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The size of a company is usually a good indicator when it comes to risk and return, but what approach should you take when investing? Peter Webb weighs up the evidence and considers the size factor

Elephants don’t gallop is a popular phrase used to describe the lower returns you get by investing only in large companies. Lots of academic studies have shown that smaller companies produce better returns. There are many reasons why this is the case. But core to this strategy is the fact that smaller companies carry much greater risk which is why, over time, you get much more reward.

Smaller companies have more risk because they tend to have business models that are generally unproven, lack funding or lack maturity. They also often struggle to generate free cash flow. The opposing situation it true for bigger companies, they should have mature, well-funded, cash-generating operations. Neither case is the rule without exception but both are generally true on the whole.

A large company in a dominant position has probably got their by being better than their competitors. Also it is likely to have constantly looked for ways to improve sales, margins and the depth and breadth of its reach over a number of years. In a mature market this doesn’t leave much room for further expansion and therefore returns from these companies are usually stable, but unexciting. A mature company may not be as exciting as a smaller one but it can deliver value nonetheless. Companies with little room to grow will, if they have management you can trust, probably look to return capital back to share holders. There is little point re-investing the money back into the company if it produces ever decreasing returns. Whichever way you look at it big often isn’t bad.

Smaller companies have no such luxuries; they face many hurdles to get to the next stage of development. These hurdles are numerous and a lot of companies fail very early on, either due to lack of funding, foresight or effective management. However, the rewards are very rich if the initial problems and barriers can be overcome. You could pick ten smaller companies but only one may get the breakthrough.

He who dares

Microsoft was once a burgeoning small cap company and look at the reward that it provided to shareholders. It successfully overcame many hurdles and barriers and prospered over many years. Sometimes you need a good break to set you on the right road. However, you don’t hear many people going on about Ashton-Tate nowadays. If you are interested in the Ashton-Tate story it is given a full chapter in the book In Search of Stupidity, a worthwhile read. The entire Ashton-Tate experience is a textbook example of mismanagement.

When you are looking at a spread of investments it is easy to get carried away with the wonderful prospects at hand in these exciting smaller enterprises. Each one has a compelling story and the line from management is usually, ‘The market for this product is predicted to be X billion by X year, Even if we only get X% of this marker the company would be worth £X’. Sadly, they also forget to omit the facts that X% of companies never get to year X, but at the end of the day the board is not paid to be pessimistic.

Analysing profit warning figures will tell you that smaller companies have greater difficulty than larger companies. Competitive conditions tend to penalise companies smaller companies which lack the funding or depth to overcome short term difficulties or effectively leverage their bargaining power with customers or suppliers.

Sizing up a proposition

But size isn’t everything and just because the company doesn’t have huge turnover, market cap or profits, does not mean you can’t ‘Go large’ on it. Smaller cap companies can hold very dominant positions in their respective markets. So discounting a company as too small for a larger stake based on a single metric is a mistake. Look at its relative position in the market and the size of that market.

So what approach should you have when mixing large and smaller more speculative companies in your portfolio? The general rule of thumb is that with smaller companies you should have high quantities of individual investments but in much smaller proportions, while with big companies you should have bigger, fewer investments. In five years time there is a very good chance that your larger company will have grown, even if at a slower rate. Investing smaller amounts in wide range of smaller companies will ensure you find that one in ten that prospers. Invest in only one and you could have a wild ride. I would worry about putting 5% of my portfolio into a riskier company regardless of its prospects; such is the risk you take on these sorts of companies. However, I wouldn’t hesitate to put more than double that in a larger company.

A good case in point is the multiple discussions I had through this column in 2004 about Unilever (ULVR). It may have been unpopular and at multi-year lows then but the subsequent returns have been very satisfactory. As a personal preference I still prefer to sit and wait for a large elephant to stumble so I can nip in and help it up again. It may be boring but it is profitable and there is no sign that is about to change.