Columbia Threadneedle: The Lure of Small Business
Small businesses offer a range of attractions as an investment that can increase a portfolio’s performance drivers and should therefore be considered as a separate asset class.
Repeated studies of long-term returns have shown that smaller companies outperform large company indices around the world. But it is crucial to understand the reason for these additional gains.
A key factor is risk; stocks of smaller companies have higher risk and higher potential returns. However, there are also many other components that make small businesses an attractive investment that can boost portfolio performance.
Small cap performance factors
The great appeal of small businesses is that they offer exposure to entrepreneurial innovation, both in terms of management teams developing new products and services and seeking out niche markets and opportunities, but also in terms of scope for fund management teams conducting their own research. to identify investment opportunities.
Repeated studies of long-term returns have shown that small companies outperform large company indices around the world
There are also a number of macroeconomic factors that connect, but also differentiate, small businesses from broader stock markets, which help explain why small businesses are temporarily out of favor.
Opportunities in small caps
Small businesses are not just miniature versions of large businesses, they can operate with different business models and in entirely separate niche markets. The range of opportunities is not only deeper but broader. The MSCI World Small Cap Index has 4,493 stocks in 23 countries.
This represents about three-quarters of all companies covered by MSCI equity indices and includes companies with market capitalizations of $10 billion and above. The index is not dominated by a handful of well-known and intensively researched mega-cap stocks.
This wide range of businesses to choose from and the potential for small businesses to expand into niche markets, exploiting growth opportunities that are simply not available to larger businesses, point to the opportunity for management activates investments.
The range of opportunities is not only deeper but wider
This is also an area of the equity market where publicly available research is scarce. There are obvious opportunities for investment management teams who spend time understanding individual companies and their markets, meeting with company management teams, and performing the analysis to identify opportunities overlooked by most investors.
Macro risks – economic sensitivity
It should be kept in mind that small scale has its downsides, for example small businesses lack the resources and options of large businesses and are therefore more vulnerable to setbacks.
Overall, small businesses tended to focus on the domestic economy and therefore more vulnerable to economic prospects.
However, this misses the greater diversity of small businesses and their activity in distinct niche markets.
For example, many UK retail businesses operated under “permanent recession” conditions in the troubled “High Street” market, but this did not affect the success of Greggs, operating in the same environment.
Data from the 1970s demonstrates that small businesses can outperform in times of high inflation, although it would be prudent to draw general conclusions from the experience of 50 years ago, given that the composition of stock markets was very different from today.
Macro risks – liquidity
Although the economic outlook is not as important to the profitability of individual small businesses, it does have an indirect impact on their stock prices, as small businesses are more sensitive to general investor sentiment and market liquidity.
However, this means that stocks downgraded during an economic downturn offer attractive investment opportunities as sentiment improves.
Mergers and Acquisitions
The small business investment opportunity can also be realized through mergers and acquisitions (M&A) by the companies themselves. Mergers and acquisitions are an important part of dynamic small business growth, providing opportunities for both expansion and consolidation and providing exits for entrepreneurial management teams.
Although the economic outlook is not as important to the profitability of individual small businesses, it does have an indirect impact on their stock price.
Corporate balance sheets are well supplied with cash as interest rates were at historic lows. With a reduced need to hoard cash against future foreclosures, we would expect companies to look to invest and mergers and acquisitions to be a key driver for smaller businesses.
It’s time for small caps
There are strong arguments for longer-term investment in small businesses and now, with this sector of the market currently in disfavor, it is a good time to revisit the arguments.
Scott Spencer is an investment manager on the multi-manager team at Columbia Threadneedle Investments