Received wisdom says small and mid-sized companies are illiquid, risky and potentially lucrative in certain cycles – but most of that is dead wrong.
There are many arguments in favour of permanently investing in these shares, rather than solely after large caps have had a strong run, which are incorrectly considered to be of secondary importance.
It is often thought that small caps are only worthwhile in very specific market phases, for example when large caps have already gained a lot and are therefore too expensive.
In reality, even over the long term, the performance of small and mid caps is very much higher. That is confirmed by a long-term study conducted by UBS.
Over 15 years, European small caps have earned a return of more than 150 per cent and mid caps 68 per cent while the prices of large caps rose by only 19 per cent.
This is not the result of just a few rare good years.
On the contrary, small caps have beaten large caps well over half the time during different periods and between 80 and 100 per cent of the time over periods of five and 10 years.
Another myth that needs to be shattered is that secondary stocks are more sensitive to sudden changes in economic activity which would cause their share prices to behave like an out-of-control roller coaster with sudden movements exacerbated by lower liquidity.
In reality, thanks to the low correlation of shares with one another, the overall volatility of SMEs is not really higher than that of large caps.
Finally, a last sweeping judgement sometimes levelled against small and mid caps is that they are said to be mainly domestic and therefore not an effective means of investing in emerging markets.
In fact, it is more the opposite: Small and mid caps form an extremely varied and diversified spectrum, with many companies geared to rapidly developing countries. For example, 88 per cent of British electronic chip manufacturer CSR’s turnover is derived from such countries.
The real reasons for investing
The main explanation for such an outperformance is not, as is widely believed, the fact that these shares are not well known and therefore cheap.
This factor does play a role of course, but above all the real reason is quite simply their stronger growth.
This is because small and medium-sized companies simply expand more quickly than large groups, which necessarily translates into superior performance in the long term.
The size effect naturally plays a role, but above all SMEs have a dynamism that the major groups have sometimes lost, burdened down as they are by their structure.
In addition, the 16,000 small and mid-cap shares found in Europe simply offer a greater diversity of situations and businesses, are more representative of the economy in general and therefore afford more investment opportunities.
One last – but essential – factor lies in the fact that it is easier to find “pure plays” among small caps that allow to bet on a specific concept.
If one wants to bet on the theme of wind energy or clothing retail it will be difficult to do so via large conglomerates as the impact is diluted. For example, wind energy accounts for only 7.5 per cent of Siemens’ revenues even though the group is one of the largest global players in this sector. It would be better to choose the Danish company Vestas, which derives all of its sales from this activity.
How to invest?
Many investors are reluctant to move into small caps, and do so just to make a quick gain while promising themselves they will get out as soon as possible.
But market timing is a difficult – and above all pointless – game to play. This is because the return, risk and correlation characteristics of small caps are such that it is better instead to permanently devote part of a portfolio to European equities.
Due to the low correlation that usually exists between large and small companies, the addition of a pocket of small caps to a portfolio will not only increase its total return, but will also push down its overall volatility.
William Sharp is manager of the £80.3m Oyster European Mid & Small Cap Fund