Tuesday, January 10, 2012

UK Value Investor

UK Value Investor

Does Size Matter?

Posted: 09 Jan 2012 02:00 AM PST

I must be getting old.  In fact, having recently turned 40 I have hard proof that I am (in the shape of the cards, socks and pants that I received).  It’s not turning 40 that’s making me feel like an old curmudgeon though,  it’s my approach to risk.

Having written about the need for sufficient diversification, I’ve been thinking about what a company’s market cap means in terms of how sophisticated an investor should probably be before buying the company’s shares.

I realise this isn’t a new idea, but there is very probably an inverse relationship between the size of the company and the minimum sophistication of the investor.  In other words, the bigger the market cap the less the investor needs to know about the company and the small the market cap the more they should know.

In some ways this may be counterintuitive because a company like BP is massively more complex than something like AGA Rangemaster.  That’s not just because BP is bigger, it’s because it does many more things in many more places around the world.  Just compare the annual reports.

But, somewhat like the QE2 luxury liner compared to a speed boat, the QE2 is hugely more complex but also hugely more stable when faced with storms and worse.  When travelling across the Atlantic most people would be better off on the big boat.

This also ties in with the idea that fundamental investing, of which value investing is a part, is about investing in real companies and not just a wiggly stock-price chart or a number on a ticker.  An analogy that I sometimes use is that investing in shares can be like investing in property, where there is a real asset generating a real income and potential capital gain.  From that point of view it’s much easier to think about where Marks & Spencer might be in 5 or 10 years time than a micro-cap company that doesn’t have access to the best brains in the business.

For the ultimate in stability (at least in terms of equities) you just have to look at a market index like the FTSE 100.  Not only is it full of the biggest 100 companies but it’s cap weighted, so the biggest of those companies make up a disproportionate amount of the index.  The average market cap is about £15 billion, which is big enough, but the weighted average market cap is over £40 billion, which is bigger than all but 10 of the constituents (i.e. BP makes up about 6% of the index at £90 billion while Hargreaves Lansdown makes up 0.1% at £2 billion so the weighted average is slanted towards the biggest of the big).

I’m not sure I’d call myself a big-cap investor just yet, but for my ‘defensive value’ portfolio I’ll be concentrating on FTSE 350 companies from now.  Not that there aren’t many great small cap companies out there, it’s just that I think it’s much easier to find good, big companies than good, small companies.