A few nuggets from two decades of small-cap investing
This is a sponsored article.
"Time is the friend of the wonderful company, the enemy of the mediocre." Warren Buffet.
We've been investing in smaller companies for over 22 years. In Europe specifically, we've tallied up 12 years of small-cap experience. During that time, we have learned a lot - from how the market operates and what to look for in companies, to what leads to attractive long-term returns for our clients. Here, we detail some of these insights and explain why we think they are as relevant today as ever.
Small-caps are great
The most important thing we’ve learned is one of the simplest: small-caps are an extremely attractive asset class. The numbers speak for themselves. According to MSCI, European small-caps have returned more than five-times that of their large-cap peers since 2000. This outperformance is not European-specific, though: a similar pattern of outperformance can be observed in multiple regions around the world. What’s driven this remarkable showing?

For one thing, size matters. By their very nature, smaller companies have more room to grow than their larger, more established peers. They are less well-known than large-caps, meaning share prices can soar when markets become aware of a company’s worth. Smaller businesses are also more nimble and able to react to changing market trends. If they spot an opening, it is easier for them to exploit it ahead of their larger rivals. Think a speedboat easily outmanoeuvring an oil tanker. The internet has undoubtedly helped here. It has allowed small-cap ‘disrupter’ firms to break into hitherto impenetrable sectors. Many have quickly taken market share and usurped their better-resourced blue-chip challengers. You only have to look at the names behind the rapid evolution of e-commerce, food-delivery, automation and healthcare to see the far-reaching impact of smaller companies.

A focus on quality dampens risk
Given these benefits, why is there still a reluctance among some investors to hold smaller companies? Indeed, we often find that investors having a minimal allocation or, at times, no allocation at all to small-caps. The reason? One commonly held belief is that they are too risky. Many investors have avoided the asset class for fear of suffering huge losses. Is that fair? No – but with caveats. It’s true smaller companies have delivered more volatile returns than their larger peers in most regions. Small-cap shares are often the first to fall when the economy turns. There is also a liquidity risk. Fewer investors hold an individual smaller company’s shares, making them harder to sell in a market downturn. This can compound share price falls.

However, we have learned that we can mitigate that risk by investing in high-quality companies. The small-cap universe is huge and comprises numerous profitable, well-managed corporations. Many have strong balance sheets, clear ESG credentials (we’ll come on to that) and defendable competitive advantages. A sizeable percentage are starter-owned and are in charge of their own destinies. It is such quality that we actively seek; it is such quality that helps mitigate risk.
In it for the long haul

Investing is also about what you don’t own. Over the years, we have avoided cyclical companies or those with speculative businesses models. Such an ethos can sometimes lead to periods of short-term underperformance or us missing out on flavour-of-the-month enterprises. We also avoid so-called ‘binary’ plays. These are companies that could potentially do really well or, in extreme cases, go bust entirely. Take the biotech space. In recent years, there have been a number of small-cap stocks that offer new and highly innovative products or solutions. Their stock prices climbed dramatically as investors sought to buy into the next dominant trend. However, much of that enthusiasm proved misplaced and many firms folded – taking shareholders with them.

So, we don’t change what we do in response to short-term trends. Nor do we chase markets fads. Instead, we stick to buying quality companies, that have the potential to deliver sustainable, predictable returns. We then hold them for the long term.

We look to buy tomorrow’s larger companies today. This involves investing over a lengthier timeframe in order for companies to develop, mature and eventually flourish.

The last factor is of paramount importance to us. We look to buy tomorrow’s larger companies today. This involves investing over a lengthier timeframe in order for companies to develop, mature and eventually flourish.
This approach also means we ‘run our winners’. While investing, it’s tempting to sell a stock that has performed well over a short period of time. It’s human nature to want to bank your profits and look for the next new shiny investment. This temptation is heightened in the small-caps space, where share price gains can be astronomical.

Concentrate
A truism: not all small-caps are equal. Despite the significant outperformance of the asset class, there’s still a lot of rubbish out there. As such, you need to be selective – and have conviction in your investment cases. We have run concentrated portfolios (circa 40-50 stocks in our European Small-cap Fund) over the course of our investment journey. Our goal is to not dilute the quality of the portfolio and to ensure our clients benefit from as much upside from our preferred holdings as possible.

Diversification benefits abound
Smaller companies are also an excellent source of diversification when part of a broader equity portfolio. This is because they can provide different sources of returns to larger caps. They tend to be more domestically-focused than their bigger, international rivals. Investors can therefore gain direct access to expanding local economies or sectors. Company-specific factors also drive most smaller companies. That means they are potentially less vulnerable (although not immune) to global trends and currency fluctuations.

So, small-cap investing is easy?
Not quite. We have found that to be a truly successful small-cap manager requires scale, resources and the right tools. Given the breadth of the small-cap universe, many companies are poorly covered by analysts. This is understandable. Around 70% of the world’s listed companies are small-caps. It therefore requires considerable resources to cover the sector. Information on many companies can be sparse. Due diligence is often time consuming and costly. The advent of MIFID II also means that, over time, there will be fewer sell-side analysts covering stocks. As such, investors with on-the-ground resources to meet management teams and other key decision-makers will therefore have an information advantage. This means there are a wealth of mispriced opportunities in the small-cap universe.

Compare this to your average blue-chip company. Here, most of the data is readily available; quarterly corporate-results calls listened to by 1,000s of analysts. Non-consensus views are therefore a lot harder to come by.

The rise of environmental, social and governance (ESG)
Twenty years ago, few investors had even heard of ESG let alone considered it an essential component of their investment process. How times have changed. For us, analysing ESG factors is vital to understanding both the risks and opportunities in any given investment. In general, we have found that companies with good ESG practices tend to perform better than those that don’t.

However, given the resources required, many smaller companies are less developed in terms of ESG than their larger peers. There are numerous companies that are doing the right things, but are failing to disclose their activities. There is no standard method of ESG reporting.

That’s why, for us, a large part of ESG is about engaging with companies. We have a comprehensive programme of engagements to try to improve the performance of the companies in which we invest. This is in terms of their financial sustainability, as well as their environmental and social sustainability.

Like all our investments, ESG is not a short-term consideration. We believe it is ultimately about long-term sustainability – of our clients’ investments, the companies in which we invest and the wider world.

ESG will only grow in importance in the coming years. Working in conjunction with our dedicated, highly experienced ESG specialists, I’m glad to say we’re well-placed to continue to thrive in this brave new world.

All the time
So, once our clients have heard all these positives, they naturally ask: when is a good time to invest in smaller companies? It’s a fair question, but our answer is always the same. Indeed, it isn’t a decision to hold or not hold. Rather, given the clear return and diversification benefits, we believe clients should always be allocated to the asset class within a broader portfolio.

Final thoughts…
There’s no doubt that smaller companies offer a rich and diverse opportunity set. They have historically outperformed large-caps, while being in the vanguard of pioneering industries. Small-caps also provide a different source of returns from larger companies, adding diversifications to a wider portfolio. There are risks, but by focusing on quality companies, we believe it is possible to offset many of these.

So, where next? To paraphrase Mr Buffet, the last 20 years have been wonderful for our small-caps strategies. Armed with the lessons above, we hope the next 20 years will be equally wonderful.