‘Can we dare to wish for a third good year for smaller companies?’ asked Paul Marsh, emeritus professor of finance at the London Business School.
Marsh and fellow emeritus professor Elroy Dimson (pictured) produce the Numis Smaller Companies index (NSCI), which captures the smallest 10% of the UK equity market.
The index enjoyed a strong 2012, when it returned 25.7% compared with 12.3% from the FTSE All Share index. But last year was even better.
In 2013, the NSCI offered a total return of 31.7% versus the FTSE All Share’s 20.8%. It was also on top in each quarter of the year, with no negative quarters.
The question is whether that run can continue, or whether 2014 will look more like 2011 when the NSCI lost 8.8% while the FTSE All Share slipped by only 3.5%.
Historically the odds are good. ‘This is a consistent story,’ said Dimson of small caps’ outperformance.
The NSCI has now beaten the FTSE All Share by an annualised 3.5% since the professors’ database began in 1955.
The margin of superiority is similar over the past decade, at 3.7% per year. Moreover, Dimson noted of the recent record, ‘this is a period that has not been special for Britain’ when small caps could have been flattered by favourable domestic economics.
Yet, as Dimson is aware, ‘There are no guarantees over a 12-month period.’ So what are the more forward-looking omens?
The preferred tool for Marsh and Dimson is dividend yield. They eschew the more conventional cyclically adjusted price-to-earnings ratio due to the lack of reliable earnings figures before the 1980s.
For what it’s what worth, though, the NSCI entered the year trading on an earnings multiple of 19.5x, making it more expensive than the FTSE All Share on 16.3x.
In getting to these numbers, Marsh and Dimson exclude loss-making constituents, as Marsh argues that ‘you get some very silly answers’ if you try to incorporate them.
On their favoured measure, Marsh and Dimson are not overwhelmingly optimistic about 2014. At the start of January, the NSCI had a dividend yield of 2.3%, less than the FTSE All Share’s 3.3%.
Looking through their database on a straightforward single-year basis, Marsh and Dimson find a positive but weak correlation between a high starting yield and higher returns over the following year. They calculate that 12% of above-average returns could be attributed to an elevated initial yield.
The relationship is firmer over longer periods, however. Plotting cyclically adjusted five-year real yields against the following five years’ real return, Marsh and Dimson reported that 45% of better than average returns could be explained by a high starting yield.
The reason, they believe, is that high yields equate to low share prices; what the technique effectively indicates is that excess returns are likely to follow depressed markets.
So given the relatively low yield available at the moment, the duo concludes: ‘It is reasonable to expect small and mid cap investing to provide more modest rewards than they did in the past.’
Yet they add that the same is likely to be true of large caps as well, despite observing that the FTSE 100 has still to regain its peak of 6,930 in 1999 while smaller cap indices have already passed their record levels.
Marsh nonetheless emphasises that none of this should be taken to mean small caps are primed for a crash in 2014. ‘Don’t write off a third good year. That is perfectly plausible.’
The AIM conundrum
While 2013 was a good year for small caps in general, it was another in which AIM lagged. The FTSE AIM All Share returned 21.3%, fine in absolute terms but ‘disappointingly close’ to the FTSE All Share’s performance, according to Marsh and Dimson, and far below of that of the NSCI.
Since AIM’s launch in 1995 it has now lost 11%, or 0.7% per annum; the NSCI has returned 350%, or an annualised 9.4%.
This prolonged slump has traditionally been ascribed to AIM’s preponderance of resource stocks, which account for 34% of that index compared with 7.3% of the NSCI excluding investment trusts. This is borne out by 2013, when an index of AIM’s resource constituents lost 16.4% and the non-resource AIM index returned 39.6%.
Yet this year, Marsh and Dimson also considered a different explanation for AIM’s underperformance: that it suffers from losing its stars as they move to a main listing.
This proved not to be the case. Of the 104 AIM companies promoted since 1999, 12 more than doubled in value (of which four at least quintupled), 15 rose by between 50% and 100%, and 16 delivered returns that were positive but of less than 50%.
Those 43 were offset by the losers, however: 15 fell by up to 50%, 19 by between 50% and 90%, 14 by 90-99.9%, and 13 became valueless. In total, including the AIM alumni would have knocked 15% off the index’s returns through its life.
‘This exercise was slightly discouraging. We rather hoped it might improve the picture,’ Marsh admitted. ‘Small cap managers who complain about losing their star investments are not supported by the evidence.’
The rationale would be that size and value is a sounder investment basis than momentum.
As to AIM’s future, the professors supposed that its key attraction now is the sector differentiation it offers.