Smaller companies make up the vast majority of the economy, are better-aligned with shareholders, more entrepreneurial - and not necessarily young and inexperienced. No wonder they both outperform and diversify large-caps, writes Nick Hamilton

It was a volatile year for global equity markets in 2011 as the euro-zone sovereign debt crisis combined with political tensions in the Middle East and North Africa, large fiscal deficits in the developed world, and slower growth and higher inflation in the emerging world came to dominate investor sentiment. Despite these significant headwinds, towards the end of the year attention began to turn to an improvement in US macro-economic data, particularly those showing a strong indication that a weak labour market was improving.

While profits will not grow as was anticipated early last year, markets have discounted out a steep earnings decline and multiples have duly contracted. There is a chance of recession in a number of European countries. However, evidence is emerging of positive, albeit low growth out of the US market and there are strong indications in major emerging markets that monetary policy will be loosened to stimulate these markets.

While we expect a volatile and potentially range-bound market for several more months or quarters, we believe that risk assets are looking attractive for long-term investment.
Historically, risk assets are vulnerable when confidence is high and valuations high. Investors today are not confident. Since April 2010, we have seen market optimism turn to extreme pessimism and while this has clearly been negative to returns, looking at 2011, there is a point where this risk aversion will turn. If we look at valuations, the correction, especially outside the US, has compressed earnings multiples substantially.
Smaller companies are confronted by challenges in this economic environment. Cyclicality, uncertainty around order books and inventory draw-down can disrupt businesses. In addition, companies require a degree of self-funding in some countries today, where borrowing outside the highest quality names is more challenging. Encouragingly, smaller companies today, as a whole (and there are many exceptions), are, in our view, attractive long-term investments.

Sensitive to economic cycles
Small companies are less insulated from economic downturns than larger companies, and their earnings can fall more sharply when growth falters. However, because of the earnings recovery potential, they will usually be out of the blocks first when economies stabilise and shift from recession to recovery. Where in large-cap land you have big stable companies like pharmaceuticals, consumer staples and utilities, the economic sensitivity of smaller companies comes about largely because of the higher degree of cyclical and industrial exposure.

The current travails of the market offer just a short-term perspective. But if we take the world’s largest equity market (the US) as a proxy for global markets due to its longer recorded history, then the evidence of smaller company outperformance, on average over longer periods, is significant. A 2010 asset class study by B P Choi and S Mukherji of Brown University, which looked at returns from 1926 to 2007, concluded that smaller company outperformance is, on average, around 1.7% per annum, in real terms (after removing inflation).

This is a significant premium when you consider the impact of compounding returns. Smaller companies had the highest return of the asset classes examined in the study (government bonds - intermediate and long-term, corporate bonds, large-cap and small-cap equities) and what was significant was that their volatility had been no greater than investing in larger companies as the holding period moved out to 10 years. The conclusion from this study is that, for the same amount of long-term risk, you can potentially receive a significant return premium.

A drive to succeed
While there are over 9,000 companies in the world’s main global indices, only around 1,600 are defined as large-cap, making the vast majority of listed shares medium-sized and smaller companies. We believe that there are compelling reasons for investing into this huge global market. Their inherent dynamism is supported by management whose interests tend to be closely aligned with those of shareholders.

The management of smaller companies tend to hold a significant amount of their own shares, so have a real incentive to succeed. Importantly, the incentive to succeed isn’t driven by profits alone but by an entrepreneurial spirit. Studies have shown that managerial ownership improves company performance. Empirical research, such as the 1988 paper ‘Management Ownership and Market Valuation’ by R Morck, A Shleifer and R Vishny points to an improvement in corporate performance when managerial ownership rises from 0 to 5%. Performance continues to rise as managerial ownership grows to an inflection point of 25%.

A common misconception is that smaller companies are new businesses and are inherently less profitable. However, we believe what is misunderstood is that many smaller companies have long histories and strong economics. Often it is the size of the end market and a desire to specialise that is the limiting factor to size. For example, a small specialist auto parts manufacturer may control the global supply of a component product but if that product has a relatively small market value, the size of the business is, by definition, limited. However, if that company controls the supply of the product, then profit margins can be above that for the industry. Size often says little about the profitability or economics of a business.

As investment managers, we also like the ability of smaller companies to identify growth opportunities and to execute business more quickly than larger companies. In a telling comment during 2010, Hewlett Packard’s outgoing CEO admitted that the size of his company was effectively limiting its ability to respond to product cycles in the global economy. Large companies become complex and dynamism is often forsaken for process, which might limit growth opportunities.

Finally, it is becoming apparent that large global companies, which today are sitting on large cash hoards, are looking to achieve innovation and growth through acquisition and that is a positive for those smaller companies which are likely to become targets as market conditions stabilise.

Uncorrelated
Smaller companies behave differently to other asset classes and long-term evidence validates the notion that they can offer substantial diversification benefits to a bond portfolio and to a large-cap equity portfolio.

Smaller companies have a negative correlation to bond markets and this has been maintained even in recent years when the correlation between large-cap equities and bonds has risen. In the long-term asset study by Choi and Mukherji, smaller companies were shown to have a powerful diversifying effect with bonds.

Smaller companies can offer diversification to large-cap equities as evidenced in the past decade where smaller-company returns have, on average, outstripped large-company returns. We believe that smaller-company returns are driven primarily by local and company-specific factors. For portfolios with predominately larger-company exposure, smaller companies can offer access to more diverse sources of growth while potentially reducing the level of risk.

A 2008 study of small-cap returns and risk undertaken by CS Eun, W Huang and S Lai in the Journal of Financial & Quant Analysis concluded that a fully diversified global large and small-cap portfolio is, on average, significantly less risky than a diversified large-cap portfolio: “International diversification with large and small-cap stocks will be substantially more effective in reducing the portfolio risk than diversification with large-cap stocks alone.”

To summarise, exposure to global smaller companies within a global equity portfolio can offer diversification benefits and the potential for strong long-term returns. Smaller companies have been shown, on average, to offer higher returns compared with other asset classes (bonds and large-cap equities) and with long-term (10-year) volatility no higher than large companies. We believe that global smaller-company investing favours a long-term, fundamental stock-picking approach; and that it can offer an attractive long-term investment opportunity.

Nick Hamilton is head of global equity products at Invesco Perpetual