Is small becoming beautiful again? In the United Kingdom equity market, smaller firms have out-performed the FTSE 100 by 10% this year. But on the charts it looks like nothing more than a statistical wonder on a 10-year run of poor performance.
EF Schumacher’s seminal economic treatise, Small is Beautiful, was first published in 1973. The “nifty fifty” bubble in the United States had just burst, bringing the valuation of mega- corporations down to earth with a bump, and with the first oil crisis raging, Arabian hands were wresting control of global economic power.
For those unfamiliar with the text, the key quotes are summarised on Amazon’s website: “Schumacher maintains that man’s pursuit of profit and progress, which promotes giant organisations and increased specialisation, has in fact resulted in gross economic inefficiency, environmental pollution and inhumane working conditions.”
The antidote was, not surprisingly, smaller- scale operating units within communal ownership. The capitalist world stole much that suited it from this prescription but rejected the package as a whole.
For a generation of investment managers schooled during the late 1970s and early 1980s, small in the stock market was beautiful.
Fund managers’ thirst for statistical evidence to support investment proposals is unquenchable.
The advocates of smaller firms were handed their bible by broker Hoare Govett which, in conjunction with academics, produced an index revealing smaller company out-performance stretching back to the 1950s.
Thus was born the myth of the “acorn principle”. Certain supposed truisms were laced through this mythology. It was said to be easier to double 10-million of profit than 100-million.
Large firms were said to have an unerring propensity towards inefficiency and small firms assumed to be more nimble and innovative.
The past decade has shown this mythology to be collective wishful thinking in an investment industry anxious to cut the Gordian knot of uncertainty binding equity markets.
Smaller firms are not necessarily more nimble or less complacent than their larger brethren. But they have been shown to be more vulnerable in an environment of ultra-low inflation, lacking the protection that comes from market domination.
The out-performance generated by shares in smaller firms into the 1980s is a fact. But using data from the US market and taking a multi-generational view, the burst of superior returns tracked by the Hoare Govett Smaller Companies Index proves to have been a single generation phenomenon.
With hindsight, this period can be ascribed to a combination of two forces: a one-off step change in the methods of management within smaller firms – ironically for Schumacher a triumph of capitalism, not communism – and the existence of unusually high inflation.
The two decades after the first oil shock saw sustained inflation rates in Britain without precedent in peacetime. Nobody could argue that the oil shocks were easy on industry, but there is little doubt that an economy’s smaller and hence more marginal producers do prosper when price rises are considered the norm.
Now, every price rise in every industry is a precious event. Larger organisations are subject to market clearing prices, just like any economic participant.
Bigger firms, though, are able to exert influence over prices commensurate with their scale. Cross-subsidisation may border on illegality but happens. Small suppliers get squeezed as margin pressure is forced down the production chain.
The huge organisations which came under Schumacher’s scrutiny have also changed their practices over 20 years. They have a finer appreciation of what constitutes economic efficiency. At the same time, they have developed a better understanding of the merits of scale.
Size matters within industries. It is not necessarily meritorious across industries. Conglomerates were a 1980s fashion. “Focus” has been the buzz-word of the 1990s. Most of the corporate convulsions have been about shedding peripheral activities and building scale in core businesses.
Small firms appeared operationally nimble compared with larger industrial combines, for whom diversification was a watchword and lack of focus the consequence.
Now, diversification tends to be across borders but within existing areas of specialisation, making it harder for smaller firms to secure an advantage.
This should not preclude periods of superior performance by small firm indices. In the UK there is evidence that monetary easing is having a positive effect.
Small firms are now at lower values than FTSE 100 stocks. They do have a certain beauty – but do not expect it to last for ever.
Edmond Warner is managing director of equities at BT Alex Brown