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Great Things Come In Small Packages

By Alan Rowsell, Investment Director, Aberdeen Standard Investments

We all have to start somewhere. The business world is no different. Apple began in a garage; Virgin in a church crypt. These two firms are now household names. For investors, ‘smaller companies’ can offer the opportunity to gain access to tomorrow’s household names – today. That’s why we think you should consider an allocation to small-cap equities as part of your wider investment portfolio. The potential rewards for doing so are clear.

Punching above their weight

As an asset class, small-caps have generally outperformed larger peers across most timeframes and most geographies. And, while past performance is no guarantee of future results, many of the positive attributes of smaller companies remain in place.

For one thing, due to their starting size, smaller companies tend to grow much faster than their large-cap equivalents. Further, they can quickly adapt to new market trends and are often in the vanguard of industry disruption. Many have also embraced the internet, giving them a material advantage over better-resourced larger competitors. Take Just Eat. It has revolutionised the way we order food – leaving larger businesses playing catch-up. The company has been so successful that Dutch firm Takeaway.com agreed to buy Just Eat for £8.2 billion. Meanwhile, smaller companies also have growing economies of scale, creating a tailwind for earnings and profits

Doing your homework

Despite this, analyst coverage of small-caps can be poor. This is understandable. Around 70% of the world’s listed companies are small-caps. It therefore requires considerable resources to cover the sector. Information on many companies can be sparse. Due diligence is often time-consuming and costly. However, this lack of coverage means there is greater potential for mispricing to occur. A company’s share price can often soar once the market finally spots its worth. As such, small-caps represent a wealth of promising opportunities for active investors willing to do their homework.

Diversification benefits

Smaller companies also offer diversification benefits as part of a wider portfolio and can provide different sources of returns to larger caps. Small-caps tend to be more domestically focused than their bigger, international rivals. Investors can therefore gain direct access to expanding local economies or sectors. This local focus also means smaller companies are potentially less vulnerable (although not immune) to global trends and currency fluctuations.

Risky business?

Of course, there’s no ‘free lunch’ in investing. Higher returns come with higher risk – and small-caps are no different. Over time, the asset class has delivered more volatile returns than larger companies in most regions. Small-cap shares are often the first to fall when the economy turns. There is also a liquidity risk. Fewer investors hold an individual smaller company’s shares making them harder to sell in a market downturn. This can compound share price falls.

But successful investing requires a deep understanding of these risks and the potential rewards they offer. That is why we take an active approach to small-cap equity investing. Indeed, price volatility often creates opportunities. Share price drops allow alert, long-term investors to buy good companies at attractive valuations.

Final thoughts…

In our view, the case for investing in smaller companies is strong. The asset class has historically outperformed large-caps. The investment universe contains a wealth of exciting, fast-growing and innovative businesses. True, investors will have to tolerate a level of volatility. However, for those looking to diversify their portfolios and potentially achieve robust long-term returns, we believe small-caps represent a compelling investment opportunity.

Disclosures:

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

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