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The ‘size effect’ – the case for investing in smaller companies

We look at what ‘small’ really means, why you could consider them and share two investment ideas.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

It's not the size of the dog in the fight, it's the size of the fight in the dog. This old adage shares parallels when it comes to investing.

Smaller companies can certainly punch above their weight and despite their performance potential, they can often be overlooked in a portfolio.

Since the stock market lows in March 2020, they’ve been centre stage in the global stock market recovery. While over a relatively short timeframe, they’ve outperformed their larger peers by some margin. This won’t always be the case though, there will be times where bigger companies will outperform smaller ones. Smaller companies are also less established, so they’re higher risk and more volatile.

In this article, we look at what ‘small’ really means, why you could consider them and share two investment ideas.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. All investments will fall and rise in value, so you could get back less than you invest.

How do you define ‘small’?

Depending where you look or who you ask, the definition of ‘small’ can vary.

The size of a company can depend on the environment they operate in. For example, a company considered small in one region could be relatively large compared to another.

A company’s market capitalisation – the total number of its shares in issue multiplied by the latest share price – is a common sorting method and way to size a company. Companies with lower market capitalisations are considered to be smaller, hence the name ‘small cap’. Remember though, just because these companies are ‘small’ today doesn’t necessarily mean they will be tomorrow as they could grow over time.

To put this into perspective, the chart below highlights the ceiling for the definition of a smaller company across several global regions. The US is home to some of the biggest in the world with the maximum being seven times larger than Egypt. In Europe it’s a similar story, particularly for countries like the UK, Netherlands and Germany. Naturally those based in less developed emerging markets tend to be further down the market capitalisation spectrum.

Maximum market cap of a smaller company by country

Source: Aberdeen Standard Investmets, Axioma, 30/06/2021.

Understanding risk - why company size matters

Punching above their weight

Academic research has long suggested that smaller companies have tended to outperform larger ones. This is sometimes referred to as the ‘size effect’ or ‘size premium’.

The chart below highlights the additional 250.5%* returned by smaller companies compared to their large cap counterparts since the start of 2003 when the FTSE index launched. Although, the journey has been bumpier. Remember though, just because they’ve done well in the past doesn’t mean this will continue.

Past performance isn’t a guide to future returns. Source: *Lipper IM, to 31/08/2021.

Annual percentage growth

Aug 16 – Aug 17 Aug 17 – Aug 18 Aug 18 – Aug 19 Aug 19 – Aug 20 Aug 20 – Aug 21
FTSE Global Large Cap 20.0% 11.0% 7.5% 8.1% 24.2%
FTSE Global Small Cap 17.6% 14.1% -0.8% -1.5% 36.5%

Past performance isn’t a guide to future returns. Source: Lipper IM, to 31/08/2021.

But what makes them so attractive?

Imagine a shipping tanker, changing course takes time and planning ahead is paramount. In contrast, a smaller vessel, like a speed boat, can easily navigate and if needed avert at the last moment. The speed boat is the smaller company – it’s nimble.

They also tend to be less bureaucratic which means there are fewer layers of management. The benefit of this is increased agility and the flexibility to adapt to changing market conditions. This can give them the edge over larger companies – the shipping tankers.

The drivers of returns are also different from larger companies, which can help offer diversification. While some smaller companies make money overseas, it’s likely their home market is their primary focus. On the other hand, larger companies often do business overseas as well. While this brings potentially more opportunity, it also means they have to deal with other potential challenges, like currency fluctuations or tariffs.

They only make up a slither of the global stock market, so smaller companies are also often overlooked by analysts. For example, one study suggests only three analysts cover a UK small/medium-sized company compared with 22 for a larger one. An under researched part of the market can be a stock pickers paradise and can offer lots of opportunity to uncover hidden gems.

Smaller companies are riskier than larger ones. They tend to trade less frequently than bigger shares so can sometimes be harder to sell.

Searching for hidden gems in the UK stock market – 3 UK fund ideas

Investing in Smaller Companies

Small caps are at the forefront of innovation and let investors get access to some of the most exciting trends and emerging themes. They keep larger companies on their toes with the threat of market disruption. And in some cases, smaller companies are creating entirely new markets altogether.

It’s important that investors do lots of research, which requires both time and information. Time you might have, but information isn’t always easy to come by, especially when it comes to smaller companies.

It could be worth leaving it to an expert, like a professional fund manager, to make the underlying investment decisions of what the fund invests in.

We think active managers (ones that try beat the market) can really add value in this part of the market, although this isn’t guaranteed, and some managers do underperform. We have several on the Wealth Shortlist, a list of funds selected by our analysts for their long-term performance potential. We take a closer look at two of those fund below.

Smaller companies should only be considered as a small part of a portfolio. It could form part of a more adventurous portfolio for the long term. We think it’s a good idea to use them alongside other investments in larger companies. Blending them with different geographies and types of investments can help diversify a portfolio.

Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

ASI Global Smaller Companies

We think ASI Global Smaller Companies could be a good option to add diversification to a portfolio, while investing in smaller companies around the world. Veteran fund managers Harry Nimmo and Kirsty Desson champion the benefits of investing in companies considered too small by many other global fund managers. They look in both developed and higher-risk emerging markets to find businesses they think are high-quality, growing and have momentum behind them.

This process results in a portfolio of between 40 to 80 companies. Just under half the portfolio is invested in the US, although this is less than the global stock market.

In contrast, they invest more than the benchmark in Italy and the UK, a region Nimmo is very familiar with. The managers can also use derivatives, which can add risk if used.



Artemis US Smaller Companies

Outside the usual names that dominate the US stock market, we think Artemis US Smaller companies could be a good addition to the US portion of a portfolio. Cormac Weldon has managed the fund since launch in October 2014. He has plenty of experience investing in the US market, having invested there since 2001, and is a manager we rate highly.

Weldon has more than 2,000 potential companies to choose from, but he only invests in around 40-60. While this can increase performance potential, holding a smaller number of investments can increase risk.

He only invests in those where he believes the upside potential is double the downside risk. This is achieved through number crunching their profitability and growth prospects over time.

The team also meet with company management on a regular basis which helps build their understanding of the business model and assess the quality of the management team.



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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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