Key insights
- Despite the recent stock market dominance of big US tech companies, high-quality smaller company stocks have a longer-term record of outperforming[1]
- The Global Smaller Companies Trust focuses on high-quality companies and has a record of outperformance over the past 25 years[1]
- With interest rates around the world beginning to fall, at the time of writing, the stage may be set for a revival of these stocks
In a stock market that’s recently been dominated by the US tech giants pioneering artificial intelligence, it’s easy to forget the attributes of smaller companies with strong businesses.
Yet viewed over the longer term, smaller companies have performed strongly. In fact, high-quality smaller companies stocks have outperformed other parts of the stock market over the decades due to the dynamism that’s only possible for a small business.[2]
Just as with all types of investment, though, smaller companies go out of favour for shorter periods when interest rates are high due to their economic sensitivity. The recent past has been one of those times, with smaller companies’ stock prices tending to lag their larger peers.
But when central banks start cutting interest rates, smaller company stocks tend to burst into life, reviving their longer-term records of outperformance. “Smaller companies have a track record of outperforming, particularly after the first interest rate cut and as the economy recovers[3],” confirms Nish Patel, The Global Smaller Companies Trust’s lead fund manager.
Refining the ‘small-cap effect’
Research into the longer term outperformance of smaller companies – known as the ‘small-cap effect’ – was first carried out at the University of Chicago in the 1980s and 1990s. Rolf Banz, one of Switzerland’s best-known investors, originally documented the effect in his MBA and PhD dissertation “The longer your time horizon, the more attractive risky assets such as small-cap get” in 1981.
More recently, though, further evidence has come to light and academia has refined these findings. Notably, research by US hedge fund, AQR Capital Management, concludes that only high quality smaller companies have truly achieved longer-term outperformance.[4]
Certainly, The Smaller Companies Trust, with its focus on good quality stocks, would confirm the research findings. Its net asset value has risen 859.8% over the past 25 years. That compares with a gain of 717.59% in its benchmark index, a blend of the MSCI AC World Smaller Cap Index and the Numis UK Smaller Companies Index.[5]
What does quality mean? The trust describes quality as having several characteristics, including: distinctive competitive advantages, robust free cashflow, pricing power, scale, operating within a favourable industry structure and, lastly, financial strength.
The Global Smaller Companies Trust 5 year discrete annual performance as at 30.06.24 (%)
2019/2020 | 2020/2021 | 2021/2022 | 2022/2023 | 2023/2024 | |
|---|---|---|---|---|---|
Nav (debt at market value) | -7.63 | 38.68 | -10.36 | 6.13 | 9.41 |
Share price | -12.58 | 39.96 | -11.18 | -0.43 | 18.11 |
Benchmark | -5.75 | 41.74 | -12.25 | 8.11 | 12.45 |
Looking forward to rate cuts
For context, though, the past few years when inflation spiked and interest rates rose have been testing for smaller company stocks. Over the past five years the MSCI World Small Cap Index has delivered an average annual return of 9.00%,[6] trailing the MSCI ACWI IMI Index’s 11.86%.
So, what happens now? In mid-2024, central banks have just begun to cut rates, which may herald a better environment for smaller companies. The European and Canadian central banks reduced their main lending rates in June, with the US and UK expected to follow later in the year.
Fund manager Nish believes the future looks bright. “We’re excited to think one thing potentially on the horizon is the first US interest rate cut,” he explains. “The consensus seems to be that will happen later in 2024, although expectations change daily. In the first 12 months after the first cut, smaller companies have historically outperformed larger ones by 10%.”
Of course, there can be no guarantees. But the longer-term magic of high-quality smaller company stocks looks established and ready for a renaissance.
[1] Source: Columbia Threadneedle Investments as at 31 May 2024. Source: Jefferies. JP Morgan
[2] Source: Source: Size matters, if you control junk. Fama-Miller Working paper. 16 April 2015.
[3] JP Morgan Securities 31 May 2024
[4] Small can be beautiful but quality is key. Financial Times, January 26, 2015. Size matters, if you control junk. Fama-Miller Working paper. 16 April 2015.
[5] The benchmark is: 20% Numis UK Smaller Companies (excluding investment companies) Index/80% MSCI AC World ex UK Small Cap Index. Data to 30 April, 2024.
[6] To May 31, 2024.
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