Certain beliefs about smaller companies persist: that they are domestic in focus, volatile and illiquid. Dan Whitestone argues that they offer a wealth of opportunities for long-term investors …
Smaller companies have an impressive long-term record of outperforming their larger peers, with 4% annual compound outperformance over more than 63 years.
That is not luck.
There are many reasons behind it, but the most important is that small and mid-cap companies have consistently demonstrated greater earnings growth.
The small cap universe is home to many dynamic companies that are opening up new markets with exciting products and technologies, disrupting older markets and influencing consumer behaviour.
The case for investing in smaller companies
The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. Index returns are illustrative only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged, and one cannot invest directly in an index. Smaller company investments are often associated with greater investment risk than those of larger company shares.
*Large Cap performance represented by Barclays UK Equity Large Cap Index until December 2010. In January 2011, Barclays began to use FTSE All-Share Index to track the performance of UK large cap companies.
 Source: Datastream, UK Equity Large Cap Total Return Index and Numis Smaller Companies Index + AIM ex. Investment Trusts Total Return Index as at 30 November 2018.
While the long-run attractions of UK small and mid-caps are clear, this is also an area where it pays to be active. The dispersion of returns in small and mid-caps is high. While many successful companies see their market value multiply several times over, there are others for whom things go wrong. And when they go wrong, they can go seriously wrong - companies can see their market values collapse and in some cases fall to zero, even after many years of success.
At the same time, the UK small and mid-cap market has a lot of choice, with exposure to businesses that are operating globally, enabling us to build a truly diversified portfolio. It is also an inefficient and under-researched investment universe compared to large caps.
More recently small caps have been hit by the view that they are dependent on the UK economy at a time when uncertainty about the economy is high. We do not share this view.
There are successful small and mid-caps which have the ability to manufacture their own growth and are not as reliant on the wider economy as might be believed. This is particularly true for differentiated companies with small shares in fragmented industries, perhaps where they are the consolidator, but also true when it comes to disruptive business models.
Our view is that we are in an upswing of technological innovation and disruption, and small and mid-caps provide fertile hunting ground for these opportunities. There are many young innovative companies disrupting industries and taking market share from legacy incumbents. This makes investing in smaller companies attractive, as we can gain exposure to companies that can continue to grow regardless of the wider economy.
What makes a good smaller company?
We focus on two types.
The first are differentiated long-term growth investments. These are companies with strong management teams, a protected market position, unique and compelling products with an attractive route to market, perhaps benefitting from structural growth, and that are well financed with clean accounting.
The second type are those that are leading industry change, the “disruptors”. The transformation that we have witnessed across so many industries in the last 10 years is staggering. For example, the smartphone is little more than 11 years old but think of all the apps that have fundamentally changed consumer behaviour, from internet food shopping to ordering a taxi, a pizza or watching a TV box set. This has had a profound effect on a number of incumbent industries that have lost market share to new platforms. How many industries have seen revenues and profits pressurised by the need to invest and to adapt and change business models?
We try to incorporate the thinking outlined above into shorting the disrupted victims of industry change. We also like to short the opposite of what we look for in differentiated successful growth companies - those businesses facing structural or cyclical industry pressures, with weak financials such as too much debt or poor cashflow.
Our skill set is certainly not market timing, and we do not know if small and mid-caps will have a great year, a good year or a poor year in absolute terms or relative to larger companies or other asset classes. However, the longer-term prospects are sound.
Regardless of the latest macropolitical debate, we aim to spend our time understanding, researching and connecting with small and medium-sized businesses, looking for the next wave of exciting emerging companies before the market realises their true potential.
For more information on BlackRock Throgmorton Trust and how to access the potential opportunities presented by smaller companies, please visit www.blackrock.com/uk
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Trust Specific Risks
Liquidity risk: The Fund’s investments may have low liquidity which often causes the value of these investments to be less predictable. In extreme cases, the Fund may not be able to realise the investment at the latest market price or at a price considered fair.
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Net Asset Value (NAV) performance is not the same as share price performance, and shareholders may realise returns that are lower or higher than NAV performance.
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