Given the ups and downs of stock markets, it’s easy to forget the longer-term case for investing in smaller companies. Yet the reasons for investors to hold them are constant, no matter how markets behave from day to day.
Broadly speaking, a high proportion of smaller companies are managed by entrepreneurs with a stake in the business and a focus on a specific niche. They tend to be dynamic, have greater flexibility than larger businesses and often allocate capital better.
There are four overriding reasons for investing in Europe’s smaller companies:
- Smaller companies can grow more. Logically, the bigger a company becomes, the harder it is to grow. An incremental €1 million of profit for a company that already earns €1 billion is no big deal. For a company with only €5 million of profit, though, it means 20% growth.
- The stock market is less efficient at valuing smaller companies. Equity research analysing the prospects of smaller companies is thin on the ground, meaning there is less understanding of their business models, corporate cultures and earnings potential. This creates a valuable opportunity to identify mispriced securities.
- Smaller companies are less liquid. Lower stock market liquidity means that stocks can be mispriced for long periods of time. In times of crisis or market corrections, the active investor can take advantage of this market inefficiency, by buying cheap and selling dear.
- Concentrated exposure to investment themes. There are many product niches and investment themes that are hard to access profitably when investing in large company stocks. For instance, large conglomerates often find the value of their more profitable businesses diluted by less interesting subsidiaries. By contrast, smaller companies can focus clearly on compelling niches and themes.
Process is everything
The European Assets Trust has a distinct process when seeking the best smaller companies, believing that high-quality smaller companies in particular make good investments over the long term. Since I took responsibility for EAT earlier in 2024, I have been systematically zeroing in on the competitive advantages that differentiate high-quality businesses, as these enable them to grow and sustain high returns on capital.
What are these hallmarks of quality?
Firstly, a company with a cost advantage can produce goods or services at a lower cost than competitors, allowing it to undercut competitors or make a higher profit.
Secondly, companies with efficient scale benefits have a lower cost per unit than competitors. This can result in higher profits or increased sales.
Thirdly, high switching costs deter customers from buying products or services from a rival company.
Fourthly, a network effect increases the value of a product or service as more people use it. For instance, as more buyers and sellers used eBay, it became more valuable to both groups.
Fifthly, intangible assets like patents, government licenses and brands limit competition from rivals.
Navigating all conditions
Whatever the noise of economics, geopolitics or politics, it pays to remember the enduring principles of investing. These principles include the key reasons for investing in smaller companies over the long term.
We are firm believers in smaller companies. What’s more, we are loyal to our process for finding quality stocks, a process that has helped us navigate our European smaller company funds through varying market conditions.
Investment risks
The value of your investments and any income from them can go down as well as up and you may not get back the original amount invested. There is no guarantee that dividends will continue to increase.
The value of your investment is dependent on the supply and demand for the shares of the Investment Trust rather than its underlying value. the value of your investment will not be the same as the value of the Investment Trust’s underlying assets.
Investments in smaller companies carry a higher degree of risk as their shares may be less liquid and investment values can be volatile.
The mention of a stock is for the purpose of illustration and should not be considered as a recommendation to buy or sell the stock.
Gearing is used for investment purposes to obtain, increase or reduce exposure to an asset, index or investment. The use of gearing can enhance returns to investors in a rising market, but if the market falls the losses may be greater.
Issued by Columbia Threadneedle Management Limited and approved for distribution 31/12/24.
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