Today, I’ll show you the sheer wealth-generating potential of small company shares. And we’ll see how they’ve outgunned traditional investments over the long run.
Now you’re smart enough to know that past performance isn’t a guide to future results. But I think you’ll like what I have to show you all the same. To set the scene, the truth about your biggest asset…
The Nationwide tells us that the price of the average UK home has moved from £1900 in 1955 to £160,000 now. So £1000 invested back then would be worth £84,000 today. That works out as an annual rate of return of 8.5%.
Let’s face it, that’s not bad. Anyone offering that return fifty-five years ago would have had their hand bitten off. And actually, UK housing has done even better than this…
How your house has kept up with ‘normal’ stocks
Of course, the house that you own has done more than simply multiply your wealth. It has also given you a place to live. That has additional value. That’s why tenants pay a rent to live in a property that they do not own.
So to calculate the true return from property, we have to assume that we are a landlord. So we add the rent that we have received to the appreciation of the property value.
I reckon that a fair rental yield is about 7%. From that we have to deduct the costs of wear and tear, insurance, council tax, periods when the property is empty, defaulting tenants and agent’s fees. So let’s assume that these would halve that 7%.
After those deductions, we’re left with net rental yield of 3.5%. Add that to our 8.5% price appreciation. What we end up with is a total long-term return of 12% per annum from our biggest asset – our house.
That’s very nice indeed. And in fact, that happens to be the very same return that has been produced by the broad UK stock market over the same period. Let’s take a look at that.
Elroy Dimson, Paul Marsh and Mike Staunton from the London Business School are acknowledged authorities on stock market history. They recently published their latest study of long-term stock market returns. It makes interesting reading.
If you’d invested £1000 in 1955, the FTSE All-Share index could have turned it into £0.5m by now. That also works out as a return of 12% per annum.
There’s an argument for owning stocks right there. That return has trounced bank deposit and bond returns and is comfortably above the rate of inflation.
But here’s the thing. If you had invested in small companies back in 1955 you would not now have £500,000. You would have £2.6m! That works out as an annual return of about 15.4%.
Here’s what I find really interesting about this. Back in 1955, if a financial adviser had been able to foresee the future, he might have said to you:
‘You will get 12% from UK housing. You will get 12% from investing in blue chips. You will get slightly more – 15.4% –if you invest in small companies.’
Then, he probably would have added: ‘But do you really want to take the risk of investing in small companies? They can be very volatile. They are risky. Their fortunes can swiftly change for good, or ill. Better, I think, to take the security of good, solid, property or blue chips…’
How an extra 3.4% a year allowed small caps to add £2.1m
But this is even more interesting. That little 3.4% of additional annual return is now, fifty-five years later, worth an extra £2.1m to the ‘risk happy’ investor. That’s the power of compound interest at work.
It is also – as the authors of the report point out – a logical outcome of the oft-quoted saying that ‘With greater risk goes greater reward’.
And there’s one more thing that jumps out of this report. That is that these rates of return have been achieved despite crises that have intermittently seriously challenged the faith of investors.
In that time we have seen the Cold War, the Cuban Missile crisis, sky-high inflation, a soaring oil price. We’ve had the tech bust of 2001 and now the great banking crisis. Through all of these, shares have shown their resilience.
2009 was a perfect example. In the face of the worst financial and economic news for decades, shares bounced back. Once again it was small companies that led the way. Let’s look at some numbers to prove it.
In 2009 the Hoare Govett index of small companies gained 54%. That was 24% better than the recovery of the All-Share Index.
According to the Hoare Govett study, ‘although the last decade has been dubbed a lost decade for equity investors, this has not been true for small- and mid-cap investors. From 2000-2009 the Hoare Govett index had a 66% return… small and mid-cap stocks outperformed large-caps, cash, bonds and investment property.’
The historic evidence in favour of small companies is overwhelming. But despite that, the Hoare Govett study concludes, small caps are no more highly rated than their bigger brethren.
That means that for the same price you have the chance to invest in something that has demonstrably outperformed over time.
We can’t possibly know whether there’s another £2.6m waiting for small cap investors in fifty-five years time. But anybody bold enough to back small companies over the long term has a wealth of evidence that points to potentially market beating returns.
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This article
was written by Tom Bulford, and is taken from his free twice-weekly email the
Penny Sleuth