Fact: size matters. It does. Anyone who’s ever been to school – and in the IR industry that could well be the majority – knows the unspoken schoolyard truth: big is best. Since then, we’ve had to endure a legion of liars from parents to teachers to sex therapists spouting the myth that, in the real world, size is irrelevant. Well, it is a myth.
Because in the world of investment – as in most others – the big boys are the ones having all the fun. Large-cap companies are currently basking in the attention of analysts and fund managers while small caps sit around enviously, occasionally grumbling and weeping feebly into their microbrewed beer.
Large caps have outperformed small caps for half a decade now and, with the prevalent mindset of defensiveness so ingrained in the investment community, it’s a trend that looks set to continue. Indeed, a survey of 95 fund managers and analysts carried out by Cisco – that’s the UK-based small cap lobby group, not the US company featuring in this month’s cover story – confirms the pessimism among small caps about this continuing into the future. Two-thirds of the respondents to the survey said they thought the recent slide in the number of institutional investors prepared to invest in smaller quoted companies would go on.
The 1999 Reuters Survey of UK Smaller Companies, meanwhile, sought the views of both sides of the investment fence and unearthed an equally depressing picture for small caps – with delistings looking set to outnumber listings by the widest margin for ten years. ‘The unfortunate and emphatic conclusion is that the small cap sector appears to be locked into a downward spiral toward a black hole of less investment,’ the survey remarks.
Playing it safe
‘Overall, institutional investors tend to prefer large-cap companies because their stock is more liquid,’ says Martin Ferguson, portfolio manager and partner at Mawer Investment Management in Calgary, Canada. ‘Liquidity equals safety. When you can buy or sell without affecting the stock price, then you’ve got an easy way out. Small caps are too volatile. From a psychological point of view, that’s a much greater perceived risk.’
Too true. And it’s a risk that should not be underestimated – in the Cisco survey, undertaken earlier this year, nearly nine out of ten UK-based fund managers cited lack of liquidity as a major factor dissuading them from investing in small cap companies.
Worshipping the god of liquidity is fine and dandy if you’re planning to jump ship as an investor. But small caps want long-term investors. For them, the short-termist approach stinks. What happened to forward-thinking investment? What’s up with a bit of sticking power? ‘There has certainly been a tendency for fund managers to be more conscious of investment risks,’ considers Andrew Crossley, fund manager at Invesco UK. ‘Unfortunately for small companies, that has meant that managers are holding equity closer to the indexes. There hasn’t been a mass of money flowing into small caps.’
While the growth of index tracking as an investment strategy certainly does small caps no favors, there are many other reasons for them being out of favor. ‘We had a deflationary climate last year,’ explains Ferguson. ‘I’d say that is probably the biggest handicap for the small cap market – a risky environment like that does not help small companies which is why they’ve drifted below the market.’
Steve Liechti, UK small and mid-cap analyst at Merrill Lynch, agrees with this view as well as outlining another connected factor. ‘We’ve seen consolidation in the fund management industry. And when two institutions merge, they want to focus on liquid stocks. Unfortunately, shareholder consolidation means that there are fewer players in the market so liquidity falls even further.’
Flooding the market
At a more practical level, M&A in the investment community generates another problem for small caps. ‘After combining, the new institution has twice the number of separate investments,’ says Liechti. ‘That’s time-consuming. So they begin to focus their funds on fewer, larger stocks partly because that’s easier for them to manage. The result is that the smallest companies then find themselves falling beneath the radar range of the big players.’ Ferguson sums it up: ‘The way the larger institutions see it, they either buy ten small companies or one large one.’
You don’t need to be a mathematical genius to understand the simple market forces at play. And it’s bad enough for the number of consumers to decrease; but when the number of products is rising too, something’s got to give. Liechti certainly sees the proliferation of small quoted companies as inimical to the sector’s success. ‘Companies are too small and there are too many of them,’ he asserts. ‘There are so many IPOs and the result is that there’s no great differentiation between any of these companies. Of course, stockbrokers are talking them into it because they then get the fees.’
