A happy hunting ground

Fans of smaller companies have a phrase they think sums up the allure of these investments. “Elephants can’t dance”, they argue, pointing out that the size of larger businesses precludes further excitement and growth; much better to put your money into smaller enterprises with more capacity to expand and the agility to do so.

The numbers bear this argument out. Over the past 50 years or so, smaller companies in the UK have outperformed their larger peers by an average of 4 percentage points a year. The short-term comparisons look good too – small caps have beaten large caps in two out of every three years over that period.

Still, we know one thing about smaller companies, don’t we? Since they tend to operate closer to the consumer and with a more domestic focus, they’re more vulnerable to the impacts of an economic slowdown – and definitely to a full-blown recession. So, given that the Bank of England has said this week that the UK may already have slipped into recession, now is surely not the moment to be considering an investment in this area.

Don’t make that assumption. It is certainly true that smaller companies have often underperformed during a recession – that is exactly what has happened in five of the past eight downturns. Here’s the thing though. The underperformance we have seen from smaller companies in the UK this year relative to large caps has already exceeded the experience each of those five cases. The Numis Smaller Companies Index is down a whacking 23% since the beginning of the year; larger shares have been broadly flat.

Reflect also on what happened in those five previous recessions once smaller company shares started to bottom out. The return from small caps over the following year averaged around 40%.

Does that mean smaller companies will deliver a 40% return over the next 12 months? Not necessarily – but the historical comparisons, and the recent performance data, do tell you that the market has already priced in the impact of recession on smaller companies. Investors may not have been pessimistic enough, of course, but current valuations do appear to reflect an awful lot of bad news.

Moreover, investors who use investment companies to get their smaller companies exposure have suffered a double whammy. Portfolio values have fallen, but the share prices of these funds have fallen even more quickly. Shares in the average UK smaller companies investment company now trade at a discount to the underlying value of the portfolio of almost 14%. In a number of cases, the discount is significantly wider.

Naturally, there are no guarantees – financial advisers and investors will recognise that the position could get worse before they get better. But for those with a long-term outlook – and smaller company funds have never produced a negative return over a seven-year period – now could just be the time to take a fresh look at this area of the market.

In which case, investment companies are an excellent place to start. The active approach they employ is particularly fruitful in the small cap arena, which is much less widely followed by analysts and researchers. And the structure of an investment company, providing daily dealing options to investors while managing a fixed pool of capital, suits smaller company investment, where liquidity can be a problem. Add in the fact that smaller company investment companies are currently so cheaply priced and this could be a happy hunting ground.