Small wonder

Small and medium-sized companies flourish in a downturn because they are agile and have room to grow, unlike larger firms. They also act as a bell-wether for economic health and offer potential for good returns, writes Rodrigo Amaral.

The skill and dynamism of Lionel Messi, the Argentine footballer who plays for FC Barcelona, shows that being small need not be an obstacle. The same could also be true in financial markets. Even though small and medium-sized companies rank among the main victims of the long running banking credit crunch, their stocks have outperformed their larger peers during the market rally that has taken place since the start of the year. The question is whether they, just like the football genius, can keep performing at the highest level in the long run.

Politicians and economists in America, Britain and Europe are hoping so. Small and medium-sized enterprises (SMEs) are widely seen as a main source of job creation at times of high unemployment. It is also argued that they are particularly apt at fostering innovation. In a fast moving economy, SMEs should therefore be more capable of coming up with quick solutions for new problems than large, slow moving corporations.

The success of companies such as Facebook, Google and other formerly tiny organisations give credence to the argument that SMEs have the keys to economic success today. That is why the plight of small and medium-sized firms has ranked high on the political agenda in developed countries.

Britain has not been an exception. Banks have been reviled in the media for withdrawing funding from all but their largest corporate clients. During the Liberal Democrat conference, Vince Cable, the business secretary, stressed that SMEs are “the lifeblood of the economy and crucial for recovery”. For his part, chancellor George Osborne has announced the creation of a credit-easing scheme to provide up to £20 billion of discounted loans to smaller companies. The coalition has also implemented a plan to award a growing volume of government business to SMEs. Francis Maude, the Cabinet minister, expects that, in the current financial year, smaller firms will make £6 billion from government commissions, doubling the values registered in 2010/2011. (Cover story continues below)

Similar projects have arisen elsewhere in the developed world. In France, the government of president Nicolas Sarkozy, which has a tough election looming, is making much of a programme to make €5 billion (£4.2 billion) of public and private money available for SMEs. The leaders of countries, such as Italy and Spain, are desperately looking for ways to make money flow again from banks to cash-strapped small firms that account for large chunks of economic production. In America, the House of Representatives has just approved a plan to boost SMEs and help them to go public. The bill is named Jumpstart Our Business Startups – or the voter-friendly acronym, JOBS.

Public opinion in several countries is that SMEs have been starved of cash and as a result need some help from the state to keep going. But investors appear to have a less gloomy take on the matter. In the rally that started in January, indices that reflect the performance of small and mid capitalisation firms have done better than the benchmark in America, Britain and France.

”Companies that under­performed last year have gone through a relief rally, thanks to the actions that the European Central Bank has taken to try and solve the liquidity problem”

The main index at London’s Alternative Investment Market (Aim) was up 17% in the year to early March, compared with 6.6% for the FTSE 100. In Paris, small and mid-caps beat the CAC 40 by 15.8% to 10.4%. Across the Atlantic, the S&P 500 rose 9%, while the Russell 2000 index for small caps increased by 10.5%. Even in Frankfurt, where the DAX was going strongly at 16.6% by the first 10 days of March, mid-caps still managed to leave it behind with a positive gain of 18.16%.

As much as the equity markets rally, the performance of small and mid-caps has abated in the past few weeks. But many stocks have gained ground already in 2012, recovering from 2011.

“Small and mid-cap stocks have seen a strong rally so far this year,” says John Leahy, the manager of the Hermes UK Smaller Companies fund.

“Companies that underperformed last year have gone through a relief rally. Not because they, in particular, are seeing a better trading environment, but rather thanks to the actions that the European Central Bank has taken to try and solve the liquidity problem in the European banking sector. Signs that the general economic activity in the US has been recovering are also helping to improve risk appetite.”

Giles Hargreave, the manager of the Marlborough Special Situations fund, agrees. “It has been a good start to the year for small caps,” he says, adding the easing of the problems at the eurozone have much to do with the good stretch. “There is much more confidence in the market today, and shares continue to be quite cheap after a flat 2011. It was about time that small caps had a good run.”

In 2011, the FTSE Smaller Capitalisation index dropped 15.4% of its value and the Aim All Share Index left 26.3%, compared with the FTSE 100’s 7.3% fall.

The fact that stocks of smaller companies outperform the market during the early stages of a recovery does not come as a surprise to investors who are used to playing in the lower ranges of the equity markets.

In fact, the performance of small and mid-caps are often seen as a barometer of market sentiment, as they tend to reflect how good investors are feeling about the outlook for the economy.

