I thought I’d take the opportunity to do a bit of joined-up thinking, and to look at the tinier end of the size spectrum. Now you might be thinking I should instead tackle the tumult in the markets. “It’s all very well you waxing lyrical about small cap shares, Owain ? but with the FTSE 100 blowing up in front of our eyes, I can’t afford to go fishing for dangerous micro-companies at a time like this.” Many readers may be feeling the market turbulence quite sharply. But what I’m about to say might keep us…
I thought I’d take the opportunity to do a bit of joined-up thinking, and to look at the tinier end of the size spectrum.
Now you might be thinking I should instead tackle the tumult in the markets.
“It’s all very well you waxing lyrical about small cap shares, Owain – but with the FTSE 100 blowing up in front of our eyes, I can’t afford to go fishing for dangerous micro-companies at a time like this.”
Many readers may be feeling the market turbulence quite sharply.
But what I’m about to say might keep us all happy.
No pain, no gain
I’m making light of the market falls but I realise that for many investors, particularly newcomers, seeing your hard-earned savings evaporate day after day can be disconcerting.
However, once you’ve been around the block a few times, you know this is what shares do. They go up and they go down. You have to deal with it if you’re going to stay invested, so you might as well grin and bear it.
The main reason to grin is that over the past 100 years or so, UK shares have gone up much more overall than they’ve gone down, all told, delivering inflation-adjusted returns of about 5% annualised.
That’s much better than the less than 1% you’d have got from cash, which is why we’re all doing what we’re doing with this stock market investing lark.
However, shares do go down, too, and when they do it can feel rotten.
What’s more, they don’t always bounce back a year or two later. Sometimes the declines drag on for years.
The FTSE 100 index is still lower in price terms than it was at the turn of the Century.
Yet such falls – and the emotional difficulty they bring – is exactly why shares deliver a superior return over time.
If the market’s gyrations were easy for everyone to handle, then everybody would choose shares over cash.
Share prices would then rise across the board, and most of the superior long-term return premium we expect for buying stocks instead of sticking with a high-street savings account would be quickly whittled away.
But many people can’t take the market’s mood swings.
And that provides our opportunity.
Which brings me to small-cap shares.
Many investors I meet – whether on our discussion boards or in the flesh – believe smaller companies are very risky.
And they’re not wrong.
The American economist Eugene Fama long ago showed that, as a group, small-cap shares are more volatile than larger companies in aggregate.
And in the language of economics, volatility is synonymous with risk.
But here’s the kicker. Smaller companies have also delivered superior returns.
Now to Eugene Fama – who won a Nobel Prize in 2013 for his work on efficient markets – this is no accident.
Just as I explained how investors in shares expect higher returns to compensate them for having to put up with the hassle of the stock market crashing every once in a while, so we investors in smaller companies demand even higher returns for the even greater swings that they in turn can bring.
Note that when economists talk about investors ‘demanding’ higher returns, they don’t mean you phoning up your stockbroker to give him an earful when your smaller-company shares fail to go up as much as you’d like.
They simply mean that if smaller companies didn’t offer higher expected returns as well as higher risk, nobody would buy them. We would all just buy the less volatile, larger companies instead — and no doubt sleep better at night.
So, demand higher returns from smaller companies we do, and over the long term we’ve got them.
In the UK, for example, the Numis Smaller Companies Index achieved a compounded annual return of 15.3% between 1955 and 2015.
That compares with an 11.9% annualised return from the FTSE All-Share over the same period. (Note that these figures are not adjusted for inflation, which compounded at 7.7% annualised over the time frame.)
That difference between the annual return from the small cap index and the FTSE All-Share is 3.4% – and 3.4% a year is huge.
What’s that you say?
“3.4% doesn’t sound very big to me.”
3.4% might not seem much – until we put it into a compound interest calculator and set the dial to 60 years.
- We’ll find that a £100 theoretically invested in the Numis Smaller Companies Index in 1955 would have grown to £494,600 by 2015.
- In contrast, the same investment in the FTSE All-Share would have turned £100 into merely £82,100.
That’s a six-fold difference!
Still think smaller companies are best avoided?
(Don’t worry – I know your answer.)
Of course, anyone interested in investing will have heard horror stories about smaller companies that turned out to be basket cases.
Indeed, the last couple of years saw a stream of small companies exposed as over-indebted, under-managed – or worst of all, frauds.
Even then, by their nature smaller companies will always be more vulnerable to economic shocks, so it’s crucial to diversify your portfolio.
But given that we’re choosing to invest in shares for the expectation of seeing superior gains, isn’t it worth re-considering whether you want to turn your back on a region of the market that has historically delivered the highest rewards?
Oh, and that has done the business for short-term investors too…
You see, last year the FTSE 100 index was essentially flat.
In contrast, the FTSE SmallCap Index rose about 7%.
And 2016, which has already proved so testing for our portfolios?
The FTSE SmallCap index is down, true, but at the time of writing the FTSE 100 has fallen further and faster.
Now this year isn’t a fortnight old, and I wouldn’t make too much out of 2015’s outperformance, either. Such timeframes are mere blips if you’re investing for 20 to 30 years for your retirement.
But the recent record does at least highlight that even during a period of increased uncertainty, the shares of smaller companies are not automatically hit harder than those of larger companies.
Will this short-term trend continue?
I have no idea.
But as a long-term investor putting money away now to hopefully provide for my retirement, I want to maximise my annual returns while time is still on my side.
And for me, both logic and the historical record means allocating some of my portfolio to smaller companies is a no-brainer.
Yes, we're in it for the long haul here at the Motley Fool, and we focus on investing in great businesses for years rather than months. It's over that kind of time horizon that we can make sensible judgments on how a business is likely to perform, and whether the price is right.
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