes of his new fund: “If you can’t put your money into it for a five- to seven-year horizon, then dont go into it.”