Smaller cap companies get a lot of attention when the economy appears to be improving because historically, their profits – and stock prices – tend to be more tied to the business cycle. But this short-term view misses some of the greatest benefits of investing in mid- and small-cap stocks over the long term.
In fact, the long-term returns of UK mid- and small-cap companies are among the best in the world – outpacing the FTSE 100, the MSCI Emerging Market index and even the S&P 500 over the last 25 years. Let’s take a closer look at the drivers of that performance.
Note: Past performance is not a reliable indicator of current and future results.
Growth is not unique to mid- and small-cap companies, but many of them are growing at a faster rate than large-cap companies, often because they are at an earlier stage of development. For example, many mid- and small-cap companies are built around an innovative or disruptive idea, product, service or solution that allows the company ample room to grow its customer base, revenues and ultimately earnings.
One of the benefits of being an active mid- and small-cap investment manager is the opportunity to invest in some of the newest and fastest-growing companies by investing at their initial public offering (IPO). The research and due diligence process before investing is intense, but the rewards can be great. Investing in a company at a such an early stage means the potential to share in a sharp growth trajectory.
Dynamic and domestic
Mid- and small-cap companies tend to have favorable combination of higher exposure to growth compared to their large-cap peers and less exposure to some of the structural and logistical challenges that larger companies face. For example, a smaller company that wants to launch a product, sell into a new market or hire a senior executive might be able to execute quickly on any of these initiatives after a few key decision-makers agree on a plan. Larger companies may have numerous layers of management, competing products or markets to consider or a long and formal hiring process. This operational flexibility and nimbleness can be a key competitive advantage for smaller companies facing larger rivals that are well-financed and established.
Large company structures are often more complicated due to international operations – from regional offices to international clients and supply chains. Smaller companies tend to derive a much greater portion of their revenues domestically, in addition to having less international operational exposure. This is particularly true in the UK, where over half of mid- and small-cap company revenues are domestic, compared to just 23% for FTSE 100 companies. In fact, for The Mercantile Investment Trust, a UK investment trust that seeks to achieve capital growth by investing in a diversified portfolio mid- and small-cap UK companies, that number is 57%.
Taking advantage of turbulence
Just as passengers feel turbulence more in a small plane than in a jumbo jet, investors in mid- and small-cap stocks may experience a little more volatility than in large-cap equity markets. Not only is the volatility okay, it can actually be helpful for active managers.
Greater potential for surprises – positive and negative – is a key factor contributing to volatility. Smaller companies, on average, are more likely to see their profits and stock prices fluctuate with the business cycle or the impact of an event, such as a management change, merger or scandal; larger companies have a greater ability to smooth their earnings and absorb shocks. Further contributing to the potential for surprises is the fact that mid- and small-cap stocks are far less researched: FTSE 100 companies are covered by an average of 18 analysts versus 10 for FTSE 250 companies. These conditions actually create opportunities for active managers who do their own research, such as The Mercantile Investment Trust, to invest in companies they believe will be the next long-term winners – and avoid those they think will be the losers. Both sides of the equation contribute to generating positive returns.
Liquidity can also be a factor in increased volatility. While the UK mid- and small-cap markets are generally considered liquid, trading volumes can still be well below those of large-cap stocks. That means in times of market exuberance or stress, smaller-cap stock prices may swing in a wider range than large caps. Particularly in down markets, The Mercantile Investment Trust’s long-term investment horizon and its closed-end structure are important advantages because the portfolio is not forced to sell holdings at lower prices to meet redemptions. That gives the portfolio managers a better chance to preserve capital and minimise volatility for investors.
Mid- and small-cap UK stocks have generated among the best long-term returns over the past 25 years. With the drivers of these returns still in place, we believe mid- and small-cap companies will continue to be engines of growth and returns for active UK investors, and The Mercantile Investment Trust will remain the home of tomorrow’s UK market leaders.