Smaller companies are an important investment theme

06 March 2014   Category: News, Asia, Global   By Asia Asset Management

Investec Asset Management’s Philip Saunders and Max King, portfolio managers of its multi-asset strategy, describe their views on investment prospects for smaller companies around the world:

The ‘smaller companies effect’, whereby smaller companies outperform larger companies over the long term, is about the closest that equity investors get to a free ride. Studied by academics around the world, notably professors Fama and French in the US and Dimson and Marsh in the UK, it has been demonstrated empirically and theoretically.

At its simplest, the theory states that smaller companies are individually riskier and less liquid, not as well researched, more expensive and more time consuming to analyse for a given pool of capital than larger ones. Without a premium return, there would be no reason to invest. In addition, less efficient pricing, a larger universe and greater diversification increases the opportunity for adding value from stock picking. Moreover, it provides active managers of all-capitalisation portfolios with a short cut to the outperformance they require to justify higher fees than for passive funds. Overweight portfolio exposure in small and medium-sized companies can improve the odds of outperformance considerably.

2013 was an excellent year for small caps globally. The total return was 32.9%* in sterling (35.4%* in US dollars), 5.8%* higher than for global markets. Returns were negative in only five Asian and emerging market countries. Meanwhile, in 13 countries, small caps underperformed their respective broad market indices and 18 outperformed. The underperformers included Japan, where the absolute return was high at 54%* and the underperformance slightly below but, otherwise, small caps outperformed in the larger markets to the benefit of the global weighted average. The combination of a strong year in absolute as well as relative terms and relative outperformance of about 150%* in this millennium has, unsurprisingly, led to ‘vertigo’ among strategists. This looks unjustified, in our view.

In Asia and emerging markets, small caps outperformed strongly in the Chinese markets but generally underperformed weak broader markets elsewhere. Unless the state controlled or directed mega-caps that dominate these markets can collectively shake off their corporate torpor, the revival in Asian and emerging markets that is likely in 2014 should quickly favour the small and mid-caps.

In addition, smaller companies in Asia trade on a significant discount to larger companies and outperformance has not compensated for faster earnings growth. As in many emerging markets, the consumer sectors are far more heavily represented in the small and mid-caps than in the large caps, often dominated by resource companies and banks. Despite an excellent year for some markets and some funds, the tailwind of consistent growth should enable outperformance to continue.

Overall, 2014 promises to be another good year for small and mid-cap exposure with the outperformance of underlying indices supplemented by more abundant opportunities for adding value from stock-picking. This potentially promises another good year for active funds. As in 2013, the driver of performance is likely to be earnings growth rather than re-ratings. Overall, returns are likely to be significantly lower than in 2013, but this is likely to be the case for the broader market and there is no reason why outperformance should not continue in 2015 and 2016.

*Sources: Dimson & Marsh; Numis Smaller Companies Handbook 2014; Merrill Lynch; JP Morgan