And sometimes it is that simple. We all know investors like to give their decisions some scientific air, producing reams of supporting facts and figures. But it’s not always so methodical. The plain fact is that large-cap companies enjoy an undeniable gravitational pull. ‘Institutions are drawn to large-cap companies partly because of the amount of coverage they receive,’ continues Ferguson. ‘Research into small companies is more scarce and that’s a significant disadvantage for them.’ Indeed, many of the small caps that feature in the latest Reuters survey lament the dearth of analysts covering them, noting that institutions just don’t invest without such coverage.
Standing out from the pack then is getting harder and harder. ‘Since Emu, many institutions, especially in the US, are now looking at European companies but on a pan-European basis,’ remarks Liechti. All this means that the pond has suddenly got a lot bigger so the small fry seem even smaller.
Big up
Some commentators predict that the present state of affairs will cause a scramble for size – and it may not be voluntary. While many small caps will knowingly give in to the urge to merge, Liechti says that mergers are sometimes forced upon them. ‘Particularly after shareholder consolidation, institutions find themselves with significant holdings in different companies,’ he explains. ‘This gives them greater power to effect a merger and this is contributing to the M&A mania we’re seeing. Normally this would be very difficult to effect because it directly affects the people around the table – turkeys don’t vote for Christmas after all. But in the last year around 10 percent of small companies have been the subject of corporate activity and a further 13 percent have been the subject of speculation.’
Katie Morris, CEO of Cisco, notes that restricted access to capital investment and hindrances to share price performance emanate from ‘investor attitudes and from stock market and regulatory structures.’ Small cap snubbing is a fairly global phenomenon with little regional bias. ‘It’s not a regional issue,’ insists Crossley. ‘Institutions don’t go round saying, We’re a bit short of Wales. That’s just not the way they look at things.’
Ferguson concurs. ‘It doesn’t really affect certain regions more than others,’ he maintains. ‘Fund managers make decisions on a company to company basis.’ Fair enough. But some see a real difference in the respective fortunes of, for example, the US and UK markets. According to the Reuters survey, ‘Unlike the UK’s small-cap dependence on a concentrating and shrinking institutional fund management group ownership, the US small caps are largely dependent on private investors.’
Liechti remarks, ‘Yes, it’s a global phenomenon but the US is a bit better off. Although a tendency toward large caps is a feature of the US too, theirs is a more technology-dominated market with high-growth small caps which investors like.’ Crossley does agree that this is the key issue. ‘Obviously, investors are keener on small but growing companies,’ he says. ‘They’re not investing in companies that are small but not growing because of their inability to raise capital.’
Securing growth is easier said than done, though – or at least securing the capital to fund it. The Reuters survey quotes one small-cap finance director bemoaning, ‘Clearly, over the past year, smaller companies such as ours have virtually been told that we have no place in the stock market, so go and sell yourselves. It is catch 22, in that growth cannot come without equity support.’
Things can only get better?
Small-cap CEOs should take a deep breath before reading on. Some 31 percent of the fund managers questioned by Cisco said poor small-cap performance was a permanent fact of life. But before slitting any wrists in the face of such doom, it’s worth noting two other factors to emerge from the survey: first, that 69 percent saw the misery as a merely cyclical problem; and, second, the tide appears to be turning already.
‘Currently on the year to date, small caps have actually outperformed,’ notes Ferguson. ‘We’re now seeing a bounce back,’ agrees Liechti. ‘The market last year expected a recession which failed to arrive. In Europe, the introduction of Emu is helping too, because the exchange risk has been eliminated. The UK is experiencing a better revival than the rest of Europe but they’re both getting it.’
At the risk of trotting out the same old platitude, companies seeking the patronage of the financial community might want to think about IR. It’s certainly prescribed by Ferguson. ‘Companies have got to be proactive,’ he says. ‘That means regular conference calls, providing access to management, and traveling to investors to market their product. At the same time, you’ve got to be honest and accountable. Pie-in-the-sky estimates don’t help.’
He has a point. Liquidity may be abysmal. You may not be able to get any analyst coverage. M&A in the fund management industry may mean your company is about to be dropped. A million-and-one small-cap companies may be vying for the same attention as you. Your sector’s performance may be habitually volatile. Fund managers may have resorted to index tracking. And a third of them may reckon it’ll be this bad forever.
But so what? Cheer up. Get out there and sell your story. Things are picking up already.
