01/11/06

The imperatives for owning smaller companies

Small cap stocks have enjoyed an outstanding run of performance in recent years. However, valuations of smaller quoted companies have moved up to levels not seen since the 1980s. This has provided ammunition for those in the bearish camp, who believe small cap stocks are overvalued. But the composition of smaller company markets has changed substantially and as such, I believe they continue to offer investors an important source of additional returns. They also provide an opportunity to invest in tomorrow's larger companies, today.

For the avoidance of confusion "Smaller Quoted Companies" are defined by professional investors as all those companies constituting the bottom 10% of the market. Given the level of concentration at the "blue chip" end of the market, this is all companies below about £1 billion in size - that is the thousand or so Full and AIM listed stocks below number 200 in size. These are substantial businesses, often with significant track records and many which I would consider to be relatively low risk. A good example close to home is Robert Wiseman Dairies.

The reason to invest in smaller quoted companies can be put into four broad categories. Firstly, they grow quicker. Jim Slater, the veteran share pundit coined the phrase "elephants don't gallop". As an investment analogy I would certainly go along with that statement. Secondly, they provide better returns. Professors Dimson & Marsh of the London Business School have shown that smaller companies have provided an annualised return of 3.6% above the blue chip dominated FTSE All-share index over the last 51 years. Thirdly, they are under researched. Overlooked companies abound, unlike the top end of the market where there is a veritable cottage industry of analysts and company watchers leaving no stones unturned. Finally, smaller companies afford the opportunity to invest in what I would call "interesting niches". Investors gain direct exposure to growth industries unavailable to the very largest companies.

A few examples of smaller companies within interesting growth niches would include Hamilton based Goals Soccer Centres, the leading owners of small sided soccer centres with third generation pitches. Another is the UK franchise of Dominos Pizza, which has easily the strongest home delivery pizza format with a growth outlook that is supported by the increasing proportion of individuals and families that enjoy the convenience of take-away food. Other fascinating growth niches would include self-storage (Big Yellow), online business information (Datamonitor), council house refurbishment (Connaught plc), engineering design software (Aveva), online clothing retailing (ASOS) and many others. These are the larger companies of tomorrow. Many of them have incipient or actual world market positions.

The flip side is that blue chip companies don't remain "blue chip" forever. The business environment is a dynamic place. Lists of "most admired companies" inevitably go out of date as the world moves on and the largest companies fail to adapt to changing market conditions. Good examples of former "most admired companies" might include IBM, McDonald's and AOL. Indeed, if one looks at the top ten companies by value ten years ago it is a different list to today. BT was the biggest closely followed a few places below by Hanson Trust, BTR, British Gas and Marks & Spencer. Marconi and Cable & Wireless made cameo appearances in the top ten at the height of the dotcom boom.

Smaller companies may have great prospects but what about the valuations? Many investors remember that smaller companies delivered poor returns for much of the 1990s. They are concerned about the sensitivity of smaller companies as a group to the economic cycle. Indeed they say that the very strength of smaller companies must mean that under-performance is round the corner. I'm strongly of the view that this is flawed thinking. The structure of smaller companies markets as measured by sector exposure is very different to the picture in the early 1990s. In those days nearly one third of smaller companies were exposed to UK based manufacturing companies largely in textiles, engineering, chemicals and packaging. These companies were facing the full onslaught of overseas competition from countries with cost bases that the UK could not match. Genuine growth sectors constituted a comparatively small part of the whole market picture. Today the picture is much healthier. UK based manufacturing is a minor part of our market while the growth sectors, which would include IT, support services, healthcare, leisure and speciality financials among others, constitute the bulk of the smaller companies market. What's more, stock markets are currently open to new issues which are the funding life blood of developing businesses.

In short, current valuations are supported by prospective rates of growth expected for smaller companies. The forecast earnings per share growth rate for smaller companies over the next year is 15.5% compared with 7.1% for the FTSE100 index according Ian Williams, the respected strategist at Oriel Securities. This is more than enough to justify current valuations. It's not over for smaller companies, there are good reasons to own them, and indeed it's more a case that normal service has resumed.

Harry Nimmo, Fund Manager – Standard Life Investments UK Smaller Companies Fund

First published in Scotland on Sunday on 5 November 2006.

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