With the FTSE 100 having fallen by over 6% since the turn of the year, many investors will undoubtedly be questioning their decision to own shares at the present time. After all, the performance of the index over the last year has been hugely disappointing, with it falling by 8.5% during the period and leaving many investors poorer now than they were at the start of 2015.
Clearly, in the long run the FTSE 100 has huge total return potential. This is evidenced by the fact that its total returns over the last 32 years have been exceptional, with the index being 5.9 times higher now than at its birth in January 1984, which works out as an annualised total return of around 9.2% (including dividends). And with the index trading on a relatively low price to earnings (P/E) ratio of less than 13 and yielding over 4%, its long term returns are likely to be very healthy.
However in the last year, smaller companies have outperformed their larger peers. For example, the AIM 100 index is up nearly 11% in the last twelve months, which is almost a 20% superior capital return than the FTSE 100. Certainly, smaller companies tend to pay less in dividends, but their potential for share price rises has historically been very strong.
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That’s at least partly because smaller companies are often more nimble than their larger counterparts and can more quickly respond to opportunities within their chosen markets. Furthermore, they are usually less mature companies which are still undergoing a major transformation through delivering new products in new locations and, as a result, are able to post faster earnings growth rates if their strategies work out as planned.
Additionally, smaller companies usually have less analyst coverage than their larger peers and it could be argued that the smaller company market is less efficient than the FTSE 100. This could lead to ‘hidden gems’ within the smaller company space, as well as the scope for upward reratings over the medium to long term.
Certainly, smaller companies are riskier than their larger peers. For example, their shares are less liquid and their businesses are often more heavily dependent upon a smaller number of key customers or a specific geographical exposure which means that profitability can be more volatile. And with a number of smaller companies being relatively new/young (as mentioned), there is more scope for failure than is the case for well-established companies in the FTSE 100 which have been in existence for decades.
As such, it could pay to have a mix of larger companies and smaller companies within a portfolio, with the importance of diversification being even more relevant when it comes to smaller stocks due to their higher degree of risk. While neither large nor small companies can guarantee that you will retire early, history tells us that shares remain a relatively appealing asset – even if in recent months it has not felt as though that is the case.
