Personal finance: The irresistible rise of the second liners

The Jonathan Davis column

Just as it was in the last great bull market which reached its peak in 1968-1972, the current stock market surge has been characterised by the extraordinary strength of large company shares and the relatively poor performance of smaller company shares.

Any professional investors who have failed to invest in largest companies over the last two to three years has inevitably found themselves lagging behind in performance. As the chart shows, the Footsie index of 100 largest shares has comprehensively outperformed the 250 index, which tracks medium- sized companies, and the All-Share.

The same phenomenon has taken its toll in the unit and investment trust business. The performance figures for funds which specialise in UK smaller companies tell their own story. The average unit trust in the smaller company sector has produced a return of 10.1 per cent since the start of 1997. The All-Share index, by contrast, has returned almost three times as much (27.0 per cent) over the same period. Even the very best performing fund in the smaller company sector has only returned 22.3 per cent, 5 per cent less than the market overall.

It is the same story, if not worse, in the investment trust world. Over three years the performance of smaller company specialist trusts has badly lagged that of the generalist trusts. At the same time, the discounts to asset value have widened, further depressing investors' returns.

In fact, apart from Far East and emerging market funds, the smaller company sector trades on a wider average discount than any other investment trust sector - 14.9 per cent, according to the broking firm Nat West Markets.

The phenomenon of smaller company underperformance dates back several years. Since 1988, there has only been one year (1993) when smaller companies have comprehensively outperformed the market as a whole. Ironically, it was only in the 1980s that academic researchers discovered what they came to call the "small company effect". This was the discovery that, contrary to the principle of efficient markets, there appeared to be clear and sustainable advantage to be had from investing in smaller company shares. In other words, returns from smaller companies were higher than you would expect even after making allowance for their higher risk.

As so often in the stock market, no sooner had this new phenomenon been discovered than it started to vanish, Paul Marsh and Elroy Dimson, two Professors at London Business School who have closely monitored the small company effect from its first appearance, concluded in their latest annual survey published a few weeks ago that for all intents and appearances the small company effect had now disappeared.

All sorts of explanations - some more convincing than others - have been advanced to explain why smaller companies should fare better in some periods and not so well in others. The most obvious one relates to the prevailing economic climate. When the climate is stable, so this argument goes, with low inflation and steady sustained growth, as it is now, it tends to favour larger companies. They have greater freedom to secure economies of scale and develop and exploit their pricing power.

By contrast, when inflation is high, and the economy turbulent, the inflexibility of large companies is a disadvantage. They find it harder to adapt to rapid shifts in demand. Smaller companies, by contrast - at least those that survive - are better able to obtain a competitive edge. There are greater returns to entrepreneurship.

Whatever the reason, the interesting question now is whether the tide is once again about to turn in favour of smaller companies. There are certainly some pointers to that effect. The latest survey of fund manager intentions by Merrill Lynch suggests, for example, that institutional fund managers have recently started to increase their exposure to small and medium-sized companies.

On value grounds, many of these companies now look attractively priced, at least when compared with the demanding ratings of the biggest companies. Whichever way you look at it, shares in the FTSE 100 are not cheap. On a p/e ratio of 21, and a yield of 2.3 per cent, the Footsie index is discounting an awful of good news.

For tactical reasons, therefore, the arguments for looking elsewhere make sense. A number of US fund management houses are said to have been picking up shares in the FTSE 250 index in the last few weeks on value arguments of this kind. It would not be at all surprising if the dramatic recent outperformance of the Footsie index over other sections of the market was to falter this year.

But will it be more than a temporary rebalancing of the past disparity in performance? Scanning the visible economic horizons, it is hard to see any fundamental reason why the prevailing economic climate should turn against larger companies and back in favour of their smaller brethren. As the split in the Bank of England's monetary policy committee demonstrates, there are real concerns about the possibility of a short-term blip in inflation. But there are as yet no signs it will be anything other than a blip.

However, the value arguments for smaller companies may be more compelling. For anyone who follows a contrarian investment philosophy, the fact that the smaller company effect should now be being written off is a classic indicator that it may now be about to return.

Of course, if the current fashion for large company shares also proves to be the apotheosis of the whole bull market, then a return to relative favour may be of scant consolation. But a burst of short-term outperformance by smaller company specialists is now overdue.