It is not unusual, therefore, that small and mid-caps leave large companies behind when things start looking better. Conversely, during periods of deterioration of investor sentiment, their market values tend to suffer more than those of bigger peers. Last year was a case in point, as gloomy markets drove small and mid-cap indexes further down than the benchmark in Britain, France and America.

”Their dividend yields may be slightly lower, but the key here is whether the underlying dividend is growing, and small and mid-caps stocks offer better growth opportunities than large caps”

A strong reason behind such behaviour is that investors look at SMEs when they seek companies that can deliver growth. Often, smaller-sized companies have more scope to grow their businesses than large rivals with a consolidated presence in the market. The fact that such firms have decided to raise money in the market is a sign that they bear ambitions to expand their operations. But they could also find themselves more exposed to unfavourable market conditions than large companies with plenty of reserves.

As a result, possibly more than other kinds of stocks, the best strategy for investments in small and mid-caps might be holding them for a while, thus giving the companies enough time to develop their businesses. A patient approach could bring rewards. A research note released by Pyramis Global Advisors late in 2011 argues that small caps generally outperform large caps when markets are recovering from a slump. But they also do better in the long run, if investors have enough nerve to stick to their holdings when they fall behind the average.

According to the authors, between 1995 and 2010, small caps beat larger ones by an average of 1.7% a year, thanks to periods like 2003 and 2009, when the difference was as high as 16.8% and 16.5% respectively. But to collect the average 6.5% returns posted in the period, investors had to keep their cool during years such as 1997, when the value of small-cap stocks increased by 1%, compared with 19% among mid and large caps. In fact, the study has found that in times of euphoria, large caps have usually done better. But when markets are down, small caps fall more dramatically as panic ensues, which leads to bargains in the segment to be spotted by adroit investors.

“The data are consistent with our experience and intuition that large market sell-offs are often associated with significant risk aversion, which can potentially create opportunities in niche asset classes such as global small cap,” wrote Chris Steward and Rob Feldman, portfolio managers, who did the study based on MSCI large, small and mid-cap indexes. “We also note that the opportunity is not symmetric; during periods of strong market performance the small-cap index has historically shown a relatively modest underperformance of 102 basis points.”

”We see 15 to 20 companies a week, and it is rare that they tell us that they are finding it difficult to raise money”

If the conclusions of the research apply to the market, so the rally of the first two months of the year likely provided an ideal entry point for investors with an eye on the small and mid-cap segment. The question is whether their valuations remain attractive and to what extent companies will be able to deliver performance in the future. Leahy, for instance, has a positive view of the small and mid-cap market at the moment. “All equities look attractive compared with gilts, and small and mid-caps look attractive compared with large caps,” he says. “Their dividend yields may be slightly lower, but the key here is whether the underlying dividend is growing, and small and mid-caps stocks offer better growth opportunities than large caps.”

Hargreave says that valuations of small and mid-caps are not too cheap any more, and, although the situation varies from company to company, investors are not likely to find bargains in this segment of the market.

“You have to look around and try to find value,” he says. On the other hand, he had identified a swagger in the sector, as companies have expressed confidence in their prospects, despite the disappointing economic environment. “It is very common that companies tell us that economic circumstances are difficult, but they are performing well nonetheless,” he adds.

This perception was confirmed by a survey released by the Federation of Small Businesses (FSB) in early March. It revealed that, even though there is no enthusiasm among SMEs concerning the British economy, levels of confidence among them have increased for the first time in a year.

Hargreave warns that macroeconomic factors, especially in the form of a worsening of the eurozone debt crisis, could still derail the situation for smaller companies. But he says many companies have already adjusted to a new economic scenario as they faced the wave of crisis of the past four years. “After 2008, companies improved their balance sheets significantly. Most companies we talk to have little or no debt.”

”Small and mid-cap companies are more nimble when it comes to innovation”

A healthy balance sheet is a precondition for many investors to even consider buying stocks of SMEs. “We look at the reliance of companies on external funding to make sure that debt levels are not too onerous,” Leahy says. “If [they are reliant on] debt, it will constrain their ability to invest in innovation and fund their growth. Companies need to have cash on their balance sheets, or bank facilities, which are cheap and realisable.”

Hargreave notes that the financial improvement achieved by some listed SMEs has been such that they have been able to dodge the scarcity of banking credit that grips Britain. “We see 15 to 20 companies a week, and it is very rare that they tell us that they are finding it difficult to raise money,” he says.

The best alternative, however, seems to be avoiding a reliance on banks or other sources of external finance.

