Shares of small companies, we are repeatedly told, are risky. But are they? A study by accountants UHY Hacker Young suggests that quite the opposite is true. In a fascinating study, they conclude that small cap shares consistently outperform the market.
And after weathering the recession, they also predict a roaring year for penny shares in 2011.
The FSA won’t like this report
What UHY Hacker has found is that companies listed on the Alternative Investment Market (AIM) have come out of the recession twice as cash-rich as FTSE-100 companies. ‘The liquidity ratio of AIM companies’, states the report, ’emerged from the recession at 2.03, compared to just 0.97 for FTSE-100 companies. This means that AIM companies have twice as much cash than they need to meet their debts, as at their last balance sheet date.’
This is rather inconvenient for the powers that wish to tell us how we should invest our money. The Financial Services Authority, for example, insists that the reports of private client fund managers carry extensive warnings about penny shares and actually prevents them from buying small company shares for their clients.
Turning up its nose, the FSA regards penny shares as ‘unsuitable’ for the majority of investors. But it does them a disservice. Studies of the long-term performance of shares have concluded that the returns from investing in small companies beat that from large companies. Calculations by the London Business School, for instance, have recorded an outperformance of some 3% per annum since 1955.
Why penny shares outperform the market
Backing this theme over in the USA, Babson College Professor Joel Shulman has just launched the Entrepreneur Shares Global Fund, which invests in companies that are ‘hand-picked for their entrepreneurial, small-business characteristics.’ Shares in companies selected through this process consistently outperform the market, says Shulman, citing a five-year track record for a similar fund of 11% per annum.
He goes on to explain that ‘organizations that emphasize entrepreneurial culture, organic growth, and aligned compensation trump corporate bureaucracy on a regular basis. Entrepreneurs keep their organization costs lean, debt levels manageable, and expansion projects within reach. Though they may not have access to cheap debt or equity, they compensate with clever ways to make their resources go further.
Consequently, they are less affected (than non-entrepreneurs) by macro credit decisions in the marketplace that reduce borrowing capacity. They have the balance sheet to withstand difficult capital market conditions and the management expertise, confidence and savvy to navigate unexpected disruptions.’
This is why the stock prices of ‘entrepreneur companies often beat the overall market and persist over extended periods.’ This much is known. But what the UHY Hacker Young study reveals is that not only do small companies run faster in periods of economic growth, but they also adapt fast when the clouds gather.
A sea change in opinion for penny shares
‘There was concern’, says UHY Hacker Young, ‘that the credit crunch would drive more AIM companies to the wall than it actually did.’
In fact what happened was that small companies reacted fast, cutting costs and conserving cash. While investors panicked and dumped the shares of small companies, very few of the latter actually went out of business. They survived and now that the economy has turned they are roaring back. Since early last year the AIM market index has more than doubled, making fools of those who underestimated the resilience of small companies and sold out at the bottom.
Going in to 2011 UHY Hacker Young finds that ‘AIM companies are emerging from the deepest recession for a generation with a healthy cash position.’ This is great news and should set them up for a good year in 2011.
But the real message knocks on the head the notion that small companies are dangerously risky. The study ‘challenges criticism from AIM detractors over the ability of small and medium sized companies to operate in difficult economic conditions. It shows that the AIM market is nowhere near as fragile as some have feared.’
This should encourage professional fund managers to devote more of their attention and of their clients’ money to small companies. Already there is evidence that this is under way. November saw the largest number of new companies admitted to AIM and the largest amount – £1.1bn – of new money raised since the banking crisis struck.
Investors are starting to realize that they were wrong to desert the sector in 2008, and are rushing to get back in. Small companies, they now see, offer not only the potential for high returns – but aren’t as risky as they have been led to believe. Here’s to 2011!