Most investors will be familiar with the UK’s largest companies which are listed in the FTSE 100 index, such as AstraZeneca, BT and Unilever. While many of these businesses are highly successful, investors may be surprised to learn that they do not tend to produce the best returns. “Historically, you would have earned significantly higher long-term returns by backing medium and smaller sized businesses”, point out the managers of The Mercantile Investment Trust.
“Medium and smaller sized businesses”, explain the managers, “tend to be faster growing than their larger counterparts and many have the potential to go on and become the market leaders of tomorrow”. By identifying such companies before they reach their full potential, investors can benefit from their superior growth prospects. And because they are less well-researched than larger companies, managers such as Mercantile’s Guy Anderson and Anthony Lynch, who do their own rigorous research, are in a strong position to buy them on attractive valuations.
There are several reasons why medium and small companies can have an advantage over larger firms. Firstly, they tend to have nimbler business models and can show greater agility when adapting to change. Among Mercantile’s current holdings, two companies which illustrate this point are WH Smith and Electrocomponents.
WH Smith has shown its flexibility by being able to operate effectively in a wide variety of settings, not just on the high street, but also in travel locations and hospitals. The firm adapts its offering to ensure it has the right mix of products in the right locations in order to maximise sales efficiency and profit margins, providing not only its traditional mix of newspapers, books and stationery, but also food-to-go and electrical accessories where appropriate.
Electrocomponents is another company which has shown its ability to adapt. An industrial and electronics distributor, it has been around since 1937, but it is currently going from strength to strength having improved its customer service, online experience and sales effectiveness, leading to increased market share. The business has also been conducting value-accretive acquisitions and benefiting from resulting sales and cost synergies.
Large companies can get stuck in their ways, doing the conventional things that they have always done and failing to spot new business opportunities or areas they are threatened. This leaves the field open for medium and smaller companies to step in as innovators and disruptors. Two of Mercantile’s holdings that fall into this category are Softcat and Team17.
Softcat is a provider of IT infrastructure to corporate and public sectors. It is involved in the digitalisation of businesses, a pre-existing trend that has been accelerated by the Covid 19 pandemic. Its sales culture and incentivised staff have been critical in allowing the business to achieve strong, consistent organic growth and market share gains.
Video games have now become the norm, but developer and publisher Team17 has a differentiated business model. As well as having its own in-house games, it partners with independent developers globally and helps them publish their products in return for royalties, delivering attractive economics through this platform.
Another advantage of smaller companies over larger, well-established businesses, is that they are more able to spot rapidly growing markets and exploit them. Two firms within Mercantile’s portfolio that have been doing this are Countryside Properties and Pets at Home.
Countryside Properties, for example, is benefitting from its fast growing ‘partnerships’ business which delivers homes in partnership with local authorities and housing associations. This model is more agile and delivers stronger returns than traditional housebuilding. Meanwhile, Pets at Home, the pet food, accessories, and vet business has been benefitting from the step change in spending on pets through the pandemic.
The aim of Mercantile’s managers when researching and deciding which medium and small companies to invest in is to find those with the potential to become the market leaders of tomorrow. Among the portfolio’s current holdings, two businesses which they believe have a strong chance of reaching the top league are Jet2 and Dunelm.
Airline and package holiday business Jet2 already has a strong market position, which has been strengthened by the pandemic as competitors have struggled and, in some cases, exited the market. It is now seen as being in a good position to take advantage of the recovery in leisure travel. Dunelm is also a market leader, to some extent, as it is the largest player in the UK homewares category, but with its strong product offering and multi-channel proposition, the managers believe it will be able to continue expanding its market share.
So with all these advantages, what happens when a previously medium or small company grows to a size which means it is promoted into the FTSE 100? If Mercantile’s managers believe there is scope for further growth, the businesses are not automatically sold. Two long-standing investments within the portfolio which have reached this stage are Spirax-Sarco, a specialist engineering business, and AVEVA which provides software for industrial automation.
Medium and smaller companies benefit from many structural advantages over their larger counterparts. The benefit to investors from allocating their capital to more nimble, innovative and faster-growing business in the mid and small-cap space is demonstrable in that this has historically translated into higher long-term returns. The Mercantile Investment Trust’s managers are committed to selecting those businesses within this market segment that have the greatest potential to blossom into tomorrow’s market leaders.