Should you invest in smaller companies?

What you’ll learn:

• A comparison of the historical performance of small, medium and large size companies
• The future prospects for smaller companies
• The smaller companies funds available on the Barclays Funds list.

The coronavirus pandemic that started in the first quarter of 2020 has had a profound impact on share prices globally. UK small and medium-sized companies were no exception. And whilst the human impact of the virus is undoubtedly tragic, history suggests there is reason for hope for investors in the sector.

Large versus medium and small

According to Numis, the broker, performance of its Smaller Companies Index in March was the fourth worst individual month in the 65 years that the widely-tracked index has been calculated. Many businesses that make up the index operate and sell mainly in the UK.

Goldman Sachs, the investment bank, estimate that only a quarter of sales by companies in the large capitalisation (large cap) FTSE 100 Index are to the UK. Around half of the sales of the members of the FTSE 250 index, the mid cap index, are to domestic customers.

In the first quarter of the year, the FTSE 100 fell around 10% less than the FTSE 250 index. Most actively managed UK equity funds invest a considerable amount of total assets in medium and small sized companies’ shares, attracted by the greater potential for growth they may offer. Whilst owning smaller companies turned out to be the wrong decision at the beginning of 2020, it has historically been a good choice. Although past performance is not a guide to future performance.

In the 20 years to the start of May 2020, and before dividends are reinvested, medium-sized companies have outperformed both smaller and larger company shares. £100 invested in the FTSE 250 index at the end of April 2000 would be worth about £250. The same amount invested in smaller companies (FTSE Small Cap Price Return Index) would be worth around £150, but only £92 if invested only in the FTSE 100 index, based on FTSE data (Figure 1). This is the reason why UK equity funds typically have a bias towards holding small and medium sized companies

Past performance is not a reliable guide to future performance.

Montanaro, a fund manager that specialises in investing in medium and smaller sized companies, has calculated that in rising or ‘bull’ markets, smaller companies have outperformed larger companies by around 8% per year. The manager also thinks that smaller sized companies are currently cheap, based on the approach to company valuations developed by the US academic, Robert Shiller. When valuations of smaller companies have been this low in the past, they suggest that the valuations will rise by an average of fifteen percent per year for the next five years though as this is based on past performance of investments, it is not a reliable guide to their future performance.

The future

But what about looking to the future? Smaller companies have a number of attractive features. They are often regarded as the large companies of tomorrow. Identifying them early in their life can be a very profitable investment.

Many operate in niche or growing sectors. Merian, another smaller companies manager, believes that the growth of online shopping will be accelerated by this crisis, and have bought clothing retailer ASOS and continue to own ‘fast fashion’ business Boohoo in their medium and smaller companies funds, for example.

Given the risks, owning company shares, and particularly those of smaller companies should only be done by those with the willingness and ability to own them for the long term. Even though we would argue that smaller companies appear good value at the moment, we would always advocate that time spent ‘in’ the market is always more important to successful investing than trying to ‘time’ the market.

Conclusion

All predictions of future fund and market returns based on historic performance alone should be taken with a degree of caution. An index also does not include the cost of management fees on returns. And there is great uncertainty about how deep and how long, the economic effects coronavirus will have on UK businesses and share prices. But even with that in mind, there appears to be a strong case for investing in the sector by investors with the appropriate time horizon and tolerance for risk.

Smart Investor offers a wide range of funds, and our Barclays Funds List may help you to narrow down the wide range available to invest in. These funds are selected by Barclays investment specialists and, based on our research, they’re the funds that have built solid reputations and established sound investment processes.

Funds are designed for the long term so you should only consider them if you can stay invested for at least five years.