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Picking the winners

The past 18 months have seen the re-emergence of smaller companies from the shadows after several years of underperformance.

Is this just a small recovery in a long term secular downtrend or is this the beginning of a move back into small-cap stocks which will continue for some time? Are blue chips to recover or will they remain friendless?

I do not believe that either category will significantly outperform the other. Instead, I would suggest that the year ahead will be one in what matters is whether the companies themselves are successful or not, whether they have what it takes to be a winning company in today&#39s turbulent times.

Even if we see little progress by the major indices, there will still be money to be made for investors willing to back the stockpickers over the quasi-trackers.

It pays to remind ourselves of why there is so much written about smaller companies versus blue chips.

The distinction really became apparent in the 1980s after several academic studies which analysed data from as far back as the 1950s showed that there was a “smaller companies effect”.

Smaller companies tended to outperform their bigger brethren. As this notion became accepted, investment in smaller companies as a separate asset class became more popular. However, by the time the trend had really taken hold of the retail investment community, the recession of the early 1990s hit smaller companies.

For several years they underperformed in a way not seen since the 1930s depression.

Towards the end of the 1990s, it was blue chips which instead seemed to lead the way. It was thought that the smaller company&#39s flexibility and rapid response to a changing environment had become less important in the global village.

Big companies showed a greater ability to adapt rapidly to change, extending their global reach and gaining a dominant market share, factors which were thought to be important for profit growth.

So retail investors, tempted by the prospect of investing in the world&#39s biggest companies, invested in a trend as it was already on the wane.

While it is true that smaller companies were better able to adapt at times when big companies carried enormous bureaucratic middle management structures, multinational corporation companies generally benefited more from globalisation.

Neither category proved to be universally applicable and neither prevailed when the environment changed.

This should, logically, be the case. Just because a company is of the same size as another, there is no reason why that company should perform in the same manner.

Grouping companies by size alone makes little sense in today&#39s information age. Industry-based sectoral analysis is more logical as companies in an industrial sector will all be facing the same challenges and opportunities.

Asset allocation by industrial sector also makes sense, by size makes no sense to me. Instead, I would suggest there are two groups of companies – the “winning” companies and the “losing” companies. This is a less easily defined concept and acknowledges the extent to which subjectivity is a key component of active fund management.

Having visited a few classic examples of each, there are certain signposts to look for and size is not among them. While the list is long, I would highlight three components in particular.

The ability to respond to a changing environment is a key divider between the winners and the losers.

The winners will not accept that they have the monopoly on wisdom and will continuously look for ways to improve what they do and the way that they do it. If the environment changes, so must they.

The losing company, by contrast, spends less time looking at ways to change and more time seeking to maintain the status quo.

Resistance to change is a symptom of the “losing” company. In today&#39s world the status quo is not sustainable.

Competition will enter any business where margins look attractive. Take the UK retail banking sector for instance.

A few years ago margins were at near record levels and predictions were that there would be an everlasting cycle of super returns.

First, the mutual building societies, then the mutual insurance companies and latterly the internet-only banks have successively forced margins down.

The best-run banks have fared well, the poorer run ones less so. Not all are still around to tell the tale.

Another key indicator is modesty. A winning company will have the modesty to admit it can get better.

A losing company has the arrogance to think it has the monopoly on wisdom.

It refuses to listen to its stakeholders – customers, suppliers, shareholders, employees, etc. When anything goes wrong the company will be the last to know.

Conversely, successful companies will be only too willing to talk to anyone about their company because they are rightly proud of their achievement but want to know if they can do better.

I have never had a problem getting to see the executives of excellent companies to discuss their business but I have lost count of the number of bad companies that have declined my request for a meeting.

Finally, there is the alignment of management&#39s interests with those of the investor. This is a complicated issue and is not just a case of paying bonuses based on share price performance.

A manager that stands to gain considerably from short-term price performance may adopt risky or inappropriate strategies simply to achieve the bonus. If the manager fails, he can move on but for shareholders the damage is more lasting. Not only should the rewards be aligned but also the risks.

These are just three examples of differences between winning and losing companies. Examples of each are found in every sector of the market. Why is this so important at this time? I believe there are two important reasons.

First, in a low-inflation environment, only successful companies succeed.

When inflation ran in double digits even the most incompetent management could eventually put up prices and increase profits. Recovery funds were filled with poor companies that would be bailed out by pricing power. In a low-inflation environment, there is no place to hide for poor companies.

Second, current market conditions favour bottom-up stock selection over top-down, quasi-index tracking management. This is because, although interest rates are going down which will aid most stocks, the TMT sectors are still seeing credit conditions tighten as banks become wearier of over-exposure to the tech sectors. So for TMT stocks the cost of capital may still be going up and therefore these elements of the indices are unlikely to keep pace with any rally based on falling interest rates.

As TMT represents a big proportion of the major indices, it may well be that the leading indices make little headway while the majority of stocks outside of the TMT area gain as interest rates fall.

Of course, if this is the case, it is bad news for the index-tracking funds that have been increasingly popular with retail investors. It is also bad news for those funds that, while professing to be actively managed, are very close to the index weightings in the major stocks.

These funds will capture little of the upside from the winning companies I have described above.

Keeping close to the market weightings in the major stocks protects the fund management group from significant underperformance but does not give the investor the reward for the risk they are taking.

I believe this year will once again be a good year for stockpickers and a poor one for those simply buying the market or trying to catch the latest trend.

If there is one thing that history has shown it is that by the time the retail investor has caught on to a theme it is time to move on. Investors should stop trying to divide the market into themes but rather back the stockpickers with proven ability to add value in the long term.

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