It is then perhaps interesting that attention is turning towards smaller opportunities. Miton Group, the established asset management group, have shared their thoughts on smallness.
How the credit boom boosted market returns
During the credit boom, the increasing availability of debt and progressively lower interest rates together boosted the rate of economic expansion. Returns on assets often delivered returns well above inflation during these decades.
In fact, the boom decades were marked by a combination of both extra economic growth and a general rise in corporate profit margins. Together these factors have often combined to generate some relatively rapid earnings growth.
In tandem, globalisation also boosted the availability of low cost goods in western markets. This tide of cheap imports imported deflationary pressures which more than offset the inflationary pressures from the extra economic growth. The result was that long-term interest rates have progressively fallen over the last three decades boosting the valuations of nearly all assets above longer term norms.
Overall, it was a combination of the unusually rapid earnings growth during the boom, enhanced by a general rise in equity valuations, that has led to equity returns regularly exceeding the rate of inflation for an extended period.
Institutional interest in the smallest stocks
During the boom years, growth was plentiful. This was good news for both large and small companies. It was also good for local businesses as well as international companies.
With the equity markets performing well, attractive returns became commonplace. Overall the massive gains made on the vast sums held in larger company portfolios during the boom have naturally greatly exceeded those made on the more limited sums invested in the smallest companies. During this period institutional investors also came to love the fact that large cap portfolios were well aligned with benchmark indices, along with their easy liquidity which facilitated quick portfolio changes at will.
The logic looked compelling. Most asset allocators have progressively reduced their weightings in the smallest quoted stocks over recent decades. In truth, a whole generation of asset allocators have learned to overlook the potential advantages of holding weightings in the very smallest stocks over recent decades.
The disappearance of the small cap exchanges
In general, politicians favour smaller companies as they tend to generate most of the new private employment in an economy. Indeed when they perform well, smaller companies tend to disproportionally boost the local economy in contrast to multi-nationals which tend to have operations on a more international basis. Finally, many smaller companies are not sophisticated when it comes to taxation and they tend to pay local taxes, rather than set up remote financial structures to minimise tax.
Therefore politicians like to find ways to enhance the availability of risk capital for smaller companies, including smaller quoted companies. A well-established way to do this is to encourage a new stock exchange to be established especially focused on supplying extra risk capital for smaller quoted companies. Over the last 20 years several exchanges dedicated to smallness have been set up across Europe. For example, EASDAQ was set up in Europe to mimic the success of NASDAQ, (as it used to be the leading smaller companies market in the world in the 1970’s).
However, with institutional weightings in smaller quoted companies progressively falling away over recent decades, these new exchanges have tended to become unviable. Indeed over the years, nearly all of the European small cap exchanges have closed down, whilst NASDAQ in the US has morphed away from a microcap exchange into a mega cap technology market.
And yet the AIM market remains
One of the only European exchanges dedicated to smallness that has survived in this period has been AIM (the Alternative Investment Market). In terms of stock market listings the UK has always had a heritage of smallness.
During the credit boom years the UK Government sustained an interest in smallness through tax incentives such as the EIS and VCT schemes and by waiving Inheritance Tax liability on most AIM holdings. All these factors helped sustain a modest allocation of risk capital for the smallest quoted companies even though institutional interest continued to fall away. It is for this reason that the AIM exchange has survived when others have not.
The advantage to current investors is that the UK still has a multitude of smaller quoted companies available for investment, whereas most other international exchanges do not. Specifically, there are greater opportunities to add value through stock selection in these stocks given that there are very few professional investors that cover the smallest quoted companies.
Such holdings not only have greater upside potential, but also they tend to offer a degree of diversification from the mainstream stocks too.
Any views and opinions expressed by Miton Group do not represent those of TD Direct Investing.
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