Small and mid cap investments offer long-term rewards as companies flourish in a favourable environment - but the focus should be on high-quality firms with strong balance sheets.
Overall, the market backdrop is favourable for small and midcaps. Many larger companies have cash-rich balance sheets, which puts acquisition activity on the agenda. Several smaller companies have been subject to bids by larger businesses over the past year. The low interest rate environment is also fuelling this trend, as it enables corporate buyers to deploy their resources in a more accretive manner, while they have access to debt facilities at attractive rates.
With respect to valuation, it is encouraging that although profits have recovered, sales in most cases have not yet returned to their peaks. Companies have generally become more efficient; they have cost-cut substantially and the currency, as mentioned above, has been favourable, too. This means that further positive earnings momentum is likely.
Small and mid-cap investment decisions need to be taken over months and years, not days. Of course, unexpected negative outcomes occur and it is important for investors to know when to cut their losses and sell. That said, when small and mid cap companies have positive fundamentals, they can carry on their outperformance for a surprising length of time. Some companies can begin in the small cap index and climb all the way up to the FTSE 100.
On the whole, cashflow and cash generation are essential to the success of small and mid cap companies. Cash generation tends to result in a strong balance sheet, which helps provide a solid defence against a weaker investment environment, such as the one the market experienced in 2008. Small companies are able to invest this cash into their own business to generate further growth.
If this growth can be sustained year after year, it can generate attractive long-term capital returns for investors. This is not the typical growth pattern for large caps, which are typically much more reliant on mergers and acquisitions to fuel their growth. This is one of the ways in which smaller businesses are able to achieve superior rates of growth.
The key is to focus on companies with strong balance sheets, strong products, a consistently positive record, as well as strong management. These businesses tend to be able to grow sustainably and to stick to it. It is exciting to find those companies, invest in them, and watch them transform themselves into larger organisations.