Share Prices & Company Research

News

28 July 2022

Small & Mid-Cap Stocks - The Key to Long-Term Returns?

Small cap stocks are often misunderstood. Many people have watched The Wolf of Wall Street or seen an advert for a penny stock trader, attempting to sell a revolutionary trading course that can make you millions each month. This reinforces the idea that small cap stocks are simply there to be traded and not suitable for long-term investors. While trading is certainly made easier by the heightened volatility in small cap stocks, the investment case for long-term investing in the asset class remains strong.

There has traditionally remained a negative correlation between company size and long-term performance, with smaller stocks often outperforming their larger and medium sized counterparts. The majority of this outperformance occurs during bull markets when markets are rising and momentum is strong, as investors risk appetite steadily increases and they seek out riskier assets with greater upside potential. Small cap stocks suit this scenario perfectly as investors inscribe additional weighting to future earnings potential versus large-cap companies with immediate cash flows.

Chart.png
While this is the case over the long-term, short-term volatility and drawdown will likely impact the range of investors who wish to access such markets. Likely, such an asset class will be appropriate only for those with elongated investment horizons and higher risk appetites. In fact, from peak to trough during the 2007/08 financial crisis, the MSCI Small Cap index fell by -61.4% compared to -55.5% for its larger cap counterpart, both devastatingly low levels, but with small cap investors suffering an even worse fate.
 
However, despite such drops, small cap stocks tend to bounce back more rapidly, owing to their high levels of innovation, growth and flexibility. In fact, the recent development of so called ‘unicorns’ (a privately held company with a valuation of US$1bn or more) has given rise to new-age technology companies, many of which have gained significant market share in short periods of time thanks to their innovative products and solutions that have been replacing legacy providers at a rapid rate, and leaving their larger competitors scrambling to find a way back to the top. Perhaps one of the best examples of this is the UK banking industry. Fintech (financial technology) companies such as Monzo and Starling have gained rapid adoption since their inception, thanks to lower fees in areas such as international spending, innovative apps that help consumers more effectively manage their money, as well as payment notifications that help customers better recognise fraud on their account. Digital challenger banks now control 8% of the personal current account market in the UK, up from 1% in 2018 as customers, in particular millennials, grow tired of the lack of innovation and functionality of legacy providers such as Barclays, NatWest and Lloyds, amongst others.
 
Companies and individuals are now demanding more user friendly, connected and targeted products and services to meet their needs, with smaller companies able to exploit niche areas of the market, offering exactly what their customers require. Their larger competitors require significantly more funding and time to create new products and are often prepared to rest on their laurels as their large market share provides a steady stream of income.
 
This has meant that smaller companies have traditionally grown at much faster rates than their larger counterparts. In fact, the Cboe UK 100 has averaged an annual sales growth of just 0.03% compared to 3.19% at the Cboe UK 250 over the past ten years, a stark difference that showcases the long-term strength of small and medium sized companies.
 
These days especially, smaller companies are often better prepared than ever to compete with the incumbents thanks to the rise of private equity capital and firms’ willingness to remain private for longer. Private markets have seen an explosion of capital thanks to a large increase in the number of market participants willing to invest in new up and coming technologies. Companies such as Google as well as collective investments such as Baillie Gifford US Growth Trust have increasingly looked to allocate towards private markets as a way of diversifying their revenue streams and widening their investable universe. This has ultimately meant that when such companies decide to list on public markets, they are well positioned in the market in which they operate and often well-funded also to aggressively take market share.
 
For those investors with longer-term time horizons, looking to tap into the often-fruitful small cap market, there has emerged a large number of funds in recent years with which they can access the area. This ranges from tracker funds which replicate an index at low cost, to more interesting actively managed funds targeting specific geographies and sectors. Selecting a fund and by association a manager that you can rely on, remains of paramount importance when looking to invest in small caps, as avoiding companies at risk of failure often remains a much more difficult job than at larger cap focused funds.

This article was taken from the May 2022 issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
 
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.
 
Small & Mid-Cap Stocks - The Key to Long-Term Returns?

More News Stories

Market Round Up
12 August 2022
Deere & Co
10 August 2022
Think Small
03 August 2022
SUBSCRIBE TO OUR PUBLICATIONS
We offer complimentary investment publications produced by our in-house Investment Research team. Please click here to view our range.