Standard Life Investments

Published Article

Professional Adviser - How to Find Tomorrow’s Mid- and Large-Caps Today


In January, Professors' Dimson and Marsh of the London Business School, published their Annual Review of smaller companies' investing. The review, now updated to end-2013, showed once again the presence of a “smaller companies effect” whereby smaller companies outperform larger companies over time.

Over the full history of the index, going back to 1955, they show that the Numis Smaller Companies Index (NSCI), the benchmark for UK smaller companies investing, has beaten the annualised return on the All-Share, the benchmark for UK mid and larger companies, by 3.5% per year. Moreover, the volatility of annual returns on the smaller company indices is now only a little higher than the All-Share. In 2013, the NSCI gave a return of 31.7% (ex-investment companies: 36.9%), outperforming the All-Share by 10.9%.

A similar phenomenon is found globally. Using the MSCI small cap and large cap indices for countries around the world over the period 2000-2013, small caps have outperformed everywhere except Norway (-4.0%), Mexico (-2.3%) and Malaysia (-2.2%). Since 2000, small caps beat large caps in 90% of countries achieving an average annualised small cap premium of 5.2%.

Why do smaller companies outperform? The answer is because they deliver higher growth. By their nature, smaller companies are more flexible, have fewer layers of management and can quickly capitalise on a particular market trend or opportunity. They are often run by the original founder, the true creative driving force behind the business, rather than second or third generation management at larger companies – think Steve Jobs at Apple. Smaller companies are able to innovate, embrace change and leapfrog their larger, more traditional competitors. Sectors as diverse as airlines, financial services, betting and gaming, media, retailing and IT have all seen smaller, more nimble players take over and start to dominate. For example, ASOS in retailing, PaddyPower in sports betting, easyJet in airlines and Hargreaves Lansdown in financial services.

Similar trends have unfolded on a global basis. Japan, for example, has proved slower than some other countries to embrace shopping online. But this has started to change and there are several smaller companies that are carving out valuable niches in online retailing. One such example is website business, which operates Japan's leading price comparison site and also its leading restaurant review/reservation website. As smartphone usage has increased and network speeds have improved, more and more Japanese consumers have turned to Kakaku's websites to shop around and save money.

Of course, capacity to innovate is not limited solely to companies operating in the 'new economy'. In the US, catering equipment supplier Middleby Corporation sells products such as ovens and fryers to restaurant chains like McDonald's. Much of its growth has been driven by the company's strong culture of innovation, which has resulted in market-leading products like a waterless steamer and a spin-fresh fryer which seek to both improve food quality and to cut cooking costs. Middleby has grown fast and has built a dominant position in what remains a very fragmented industry. We therefore regard it as a perfect example of what our smaller companies team calls one of 'tomorrow's larger companies today'.

Why then, despite their consistently strong returns, do smaller companies continue to be underappreciated and overlooked by investors? In our view, there are several reasons:

  • Lack of analyst coverage. Brokers focus on larger companies as these trade in greater volumes and therefore generate higher commissions.
  • Increasing investor short-termism, combined with the rise of hedge funds and high frequency trading, has channelled investors into larger and more liquid stocks.
  • The rise of passive investing (via index trackers and ETFs) has proved a further deterrent to smaller company investing since these strategies are difficult to implement in the small cap world.
  • Perception of higher risk.

Most investors perceive smaller companies to be much higher risk but, in fact, the data does not bear this out. Smaller companies are actually only slightly more volatile than larger companies and risk-adjusted returns, which are what long-term investors should focus on, are far superior. In addition, it is a surprising fact that smaller companies actually exhibit better corporate governance scores than larger companies. Recent years have proven that company size is no guarantee of company stability. Since the start of the millennium, some of the largest and seemingly most stable companies have either imploded or declined precipitously in value, e.g the large banks during the 2007/2008 global financial crisis or Enron in 2001. Moreover, smaller companies are often established, global businesses with good track records of profitability and strong balance sheets. As defined by MSCI, market caps can be as high as $8bn. Consequently, the risk differential between the largest and smaller companies may not be as great as might be assumed.

Alan Rowsell, Fund Manager, Global Smaller Companies Fund, Standard Life Investments.