Meno’s Paradox first appeared in the Socratic dialogues. It represents sophistry at its most adroit and Plato at his most exquisite. Yet the concept is perhaps best expressed not in an ancient Greek elenchus but in a 1972 episode of Steptoe and Son, a sitcom about two bickering rag-and-bone men.
The scene in question features the title characters quarrelling over who should write an article for their parish magazine. Steptoe Snr contemptuously brands his offspring incapable of spelling ‘chrysanthemum’, to which Steptoe Jnr defiantly replies: “I can look it up in the dictionary.”
The father is quick to seize on this fallacy. “How can you look it up,” he says, “if you can’t spell it?”
Investors may face a similar puzzle at a time when the case for diversification is back in the spotlight. Recent volatility around leading technology stocks has re-emphasised the merits of looking further afield in the investment universe – but exactly what are we looking for?
One possibility is UK smaller companies. Widely unloved for several years, they could now finally emerge from the shadows for numerous reasons – including a cut in interest rates, attractive valuations and a history of outperformance relative to their larger counterparts.
Crucially, though, these stocks are not just underappreciated – they are also under-researched. Most are covered by barely a handful of analysts, and some are covered by just one or even none.
This sounds like Meno’s Paradox in full effect. How can investors who want to optimise risk and return across their portfolios seek out these opportunities if little or no information about them is available in the first place?
The solution is logical enough. As Steptoe Jnr tells his sneering parent in response to the chrysanthemum gibe: “I shall get someone else to spell it for me!” This is where market knowledge, high-level engagement and informed stock-picking enter the reckoning.
Eyeballing and early adopters
The task of identifying a stock’s appeal usually falls to investment analysts. These supremely diligent souls work for fund brokers, financial advisory firms and major investment banks.
Their basic function is to guide buy and sell decisions. They do so by sifting through a wealth of data – including company statements, price moves, currency adjustments and yield fluctuations – to assess a specific stock or other asset.
The number of equity analysts likely to be eyeballing a given business can vary substantially. As our own surveys have shown, a company’s market capitalisation is a key factor in this regard.
A FTSE 100 constituent is likely to be monitored by around 20 analysts. The figure for a FTSE 250 business is around 10, while the figure for a micro-cap firm – that is, a company with a market value of less than £200 million – is just one.
The tail-off is normally a product of liquidity and trading volumes. An investment bank, for example, may take the view that there is insufficient viability in exploring smaller-cap stocks.
This can give an edge to investment teams that conduct their own research. It can also favour fund managers whose track records in this sphere make them a go-to port of call for specialist brokers capable of unearthing hidden gems.
But why might it pay to be first? The answer is that many of these smaller companies, despite having sound business models and a capacity for long-term growth, remain significantly undervalued.
This means investors who spot potential before the broader market cottons on may reap the greatest rewards over time. Not least in the current environment, early adopters could get the most out of the recovery and subsequent elevation of a smaller company’s share price.
Digging deeper
Of course, quantitative investment analysis might reveal only part of the story. As active managers, we believe direct engagement with companies is essential.
Meeting executives in the smaller-cap space can be hugely instructive. Their grasp of a business’ workings and prospects is often much more detailed and intimate than that of a large-cap organisation’s senior management.
We feel it is especially important to understand the dynamic between a chief executive officer and a chief financial officer. Is the latter strong enough to stand up to the former? Do they have a truly shared vision? Is their strategy realistic?
Equally, the people who run the ship need to recognise that we expect the best for a company. We are not merely interested onlookers. We are there to maximise our investment and benefit shareholders and other stakeholders by helping the business survive and thrive.
All this information – gleaned both from analysis and from engagement – is ultimately used to select stocks. It should equip us with a more fully formed picture of which to buy, which to hold and which to sell.
Naturally, much the same approach might be applied across a variety of assets and regions. In-depth research, strong relationships and an on-the-ground presence can deliver a competitive advantage in many investment settings.
Yet we would argue the effect is more powerful in some arenas than in others. In the realm of UK smaller companies – a sector that continues to suffer from an undeservedly low profile and which might be disproportionately vulnerable to economic downturns – it can produce a degree of insight not easily acquired by would-be market participants.
The lesson: this is a corner of the investment universe that may demand not only long-overdue attention but demonstrable expertise. All things considered, you do not need to be an ancient Greek philosopher to see the wisdom in that.
Eustace Santa Barbara is co-manager of the IFSL Marlborough Special Situations, UK Micro-Cap Growth and Nano-Cap Growth funds. The views expressed above should not be taken as investment advice.