Bloodhounds, penny shares and what your uncle doesn’t know

When I tell people I write a newsletter called the Penny Share Letter, I sometimes get funny looks.

When I tell people I write a newsletter called the Penny Share Letter, I sometimes get funny looks.

Some haven’t heard of penny shares. Some people think they’re, basically, gambling. And some think they’re a scam.

Penny Shares? You mean like the Wolf of Wall Street?

It ticks me off, to be honest.

I don’t expect ordinary people to rattle off long-run performance statistics, Sharpe ratios or factor influences.

But for their own sake, if not mine, it would be good if people knew one simple fact about penny shares:

Over a very long period, penny shares have been shown to outperform every other asset class.

Another year of outperformance

Doesn’t this seem like pertinent information? Something your uncle, daughter and parents should perhaps know about?

It certainly does to me. I find it baffling that more people don’t know about penny shares. Especially young people, who have more investing time ahead of themselves and a chance to make much more money from them.

But don’t take my word for it. I’m biased, after all.

Take a look at the latest research from Paul Marsh and Elroy Dimson, Emeritus Professors of Finance at London Business School…

Every year Marsh and Dimson crunch the numbers on small cap returns in the UK. They take the most recent data — which, in fairness, anyone could grab off a Bloomberg terminal — and put it into long run context.

In 2017 they found the Numis Smaller Companies Index (the NSCI, which is made up of companies in the bottom tenth of the UK stock market, by value) gave a total return of 18.8%. That’s compared to a 13.1% return for the FTSE All-Share Index in the same period. So small caps outperformed the rest of the market by 5.7% last year.

That was a particularly good year for small caps: 18.8% return, for a 5.7% outperformance. But it’s not that extraordinary, to be honest. Since 1955 the NSCI has returned 13.1% per year and outperformed the rest of the market by an average of 3.4% per year.

So, that’s what we’re talking about: a 3.4% annual outperformance in the long run. 3.4%. Doesn’t sound like much does it?

Well, in the investing game an extra 3.4% is a massive tailwind. Add it up over time and you’re much, much better off.

Dimson and Marsh helpfully crunched the numbers. £1000 invested in the FTSE All-Share at the start of their data set in 1955 would get you… £1,095,000 today. Over 1000x return — not bad. That’s why basically no-one disagrees that shares are the best way to invest for the long run.

So what does that 3.4% tailwind get you?

Well, the same £1000 in the NSCI in 1955 would get to £7,209,000. That’s compound interest for you. If you stick with small caps over time, you’ll end up with a multiple of what you’d have made investing in ordinary shares.

As aforementioned, the NSCI is made up of the companies which make up the bottom tenth of the stock market, by value. And you might think that means it’s made up of a small selection of all listed British companies. But that’s not how it works…

Of the 1,892 companies listed on the London Stock Exchange, around 180 make up the top 90% of the market value. So NCSI is made up from the remaining 1,712.

So when you’re talking about “small caps” or “penny shares”, you’re not talking about some weird little niche. You’re talking about 90% of all the companies listed on the stock exchange.

Bloodhounds

So, what gives? Why do small caps do so well? And why do ordinary investors get a taste?

The short answer is, the pros can’t invest in small caps.

Professional City traders are like bloodhounds. They roam all over the markets day-in day-out, sniffing out any potential profit opportunity. When they find an arbitrage, as they call it, they take the profits for themselves. Until there’s nothing left for the the little-guy private investor.

But small caps / penny shares are much too small for the pros. Those guys steer billions of pounds on behalf of big pension funds and the like. A small cap I recommend to my Penny Share Letter readers might only be worth £100m, total. The pros don’t want to own companies outright, they just want a small slice of them. So if they were to buy a 10% stake in a £100m small cap, they’d only have invested £10m out of the billions they’re responsible for. And the amount of work would be the same. So they don’t do it — it’s just not worth it.

Warren Buffett got his start investing in small caps. Now, though, he just can’t do it. He’s gotten too big. Here he is in 1999, talking about the power of small caps:

“…it’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.

In 2005, he repeated the point:

“Yes, I would still say the same thing todayYou have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all

“Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.”

This chimes with what Dimson and Marsh say. Over the last 16 years, they’ve found that broker recommendations aren’t much use when it comes to valuing large-cap stocks. But for small caps, they predicted future returns much better.

Why? Because the bloodhounds, and the likes of Warren Buffet haven’t taken the profits for themselves. That’s why best opportunities are found “way, way off the map”.

(My guide to “way off the map” investments is the Penny Share Letter. I’ve been publishing it for a couple of years now. It has several thousand satisfied subscribers. Want to be one? Click here.)

So, the next time an uncle asks what I do, I won’t bother asking what he thinks of penny shares. That’ll just annoy me. I’ll just take his email address and send him this article.

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