18 Mar 2024
Author | Thomas Watts, Investment Analyst
Why size isn’t everything as Thomas Watts discusses the opportunities smaller companies offer.
Investment Analyst Thomas Watts highlights the opportunities that lie in small, quality companies and finds that a certain, well-known book of fables is a surprisingly useful guide to the investment landscape.
When it comes to investing, the well-known collection of morality tales, Aesop’s Fables, isn’t necessarily the first book an investor would think to read.
However, although sounding simple, through his works, the ancient Greek fabulist can actually teach us a great many lessons about the skills and discipline needed to be a successful investor.
Take the Tortoise and the Hare for example, one of Aesop’s best-known stories. It’s a cautionary tale of over-confidence and arrogance on the hare’s part, with the steadier approach employed by the tortoise winning the race in the end. A good allegory for investors who chase instant gratification through speculation, rather than employ a steady, well thought out approach to portfolio management, which usually produces the best outcome over the long term.
The Lion and the Mouse is also one of Aesop’s more popular fables, where a chance encounter between two unlikely friends shows us that size isn’t everything. In fact, the term ‘good things come in small packages’ is often attributed to Aesop, a line used within the story to describe the mouse. Indeed, in the vast landscape of domestic and continental equities, while larger companies may enjoy a longer reach and perceived dominance in their sector like the lion, smaller cap stocks enjoy a narrative of resilience, growth and often untapped potential, mirroring the heroics of the mouse.
With this in mind, the much-maligned UK economy has defied many expectations of falling into a deep recession thus far, although small cap valuations remain tantalisingly low, presenting an opportunity for discerning investors with longer time horizons. In essence, there’s the potential to buy strong, quality companies at heavily discounted prices. Offering an attractive entry point is not just confined to UK small caps however, if we look across the Channel, European smaller companies are also trading at historic lows relative to their larger peers.
It’s a story nearly as old as Aesop’s fables themselves, that small caps tend to fare worse during the run up to an economic downturn than more robust, more diversified larger companies. To some extent, this is true. However, what’s usually overlooked is that exiting, or even during a recession, it’s usually smaller caps that lead the way, often recovering quicker and benefiting more than most from any central bank economic stimulus. Such a bounce back is largely attributable to forward market pricing, looking towards an economic recovery as early as three months into a recession according to data (source Bloomberg), meaning that somewhat perversely, it’s those companies most vulnerable to a downturn that can begin to outperform during the depths of it.
As the economy turns a page and exits a recession, smaller companies are also often able to adapt far quicker than their potentially more cumbersome large cap peers. The nimbleness demonstrated by small caps often results in quicker reactions to changes in the business environment, taking advantage of the new opportunities an evolving economy can present.
Mirroring the agility of such companies, at abrdn our full focus is also to anticipate and respond to changing economic conditions and with this in mind, we’ve modestly increased our weighting to the sector. We now feel smaller companies, both at home and on the continent, are in somewhat of a sweet spot to provide a strong degree of risk adjusted returns for the portfolios.
Of course, not all smaller caps are the same, with varying degrees of earnings quality exhibited across the company spectrum. Heading into a probable recession in both the UK and Europe, we favour higher quality companies that can demonstrate robust profitability strong cashflows and a management team that consistently adds value, preferring to invest in funds that can find such companies at reasonable valuations.
Helping us build up a material position in small caps, both here and on the continent, we’ve recently initiated positions in the Royal London UK Smaller Companies and Janus Henderson European Smaller Companies funds respectively. Both offerings look for all the qualities listed above in their stocks, while holding a strong valuation discipline, refusing to pay for growth if it comes at too high a price. Both funds hold the characteristics of ‘core/core growth funds’, but are allowed the flexibility to adapt throughout the market cycle within reason, putting them at the heart of our small cap exposure.
We believe that cheap valuations, combined with the adaptability of smaller companies to thrive in a post recessionary world, held within a prudently managed fund could be the last word as a return driver over the coming years for UK and European portfolios. With many misconceptions still surrounding small cap company’s ability to perform during a recession, perhaps Aesop’s teachings are more valuable than ever, as they say, you should never judge a book by its cover…
abrdn Portfolio Solutions Limited offers a range of portfolio strategies for adviser firms, with a choice of management styles and risk levels to meet clients’ investment needs. To find out more, go here.
The value of investments can go down as well as up and your clients could get back less than they paid in
The views expressed in this blog should not be regarded as financial advice.
Risk warning
The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested. Past performance is not a guide to future results.