Smaller companies may outperform for a multi-year period, says Gartmore's Gervais Williams.
Last week Capita Registrars, which provides share registration services, released its quarterly UK Dividend Monitor Report. The report highlighted the parlous state of UK dividend distributions and led one commentator to comment the hardest job in fund management must be an income fund manager. What, then, would he make of managing the small-cap asset class, where the institutional and mutual fund outflows have been persistent for a decade, and investment trusts trade at heavy discounts to their underlying assets?
For 20 years now, the duration of the credit cycle, smaller companies have persistently underperformed large caps with just short bursts of outperformance. This pattern has fostered the perception that the main reward from small caps is from timing the asset class.
But there are changes afoot. Two powerful trends have emerged we believe will challenge this perceived wisdom, and mean smaller companies may outperform for a multi-year period: re-recognition of the small-cap effect, and the slow expected recovery ahead.
20 years of role reversal
Hoare Govett studies have consistently demonstrated the smaller the companies you invest in the higher the long-term return, a phenomenon which can be attributed to the small-cap effect, the fact the scale of change within a business to be underestimated by markets is more likely for a small company than a large one. It is also more likely there is a difference between a market’s perception of a stock and the business reality in the small-cap space.
As with many great investment research insights, the moment Hoare Govett went public in describing the small-cap effect the rule began to break down. Its release coincided with the beginning of two decades of credit-fuelled globalisation and economic growth which benefited the large cap asset class disproportionately.
The conventional metrics (like earnings growth and dividends) by which fundamental investors typically evaluate companies were driven to unsustainable levels by the use of leverage. This applied to both financial companies, of which there was a greater preponderance in large-cap indices, and non-financial companies alike.
Share prices of those who retained traditional disciplines, like Lloyds (pre HBOS) were punished with low P/E ratings and high dividend yields. Alternatively, for those not prepared to over-optimise balance sheets in public markets, there was a private equity partner more than willing to play the carry trade. The paradox, of course, is ultimately the pension funds paid a different asset class more money to run the same companies with more debt.
The small-cap effect was still present, but its relevance was simply diminished, even overwhelmed, by a global credit asset bubble. Small companies still grew earnings but were either unwilling or unable to add undue leverage.
The path ahead
IMF experience and research demonstrates post credit crunch economic recoveries tend to be pretty muted. It takes time for the excesses of personal and corporate balance sheet inflation to wash through the economy with a dampening effect on economic growth.
If we accept we are in for a lengthy period of slow growth, it is going to be difficult for large companies to drive earnings. By removing the abundant supply of credit which has characterised the past two decades, large companies will lose the driving force which has enabled their exceptional performance.
Yet in fact the real debate is not about large versus small caps, but whether investors wish to invest in equity, and what characteristics of an equity investment they seek.
This is where the Capita quarterly is eye-catching. All the historical studies of long-term investment returns point to the same conclusion: the power of dividend compounding as the engine of investment return.
The places equity investors have traditionally sought income have disappointed, particularly banks.
The Capita report shows in 2009 UK dividends were cut by 15%. The virtues of income investing normally embrace a diversified portfolio of businesses, in control of their own destiny, and distributing a well-covered and sustainable dividend. But just five names were responsible for 47% of all UK dividends in 2009, and 15 names were responsible for almost 70% of distributions. That is a level of portfolio concentration most investors find intolerable. Stock-specific risk investors fear small caps is more than a creeping feature of many income funds.
Despite this, small caps are almost universally perceived as riskier investments, more likely to fail. The collapse of the banks in particular has already shown failure and risk do not respect size.
How can small caps outperform?
But what if small companies, which have persistently been advised they are capital growth plays and are conditioned to under-distribute, not only delivered real earnings growth but started raising payout ratios?
While stories like oil discoveries in the Falklands capture the headlines, the reality is there is a far wider set of opportunities, of around 1300 names, which frequently deliver real revenue, profit, and cash flow. Further, they offer considerable scope for growth in all these measures, given their exposure to niche or new and growing markets. Despite this, the ratings are often single digit.
Interestingly, there have been two occasions since the war when small cap dividend growth outpaced that of large companies, and each was accompanied by a multiyear period of outperformance of large caps by equities.
This is not a leap most investors will make rapidly. It challenges all the modern conventional perceptions regarding the universe, the most common of which is risk. But we are already seeing evidence of this trend taking place within this universe, as companies that initiate, reinstate or grow dividends have their share price rewarded accordingly.
Gervais Williams is head of small caps at Gartmore
