Why Do Smaller Companies Outperform?

The FTSE 100 is, by definition, only 100 companies. Small and mid-cap stocks offer a broader range of opportunities and chances for profit

Holly Cook 9 December, 2013 | 10:50AM
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Holly Cook: Welcome to the Morningstar series, ‘Why Should I Invest With You?’. Joining me today is Roland Arnold. He is co-manager of the BlackRock UK Special Situations Fund.

Roland, thanks for joining me.

Roland Arnold: Thank you for having me, Holly.

Cook: So, BlackRock UK Special Situations is rated Gold by Morningstar’s analysts. It’s not only performed extremely well over the last three, five years versus peers, but that Gold rating means we think it’s going to continue to do well going forwards. In a nutshell, what is it that you’re doing right?

Arnold: The core principle of the fund is that we believe that performance comes from investing in small and mid-cap companies rather than necessary large-cap companies. So to that end, there’s always a minimum of 50% of the fund within the small and mid-cap universe. Actually if you look back over time historically, we have data series going back to 1955 that show that actually over that period you’ve had seven times as much money investing in small and mid-cap, which you would have done investing in large-cap.

We think there are number of reasons why small/mid-cap companies tend to perform better over the longer term. I mean, first and foremost, because they’re smaller, they can grow more quickly, just the law of large numbers; adding a cusp when you’ve got 10 is more powerful than a cusp what you’ve got 1,000. Especially the bigger thing is management and the ability of management to these businesses. If you’re a large-cap company, there’s an awful lot of inertia in terms of the business model, new businesses, new products, new services. It’s very difficult to have those making a change in the big companies; with a small company they can do.

So we believe going forward that those principles are exactly the same and we’ll continue to run through the small-cap investments.

Cook: So let’s talk a bit about where you actually see the opportunities at the moment. I mean, you’re talking about the market cap there. I know that some of the biggest holdings are large-cap stocks, but as you’re saying, you’re focusing really on the mid and small-caps. So is it small-caps, mid-caps, large-caps, where do you think the U.K. investor has the best opportunity at the moment?

Arnold: We’ll always say that small and mid-cap investing is where you’re going to find the best opportunities. I mean, firstly, because they’re such a broad variety of companies. So the FTSE 100 is, by definition, only 100 companies. When you look at small and mid-cap, there’s an awful lot more companies to look at and awful lot opportunities.

The second thing is actually in terms of the scale that these businesses can get to and the kind of opportunities you can see, whilst in short term sometimes small and mid-cap looks expensive on a straight valuation basis, the ability for these companies to grow their earnings in excess of market expectations for a long period of time exist in a way that perhaps it doesn’t do with the FTSE 100 companies.

So right now we’re looking at areas like industrial CapEx and corporate CapEx, which has been weak for a number of years. But we see with the amounts of cash on corporate balance sheets that some of that should at some point start coming back as companies get more confident for the future. We’re also looking at consumer stories where there is a very strong supply side dynamic to those stories. So rather than just relying on increased consumer demand and consumer spending more in existing store base, actually they’re taking share of other players, taking market share by investing in products or technology or investing in new services, which means actually more returns or more shoppers want to come into those stores.

Cook: You’re investing solely in the U.K. So for our viewers, which kind of sectors perhaps are you seeing most opportunity? You mentioned industrials for example.

Arnold: I suppose there are two things to say it. Whilst we invest solely in U.K. companies, actually the international base of U.K. companies, so the international earnings base we’re exposed to very wide. So the FTSE 350, only roughly a quarter of the revenue comes from the U.K. The companies we look for those very much exclude the consumer stocks, which clearly will be domestic. But generally the companies we look for are very much those with international exposures, exposed to both the emerging markets and the developed world, because that why you get to pay the balance when growth expectation shift internationally.

What’s most important is whether these companies are market leaders or not and whether they can capitalize on that growth and that market exposure that they have. In terms of sectors, I say we are very much over-weighted in the industrial sectors at the moment. That remains the largest over-weight at the fund and has been for some time. But the consumer over-weight is now an important part of the exposure as well.

Cook: Great. Well, it’s very interesting to get your views on the U.K. market. Thanks for joining me, Roland.

Arnold: Thank you for having me.

Cook: For Morningstar, I’m Holly Cook. Thanks for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Holly Cook

Holly Cook  is Manager, Morningstar EMEA Websites