Elephants still don’t gallop

Although we still have a few weeks of the year to go, it appears smaller companies have once again outperformed their larger brethren – albeit at perhaps a more modest pace than last year. There exists an inherent long-term reasoning as to why this is the case but, shorter-term, there are also other reasons to be positive about the outlook – particularly as we enter the New Year. So while the debate about the nature of the economic recovery and investment styles remains relevant, the sector in general should continue to outperform.

The inherent logic

Although there have been periods of underperformance, an overweight position in smaller companies has proved to be one of the more reliable investment strategies in generating higher returns relative to the wider market.

The fundamental reason is that elephants don’t gallop. Smaller companies tend to be more ‘nimble’ in seeing opportunities and responding to market changes. There is less baggage and bureaucracy to handle. They tend to be more entrepreneurial. Indeed, by comparison, the lack of entrepreneurship in our larger companies, and adherence to a financial system too focused on the short-term, has plagued their performance. The column ‘Where are our pioneering giants?’ (IC, 8 February 2019) highlights this theme in more detail.

If anything, the advance of technology is quickening the pace of smaller companies. By helping to reduce costs and find new markets both home and abroad, it is better enabling them to embrace the disruptive practices needed to better compete regardless of size. Little wonder the Numis Smaller Companies Index (NSCI), which represents the bottom 10% of the market excluding investment trusts, has risen three-fold over the period since 1999 when the FTSE 100 has struggled to make gains.

Further positives

However, there are further reasons to be positive at this point. Despite their increasing international reach, many smaller company fortunes remain largely tied to the domestic economy. The ‘project fear’ message regarding Brexit has proved completely erroneous, but this did not stop these undue concerns casting a long shadow over the UK market. This is now lifting. More large investment houses are overweighting the market – including those who helped lead the pessimistic chorus, such as JPMorgan.

Recent forecasts suggest the UK economy will be one of the fastest growing next year. Numerous trade deals have been signed and talks instigated as to the UK joining the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which promises huge potential. Inward investment continues (with some high profile positive news in recent months) because the UK remains an attractive place to do business for a host of reasons. Unemployment remains comparatively low by international standards.

Such factors suggest optimism and this is partially reflected in a currency which is slowly strengthening. And yet, despite the long shadow receding somewhat, the market remains attractively rated by international standards – as evidenced by the extent of M&A activity, often instigated by overseas buyers. This all provides a useful tailwind for UK smaller companies given the sector is broadly rated in line with the FTSE All-Share and yet continues to offer superior returns over time.

Sentiment towards the sector is already improving. After six consecutive quarters of outperformance to 30 September, net inflows into UK small company funds are on the rise. 2019 and 2020 saw outflows but recent figures from Montanaro Asset Management for 2021 suggest this has more than reversed. And the scale of this reversal is impressive. Indeed, the sector has seen nearly £2.2bn of outflows over the last 15 years, yet 2021 (to 31 July) has so far seen around £750m of inflows. This is indicative.

However, the current debate about the nature of the economic recovery cannot be ignored. As a result of the very high levels of government debt, policy-makers are robustly pursuing monetary and fiscal stimulus in an effort to generate a strong economic recovery, in order to help pay down the debt. And while accepting that the global economic backdrop has become more challenging in recent months as countries continue to grapple with Covid and its variants, if successful it should bode well for smaller companies in general.

Meanwhile, the high debt level is further encouraging governments to keep interest rates artificially low for fear of startling the bond markets. Policy makers are relaxed in part because borrowing costs are low – low gilt yields largely reflect substantial purchases by governments using printed money. Governments are prepared to tolerate higher inflation as a consequence in part because it helps erode the debt over time, believing it can be tamed when needed. The policy has the added benefit of concealing the true agenda in plain sight.

Yet other factors suggest inflation will not being transitory. Courtesy of the pandemic, business supply chains will be shortened which will adversely impact on profitability unless prices rise. Further long-term structural shifts in the inflation equation include globalisation ‘stalling’, the new balance between capital and labour, an ageing population, and the continuing standoff between the US and China. In combination, rising inflation is now part of the investment landscape almost whatever the economic backdrop.

How will smaller companies perform in such an environment? Policy makers’ logic of keeping interests artificially low only holds as long as the bond markets hold. But Treasury yields have been edging higher. Unless a forced buyer or in search of robust diversification, gilts are not the investment of choice. Looking back to the introduction of the NSCI in 1955, it is interesting to note how the sector has performed relative to larger companies during periods when bond yields were rising and falling.

In broad terms, during the bond bear market up to the early eighties when yields rose from 2% to 15%, UK smaller companies outperformed by 5.6% a year on average. Afterwards, during the bull market, they outperformed by nearly 2% a year. A closer examination of relative performance since 1962 suggests they outperformed in most environments, whether deflationary or inflationary, except very high inflation (over 12%). It would appear the sector’s inherent strengths can more than compensate for various inflation scenarios.

And further data analysis suggests now is a good time to ensure an overweight position. Looking at the NSCI index since 1962, and at the average returns of each of the first four months of each year, smaller companies have produced an average return of 8.6% which compares with just 2.2% over the remaining eight months. This perhaps reflects optimism as each year starts, which then gets tempered (‘sell in May’, etc). There are always exceptions which prove the rule, but this pattern is sufficiently pronounced for it not to be ignored.

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