It’s time to face facts, not fears

After two tremendous years for smaller companies, investors are scuttling back to the relative safety of the FTSE 100. But there are two big reasons why small-caps should continue to do well.

Despite continued weakness in the British consumer sector, employment remains high, inflation appears to be under control and interest rates may have peaked. Against such a background, smaller companies continue to hold up well and these favourable conditions look set to continue.

Following the dotcom crash in 2000, the environment became tough for smaller companies, leading many analysts to desert the sector. This created a highly inefficient market with many oversold stocks, despite the fact that a good proportion of companies had emerged from the downturn in a leaner, stronger position.

However, over the past two years, smaller companies have enjoyed a tremendous run, starting from a relatively low base and propelled by attractive valuations, growth prospects and investor optimism. But over the last quarter or so, investors have retreated into so-called safe havens among FTSE 100 stocks amid a deluge of fears over interest rates, inflation, and a general lack of direction from the market. This was in spite of the supportive earnings season for many smaller companies that characterised the beginning of the year.

But there are two fundamental reasons why smaller companies should continue to outpace their larger brethren for some time yet. First, and most important, is their growth potential, and it is important to analyse valuations with respect to this. Smaller companies tend to exploit niche markets that are so often not suitable for larger companies to enter, let alone operate in. This specialisation produces significantly high barriers to entry, which in turn gives small companies pricing power and can nurture bid potential. Undoubtedly, in this low inflationary environment, pricing power is crucial.

Furthermore, the trend towards globalisation and the use of the internet has increased price transparency and competition. More than ever, companies need to differentiate themselves, and it is this ability to carve out and exploit niche opportunities that puts smaller companies in a stronger position relative to their larger counterparts. Generally speaking, smaller companies have suffered more from rapid and dramatic interest rate rises, and this has, in my opinion, become an unfair charge levelled against their relative stability. The key terms here are rapid and dramatic. With core inflation currently below target, oil prices still stubbornly high, and the Bank of England’s Monetary Policy Committee taking care not provoke panic in the housing market, interest rates appear to be close to or at their peak.

Another blanket assumption is that smaller companies are necessarily of a higher risk profile than larger companies. It is fair to say that the Alternative Investment Market demonstrates less stringent disclosure requirements than mature indices. However, this should not suggest that larger companies are more transparent. Such companies are often too large to understand sufficiently in detail. Indeed, some high-profile large-caps have been caught out with subsidiaries and offshore operations that were widely unknown. Smaller companies are easier to understand, and investors have much better access to management.

Smaller companies are, by definition, less liquid than their larger counterparts, meaning they are harder to buy and sell in volume and can exhibit a certain degree of volatility. But a small-cap manager will automatically factor this into the nature and timing of the investment.

So where are we now? During June, British equity markets recovered somewhat, despite some profit-taking on the back of higher oil prices and the potential impact on global growth. Smaller companies have held up well over the month, with substantially less volatility than their larger brethren. Despite the FTSE 100 index reaching a three-year high during the period, economic data has been mixed. Consumer spending has continued to weaken, GDP growth has been revised down and manufacturing output expectations have declined. The service economy, however, remains robust, and government expenditure continues to support employment. Against this backdrop, it is unlikely that interest rates will rise; indeed, the market is anticipating a cut in the near future, with some commentators citing August as the likeliest opportunity. A more benign interest rate environment should therefore offset some of the concerns about the economic outlook, lending support to smaller companies.