Smaller is best for a big return

UK equity portfo-lios typically invest in the largest 350 quoted companies – and stocks such as pharmaceuticals group Shire plc and technology group ARM have done really well over the last 20 years.

When big stocks move up significantly they generate major profits – and that makes a difference even to the largest portfolios.

The problem for smaller quoted companies is that they are just too tiny. Even when their share prices rise five or ten-fold, the absolute return in cash terms is not enough to move the needle for big institutional portfolios.

Which makes it all the more extraordinary that most institutional portfolios are about to change their attitude to the smallest quoted companies. Indeed, not just their attitude, but how they deploy their capital.

The bottom line is that in the coming couple of decades we can expect most institutional portfolios to invest perhaps 10pc or even 15pc in the smallest quoted companies.

The point is that world trends have changed. It’s a really big shift – so big in fact, that it’s making international headlines, and not just in the financial sections, but on the front pages of national newspapers.

World growth has stagnated, and this wasn’t how it was supposed to be after 2008 when interest rates around the world were cut to record low levels – and have remained there ever since.

Governments have boosted economic activity too – through running sizable budget deficits for years and years. Central banks have tried some pretty unconventional strate- gies as well. QE in the US has injected some $3700bn into the world’s economy.

The UK has been at it too with the Bank of England buying in over a quarter of our entire national debt.

The problem is that when world growth stagnates, big companies struggle. They have big market positions and so when their markets flatline, they either get used to it, and learn to tread water, or they cut prices to grab extra market share and risk a price war.

The distinct advantage of being smaller is the greater growth potential compared with larger stocks. At times of stagnation it’s tougher for everyone. But the minnows only need small increments of market share to keep growing. During the 1960s and 1970s smaller stocks outperformed in spite of industrial strife, sustained inflationary problems and currency problems so severe that the IMF had to come in to rescue the pound.

Over recent decades we collectively have been borrowing growth f rom the f uture. That boosted growth during the boom. But now it’s payback time.

Professional investors are already starting to think small. The trouble is it’ll take years to get enough capital invested: each investment is relatively tiny so they have to buy lots of holdings. Many smaller companies don’t trade much, so the drip, drip, drip of cash into these businesses will drive up their share prices. It looks like the beginning of a new super-cycle of smaller company outperformance. Those who fail to embrace the change will miss out – and if that persists, then clients will move their funds to those that are delivering better returns. It’s a virtuous circle that’s only just beginning.

There is nothing new in this. Prior to the credit boom most professional investors routinely allocated 10pc or more to the smallest stocks. Not only does it boost potential returns, it also diversifies the risk through widening the range of holdings. On top of this, a well-supported ecosystem of smaller quoted companies, which are mainly domestic businesses, generates extra growth for the UK economy.

It is small companies that create most new private sector jobs so it adds up to extra employment growth too. Finally because smaller businesses tend to have less ability to use sophisticated tax avoidance schemes, when they do well i t swells the national tax coffers.

It’s a case of our collective savings becoming better aligned with the wider interests of us all. Who says there aren’t enough good news stories around in the markets?

Gervais Williams, managing director at Miton Group plc, was Investor of the Year at Grant Thornton’s Quoted Company Awards in 2009 and 2010, and in 2014 he was What Investment Fund Manager of the Year. The views expressed are Williams’ and not necessarily Miton’s, and do not constitute investment advice.