Are You Getting Your Share Of Smaller-Company Gains?

I thought Id take the opportunity to do a bit of joined-up thinking, and to look at the tinier end of the size spectrum.

Now you might be thinking I should instead tackle the tumult in the markets.

Its all very well you waxing lyrical about small cap shares, Owain but with the FTSE 100 blowing up in front of our eyes, I cant afford to go fishing for dangerous micro-companies at a time like this.

Many readers may be feeling the market turbulence quite sharply.

But what Im about to say might keep us all happy.

No pain, no gain

Im making light of the market falls but I realise that for many investors, particularly newcomers, seeing your hard-earned savings evaporate day after day can be disconcerting.

However, once youve been around the block a few times, you know this is what shares do. They go upand they go down. You have to deal with it if youre going to stay invested, so you might as well grin and bear it.

The main reason to grin is that over the past 100 years or so, UK shares have gone up much more overall than theyve gone down, all told, delivering inflation-adjusted returns of about 5% annualised.

Thats much better than the less than 1% youd have got from cash, which is why were all doing what were doing with this stock market investing lark.

However, shares do go down, too, and when they do it can feel rotten.

Whats more, they dont always bounce back a year or two later. Sometimes the declines drag on for years.

The FTSE 100 index is still lower in price terms than it was at the turn of the Century.

Yet such falls and the emotional difficulty they bring is exactly why shares deliver a superior return over time.

If the markets gyrations were easy for everyone to handle, then everybody would choose shares over cash.

Share prices would then rise across the board, and most of the superior long-term return premium we expect for buying stocks instead of sticking with a high-street savings account would be quickly whittled away.

But many people cant take the markets mood swings.

And that provides our opportunity.

Small victories

Which brings me to small-cap shares.

Many investors I meet whether on our discussion boards or in the flesh believe smaller companies are very risky.

And theyre not wrong.

The American economist Eugene Fama long agoshowed that, as a group, small-cap shares are more volatile than larger companies in aggregate.

And in the language of economics, volatility is synonymous with risk.

But heres the kicker. Smaller companies have also delivered superior returns.

Now to Eugene Fama who won a Nobel Prize in 2013 for his work on efficient marketsthis is no accident.

Just as I explained how investors in shares expect higher returns to compensate them for having to put up with the hassle of the stock market crashing every once in a while, so we investors in smaller companies demand even higher returns for the even greater swings that they in turn can bring.

Note that when economists talk about investors demanding higher returns, they dont mean you phoning up your stockbroker to give him an earful when your smaller-company shares fail to go up as much as youd like.

They simply mean that if smaller companies didnt offer higher expected returns as well as higher risk, nobody would buy them. We would all just buy the less volatile, larger companies instead and no doubt sleep better at night.

So, demand higher returns from smaller companies we do, and over the long term weve got them.

Big outperformance

In the UK, for example, the Numis Smaller Companies Index achieveda compounded annual return of 15.3% between 1955 and 2015.

That compares with an 11.9% annualised return from the FTSE All-Share over the same period. (Note that these figures are not adjusted for inflation, which compounded at 7.7% annualised over the time frame.)

That difference between the annual return from the small cap index and the FTSE All-Share is 3.4% and 3.4% a year is huge.

Whats that you say?

3.4% doesnt sound very big to me.

3.4% might not seem muchuntil we put it into a compound interest calculator and set the dial to 60 years.

• Well find that a 100 theoretically invested in the Numis Smaller Companies Index in 1955 would have grown to 494,600 by 2015.
• In contrast, the same investment in the FTSE All-Share would have turned 100 into merely 82,100.

Thats a six-fold difference!

Still think smaller companies are best avoided?

(Dont worry I know your answer.)

Dig deeper

Of course, anyone interested in investing will have heard horror stories about smaller companies that turned out to be basket cases.

Indeed, the last couple of years saw a stream of small companies exposed as over-indebted, under-managed or worst of all, frauds.

Even then, by their nature smaller companies will always be more vulnerable to economic shocks, so its crucial to diversify your portfolio.

But given that were choosing to invest in shares for the expectation of seeing superior gains, isnt it worth re-considering whether you want to turn your back on a region of the market that has historically delivered the highest rewards?

Oh, and that has done the business for short-term investors too

Small falls

You see, last year the FTSE 100 index was essentially flat.

In contrast, the FTSE SmallCap Index rose about 7%.

And 2016, which has already proved so testing for our portfolios?

The FTSE SmallCap index is down, true, but at the time of writing the FTSE 100 has fallen further and faster.

Now this year isnt a fortnight old, and I wouldnt make too much out of 2015s outperformance, either. Such timeframes are mere blips if youre investing for 20 to 30 years for your retirement.

But the recent record does at least highlight that even during a period of increased uncertainty, the shares of smaller companies are not automatically hit harder than those of larger companies.

Will this short-term trend continue?

I have no idea.

But as a long-term investor putting money away now to hopefully provide for my retirement, I want to maximise my annual returns while time is still on my side.

And for me, both logic and the historical record means allocating some of my portfolio to smaller companies is a no-brainer.