This month Neil Birrell, Premier Miton’s Chief Investment Officer and lead manager of the Diversified fund range, wonders if smaller companies really are coming back into fashion and worries that we are all just a bit too complacent at the moment.
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
In favour (or coming back into favour): smaller companies
We have been long term advocates of investing in small and medium-sized companies. As economies, societies and technology develop and change, new, innovative, entrepreneurial companies set up to exploit and service the opportunities that are created.
After all, Bill Gates and Paul Allen got Microsoft going from a garage in Albuquerque and Marks & Spencer got going from a stall at Kirkgate Market in Leeds. Not all start-up companies are that successful and many fail or get taken over by larger companies who recognise the opportunity, but it is an exciting area to invest in.
It can be perilous as well, smaller companies are seen as higher risk for good reason. They do fail, they typically have less experienced management teams, can consume cash and have more debt.
Therefore, selecting the right companies to invest in is very important; that requires skill and experience, thankfully these are features we have in the investment team.
Let’s get the background in place:
- Smaller companies have outperformed large ones over the long term.
- Smaller companies typically only underperform large ones during bubbles and crises. The Dot Com bubble, global financial crisis and COVID all being examples.
- Smaller companies have been underperforming large ones for over two years now. Why? Because of fears of recession.
- Smaller companies start outperforming large ones as economic activity picks up. That’s happening now.
- Smaller companies are at a valuation discount to large ones, with the gap being extreme in some regions, such as the US.
The party is starting
The chart below shows the performance of large companies globally (MSCI World Index) and small companies globally (MSCI World Small Cap Index) over the three months to 11 June. As you can see, smaller companies have not done as well as large, but that does not tell the whole story.
Performance of large (MSCI World Index) vs small companies (MSCI World Small Cap Index)
Source: Bloomberg 11.03.24 – 10.06.24.
Past performance is not a reliable indicator of future returns.
The main reason is that US smaller companies make up 56% of the world index and, as shown in the chart, they have not yet recovered, which is surprising given the strength of the economy. It may be partly due to the ongoing influence of the giant companies such as Microsoft and Nvidia and the technology sector more broadly (some of which we think will run out of steam).
However, as you can see, the MSCI Europe ex-UK and the MSCI Emerging Markets Small Cap indices are on the recovery path, while at home the FTSE Small Cap and FTSE 250 (mid-cap) indices have been doing well.
We believe the background is in place for a substantial long-term outperformance of smaller companies over large. It’s happening in some regions now and we are of the view the US will join the party, which will carry on for some time. It’s a party you’ll want a ticket to.
Out of favour: complacency
Equity markets have, for the most part, been strong this year. They have been going up in the face of inflation, staying higher than expected and interest rates are not falling as soon or as fast as hoped for.
We also have the uncertainty around politics and conflicts in Ukraine and the Middle East. On top of that, major countries’ governments are heavily indebted, with spending plans to meet and the cost of borrowing high.
Investors seem largely immune to this. The VIX Index estimates the expected level of volatility of the S&P 500 Index, it is considered to be a good measure of how investors view the outlook for risk. In periods of stress it spikes (see the chart below and the COVID period) and when everything is calm it is low. It is currently very close to lows for the last five years.
VIX Index
Source: Bloomberg 22.05.19 – 11.06.24.
This suggests that investors do not see much risk on the horizon. This, along with company directors selling shares in their own companies at a higher rate than usual, and the level of hedging in the equity market overall being lower than normal, leads me to wonder if most people are thinking that everything is, well, alright.
When, in fact, we could get surprised by a piece of bad news which would create some downside in equity markets.
I don’t think it’s anything too much to worry about, but it is worth having it at front of mind and being prepared for.
Being complacent over financial markets is not a good thing at any time, but particularly not when everyone else is.