Should private investors still favour smaller and medium sized companies?

Historically this has been seen as an area where individuals should have an edge over big investing institutions; picking companies that might have longer term growth potential, possibly be bid targets, and where public research may be more limited.

It made sense to buy into businesses at an early stage before they grow to a size that attracts attention and hopefully higher valuations. Now there is increased pressure on liquidity in these shares, making them harder for institutional investors and pension funds to hold.

Is this a warning signal for smaller investors?

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Faith in small and medium sized companies to beat their larger counterparts on average is supported by the long-term performance pattern. But picking individual companies involves much more risk of failing to get an average result. Some investors believe that the lower institutional and stockbroking interest in smaller companies means makes it more likely that a diamond can be found, but the risk works both ways.

Small companies tend to be more exposed to the domestic UK economy. However, increasingly medium sized companies operate internationally, though typically still more UK-exposed than the biggest FTSE 100 businesses. Shares outside the top 100 do on average also tend to be more growth-oriented, and that made for better performance in the immediate aftermath of the pandemic. But as inflation and interest rates have picked up, big companies have been the winners.

Smaller, and medium-sized companies tend to attract private investors, believing they have an edge in a less researched growth area before big investors join in. But now, regulation is making it much harder for big investors to buy-in until a company grows to a significant market capitalisation.

Smaller company shares are harder to buy and sell and yet unit trusts are facing regulatory pressure to offer easy daily trading. For a private investor holding a share long-term it may matter little if trading in shares varies from day-to-day. But the regulatory pressure on open-ended funds and institutional investors focuses on ease of share dealing and creates risk for fund managers.

Adding to regulatory pressures is a trend for consolidation in the wealth management sector, encouraging a focus on bigger listed companies to ensure consistency across clients. This may force a reduced interest by them in smaller companies.

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Already, it seems to be making it harder for small and medium-sized companies to raise new capital in the stock market, often part of their growth strategy. And some are falling prey to opportunistic takeovers while their shares trade at low levels. Outside the top 100 London-listed shares, many companies feel the UK stockmarket is not working for them.

Now, even the proposed unwinding of some of the research regulation that hit smaller companies looks like too little, too late. The rest of the world has not followed the British regulator’s enthusiasm for controlling company research. And the investment vehicles that seem better suited to taking a long-term view – investment trusts and other closed end funds – face more restrictions on charges and investor access.

Consumer Duty regulation is making it difficult for investment platforms to offer investor access to investment trusts that have higher costs, even though fees may reflect the challenge of researching and managing smaller company investments. This may reduce investor choice in routes into this area.

For some retired investors and those investing through an Individual Savings Account or ISA, income may be a key focus. And some private investors may see advantage in some of the tax privileges granted to Alternative Investment Market shares. However, that sector has been a poor performer in recent years and tax benefits may not last.

Shrinkage in the London market for smaller and medium-sized companies may lie ahead. Shareholders may even benefit if this comes from bid activity. But maintaining investor interest in theis sector may mean companies paying out bigger dividends.

Colin McLean is director of SVM Asset Management