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Small Caps: Finding Growth in a Low-Growth Environment

January 9, 2017 | U.S. Equity

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The prospect of subdued economic growth for the foreseeable future has many investors looking for areas of the market where they can find pockets of growth in a low-growth environment. While many businesses are constrained to grow close to the rate of the overall economy, there are multiple ways small companies are unique and can grow much faster than the overall economy.

Niche Areas of Growth

One way for a small company to capture higher growth is to operate within a niche or subsector of a larger industry. Take the property and casualty insurance industry (P&C). The industry is relatively mature, with a global size of approximately $1.2 trillion that is growing roughly in-line with global gross domestic product (GDP).

Like most companies, P&C insurers are heavily dependent on software to run their businesses efficiently. Many P&C insurance companies currently use in-house software to meet their IT needs. However, due to cost and operational risk, many of these in-house solutions have been neglected and have not kept pace with technological and computing advancements.

In order to meet the demands of modern consumers and offer new approaches to providing insurance, upgrading these outdated solutions has become a priority for P&C companies.

Large software companies haven't been able to offer competitive products to P&C companies for two primary reasons. First, they lack the required industry-specific knowledge which is vital to address customer needs. Second, they prefer broader end markets that provide larger potential selling opportunities.

Conversely, smaller companies can become experts in verticals such as P&C, filling the marketplace void by offering industry-tailored solutions. With demand high for specialized software, the growth rate for companies that provide these solutions is much faster than the broader industry.

Market-Share Gains

Another way smaller companies can grow independent of economic growth is through market-share gains. Small companies typically have less market share than their larger counterparts. Even when small companies capture market share at the same rate versus their larger counterparts, they grow at a faster rate.

Consider this hypothetical example. If Large Company A has 35% market share in the global toothpaste market and expands its market share by 1%, the company grows by 3% (1% divided by 35%). However, if Small Company B has 5% market share and grows its market share by 1%, the company grows by 20% (1% divided by 5%).

Because small companies begin with less market share, the incremental share gained has a larger impact on their growth rate. Smaller companies are often more innovative than the incumbents and, in turn, are disruptive to the industry. This allows small companies to compete and take market share despite the lack of scale and lower sales and marketing budgets.

Geographic Growth

Lastly, small companies are often regional, operating in specific geographical areas. That leaves significant room for growth if they expand outside of their region. The classic example of this is Starbucks. At the time of its initial public offering in 1992, the company operated 165 locations, primarily in the Northwest U.S., and had a market capitalization of $300 million.

Starbucks' footprint spread internationally, and by 2000 the company had 3,500 locations in 16 countries. Currently, it operates approximately 22,500 locations across the world and has a market capitalization of $79 billion. By expanding its geographic footprint outside of the Northwest U.S., Starbucks was able to grow into one of the largest restaurant chains in the world.

Implications for Investors

 A small company may grow due to one of these factors or all three simultaneously, and the ability to do so makes them differentiated in the context of an investment portfolio. Given a significant portion of a stock's return is earned through the growth of the underlying business, we believe there is a compelling case for an allocation to smaller, higher growth companies in the current environment.