In a survey with small and mid cap companies released at the end of February, BDO, a consultancy firm, and the Quoted Companies Alliance (QCA), a lobby group, found that most companies interviewed have no plans to raise money in the near future. Another survey, by BDRC Continental, a market research firm, found that only 3% of the SMEs consulted at the end of 2011 had applied to renew their banking loans in the previous year, and 7% had sought new or renewed overdraft facilities. But that does not mean they have relinquished their plans to grow. Two of every three SMEs consulted by BDO and QCA said sales should rise in the next 12 months, and almost half expect they will have to recruit new staff to keep up with a higher workload.

For equity investors, it is important that SMEs remain committed to seek growth and can fund their investments without relying on banks, especially as the ability to come up with innovations is an important factor behind the decision of purchasing or not a small or mid-cap stock.

“Innovation is one of the main ways in which companies can achieve and sustain high returns,” Leahy says. “Small and mid-cap companies are more nimble when it comes to innovation. They are in a less mature stage in their life cycle than large companies and still have room for growth. We are looking for problem-solvers,” he adds.

Leahy argues that, contrary to what many people think, Britain harbours a significant army of SMEs that are highly innovative and stand out in their sectors, even compared with rivals based in other countries. But that does not necessarily mean the next Twitter or eBay will be found here. Innovation can emerge in sectors that sound less glamorous, but sometimes tap into contemporary needs.

As an example, Leahy mentions the Rushden-based RPC, a producer of plastic packages, which has taken advantage of a change in consumption patterns to become the largest company in Europe in this sector. The company is the “leading manufacturer of rigid plastic packaging and supplies products made by three conversion processes: blow moulding, injection moulding and thermoforming,” its website explains.

RPC provides alternatives for companies that want to replace packaging made of glass and tin with others that are lighter and, consequently, help them to reduce transport costs and carbon emissions. In other words, the firm’s business is driven by contemporary trends that have been consolidated by consumer pressure and regulatory requirements. Its list of clients includes Kraft, Nestlé, L’Oréal and Unilever. The Northamptonshire mid-sized company today employs 7,200 workers in 18 countries.

Leahy looks for companies that do not rely too much on the domestic market for its revenues. In the SME universe as much as among large caps, sectors such as British banking and retail have been seen as particularly unpromising. Benefiting from wider trends and economic developments is therefore a central ingredient for the choices of fund managers and other investors.

For instance, export­ers that have a significant share of their sales going to fast growing emerging markets find immediate fav­our with many investors. Those that take their revenues out of exports to America, where the economy is in a better shape than Europe’s, have also started to draw attention again. “In the UK, there are many world-leading companies that are not affected by the headwinds of the domestic economy,” Leahy says. “They can look much further afield.”

According to the FSB, about 23% of all British SMEs are exporters. They ranked among the most optimistic companies in the latest survey of business confidence released by the federation.

Hargreave notes that, in addition to retailers, other segments have struggled in the British SME market. Curiously, one of them is the oil and gas sector, as firms involved in projects in the North Sea have found it especially hard to raise money with banks, a necessity considering the costs involved. But he says that high oil prices and an improving economy should change the view of banks about the sector in the short run. Hargreave is sanguine about the economy, and consequently SMEs, as a whole.

”There is quite a good case for buying stocks that are more centred on the UK, like retailers, property companies and house builders”

“The UK economy has improved, and there is a good case for buying stocks that are more centred on the UK, like retailers, property companies and house builders,” he says. “Those companies have done well, and that is because there is more demand. It looks to me that the UK economy is doing rather better than the press wants us to believe.”

A concern is the risk that inflation will flourish in Britain in the wake of quantitative easing. An inflationary spike would trigger a rise of interest rates that could affect consumers and crush any recovery in the British economy, Hargreave argues.

However, there are reasons for optimism about SMEs, he says. “It is a good atmosphere for companies at the moment. Interest rates are low, and governments and banks are trying to stimulate activity. There is no inflation, and some growth is coming back. These conditions may not last, though.”

SMEs could also get a boost from all the state-sponsored initiatives to revive their activities and to help them recruit people and innovate.

The expectation that such plans will inject more energy into businesses has been highlighted as one of the reasons behind the strong show of small and mid-caps in early 2012.

But Leahy warns the best route for companies is to make sure they can move forward without depending on any external help, be it from banks or from government agencies. Investors should also think twice before making decisions based on such promises. He says, for instance, that his fund prioritises companies that look prepared to flourish, no matter what the market circumstances. “Hope is not a strategy,” Leahy concludes.