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Time to invest in smaller companies?

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

Smaller companies tend to particularly benefit from favourable economic conditions. We explore some of the reasons why.

Click to toggle accordion What you’ll learn:

Why strong economic growth is often linked to strong small cap performance.

Ways to gain exposure to smaller companies.

Why buying shares in individual small companies is a very risky approach.

The shares of the smallest companies listed on the stock market are often seen as higher risk than their large counterparts, but with potentially greater rewards for investors in pursuit of profit, as part of a diversified portfolio.

When looking back through history, there appear to be times when smaller companies, known as small caps because of their relatively small market capitalisation, have done well versus the wider market. And today, some commentators are speculating that the current global economic environment, with both a positive global economic backdrop and strong company fundamentals, warrants a look at this area of the market.

The case for smaller companies

Strong economic growth is often linked with strong small cap performance. While GDP growth is positive for shares in general, small caps particularly benefit from this economic environment.

Part of the reasoning behind this is that there is a stronger bias towards cyclical sectors in the small cap market. In the UK, for example, industrial companies - typically a cyclical sector that does well during periods of economic growth - make up 20% of the MSCI Small Cap Index, but only 8% of the large cap FTSE 100 index. According to latest data from the Office for National Statistics (ONS), 99.6% of the 2.6 million companies registered on the Inter Departmental Business Register employ fewer than 250 people each, with those companies employing 45% of the entire UK workforce.1

Smaller companies also potentially ‘benefit’ from protectionism. They generate more of their profits domestically than large-caps, with typical examples of companies within the small cap sector including retailers and housebuilders. As a result, they could perform more than large caps if governments were to adopt more protectionist trade policies, which would potentially hurt the larger companies, who rely more on exporting their goods and services.

Smaller companies are expected to grow their earnings at a faster rate than their larger counterparts, which should theoretically feed through in the companies’ share prices. Taking Europe as an example, recent research has concluded that the earnings of smaller companies will rise on average by 5.4% every year for the next 7 years.2 The same research concludes that earnings of large cap companies across Europe will not grow at all over this period. However, these are merely forecasts, and may not hold true. There are no guarantees that the earnings of smaller companies will rise, under any conditions.

Putting these factors together, it’s clear to see why some commentators are saying now is the time to look at small caps.

However, bear in mind that it’s important to remember that the value of any investment in smaller companies can go down as well as up. As with any investment, there up, and no matter how diversified a fund or investment portfolio may be, there is the risk of losing money, and the smaller companies sector by its very nature can be particularly risky, with these companies having greater chance of failure than their larger counterparts. If you’re unsure where to invest, consider seeking professional financial advice.

Ways to gain exposure to smaller companies

It’s possible to buy shares in an individual company, but this is a risky approach as it focuses on their specific product, market or service. This is especially the case with smaller companies, considering the higher risk nature of these companies. There may also be liquidity issues, with shares in smaller companies potentially being hard to sell if you want to cash in your investment, with fewer buyers during difficult economic periods.

These can be either active or passive investments. A passive investment product gives you direct exposure to the entire small cap market, enabling you to benefit from the total return from the asset class. Whereas an active manager will build a portfolio of companies that he/she believes are best positioned to benefit.

However, because the number of smaller companies is so great, compared to larger counterparts, an active manager will only be investing in a small selection, which means the various active funds can be quite different to each other. As such, there can be a wide disparity in the performance of small cap funds, making it that much more important to choose the right fund. Remember that past performance isn’t a guide to the future, however.

An example is the Old Mutual UK Smaller Companies Focus Fund. With just 74 holdings, the fund takes a concentrated approach to investing in UK small cap businesses. Other examples include Unicorn UK Income, and Fidelity UK Smaller Companies.

Alternatively, if you wish to gain passive exposure to the entire UK small cap market via an Exchange-Traded Fund (ETF), the iShares MSCI UK Small Cap UCITS ETF gives broad market exposure to all 274 companies in that index.

Learn more about how ETFs work

Please bear in mind that our mentioning these funds should not be considered a recommendation. If you’re unsure where to invest, consider seeking professional financial advice.

Remember that any all investments in smaller companies can fall as well as rise in value, so you may get back less than you invest but investments in smaller companies are subject to higher risk and you are therefore at greater risk of their failing.

Remember, the value of investments can fall as well as rise and you could get back less than you invest. We're not recommending Ready-made Investments as being suitable for you based on your personal circumstances. If you're unsure about this investment’s suitability for you, you should seek independent advice.

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