Bigger is not always better

In nature it is true that, on average, larger species tend to live longer than smaller species. The bowhead whale, also known as the Arctic whale, can live for a Methuselah-esque 200 years. In contrast, the poor mayfly hits its mid-life crisis after just 12 hours of life. Yet within species there are many contradictions to this general rule, where smaller survives longer than larger.

So too in the stock market there is a general assumption that size is some sort of proxy for risk; the bigger the market capitalisation (cap.), the less risky it is. At a very basic level there is some truth to this given larger companies typically have greater access to capital, but as Carillion and Thomas Cook shareholders would attest, it isn’t always the case.

Three key investor risks

Digging deeper reveals risk to be more hydra-headed in nature. Of these, we believe investors must appraise three key risks:

  • Valuation risk (how expensive the shares are)
  • Earnings risk (how volatile profits are likely to be)
  • Financial risk (how strong the balance sheet is)

For larger-sized AiM companies we believe that Valuation risk presents the biggest threat of the three and where a disproportionate amount of investors are IHT-focussed and less ‘price sensitive’ than non-tax orientated investors. At some point, the size benefits of extra liquidity, sheer scale, and more established treasury and finance functions are trumped by valuations trading too far above a company’s intrinsic value. There is a second order effect at work here too; if the majority of a company’s shareholders are IHT investors, and Business Relief rules ever became more punitive, there is then the potential for a large amount of selling pressure as they all head for the exit at the same time. This would pressure the share price of even a fairly-valued asset but, with larger cap valuations elevated, we feel the downside risk is amplified further still.

Even absent any tax rule change, the axiom that ‘risk is primarily a function of price’ holds true. The more an asset is ‘priced for perfection’ the more sensitive that price is to a negative announcement (a profit warning). A share price that had overshot on the upside and suddenly falls, not settling until a lower level has been reached and often well below fair value, is driven by investors’ emotions suddenly flipping from greed to fear.

That is why we focus on the £250m and below market cap. companies, which are less crowded with larger IHT investors and trading at much more reasonable valuations on average. That said, we are not dogmatic in shunning a company simply because it is large; if the risk/reward is compelling we can and do invest in such names. These though are the exception and with our unconstrained ability to go wherever we find best value we currently see more opportunities lower down the market cap. spectrum. Rather than chase ‘yesterday’s winners’, we seek to ally ourselves instead with ‘tomorrow’s winners’.

Benefits of buying ‘smaller’ stocks

An added benefit of buying smaller stocks is that as they grow in size, they start to attract more and more investors as the market cap expands and so too liquidity. A company shunned at £100m in size can suddenly become investable simply because its market cap has grown to £200m, despite always having the same growth attractions. This process typically leads to re-rating of the Price/Earnings (P/E) ratio.

To demonstrate, say ABC Plc’s share price is 100p (P) and has earnings (E) of 10p, then its P/E will be 100/10 = 10x. Rearranging the formula, if E grows to 15p and the P/E ratio is unchanged the share price would be 150p (10 x 15p), a 50% return. If, however, the P/E ratio also expands to say 15x, which is likely given such strong earnings growth and a bigger market cap., then the share price would be 225p (15 x 15p) delivering a 125% return. Investors get the twin boost of earnings growth and a higher P/E ratio which together serve to amplify total shareholder returns.

While the above theoretical demonstration is a potent one, to promise you that it would work every time in practice would be a canard. What we can promise though is that by dint of our size and nimbleness we can exploit such a dynamic with more regularity than larger investors are able to. By having ‘more shots on goal’ we don’t need to be Harry Kane to convert enough opportunities. This has and should continue to serve our investors well over time.

For further information on the points raised or about our AIM IHT service more generally, please get in touch with one of our team today on 020 3195 3500 or contact enquiries@stellar-am.com.

 

Written by Stephen English

 

Important Information

Stellar Asset Management Limited does not offer investment or tax advice or make recommendations regarding investments. Prospective investors should ensure that they read the brochure and fully understand the risk factors before making any investment decision. The value of investments and the income from them may fall as well as rise and is not guaranteed. No assurance or guarantee is given that any targeted returns will be achieved. Forecasts of potential future results are not a reliable indicator of actual future results.

Stellar Asset Management Limited of Kendal House, 1 Conduit Street, London W1S 2XA is authorised and regulated by the Financial Conduct Authority.