Peter Dixon, Global Equities Economist looks at the potential offered by small and medium-sized enterprises

  • Although the activities of large companies dominate the financial media, small and medium-sized enterprises account for 99% of all companies and two-thirds of employment in the industrialised world.
  • One problem common to all such organisations looking to expand is lack of access to finance which some companies can overcome by a stock exchange flotation.
  • This is not always the end of their difficulties given the aversion of institutional investors to small and mid-cap stocks.
  • Although their market performance is more volatile than their large cap counterparts, and they generally pay lower dividends, mid-caps do tend to outperform benchmark indices over time.
  • In an environment where investors struggle to generate decent returns, they cannot continue to ignore the potential offered by mid cap stocks.

An overview of the SME sector

Small and medium-sized enterprises (SMEs) are the backbone of the industrialised world. According to the standard European definition, such companies have less than 250 employees and an annual turnover under €50m (or a book value below €43m). Data compiled by the European Commission suggest that SMEs accounted for 99.8% of all firms across the EU and two-thirds of employment in 2013. We can further break down the SME sector into micro-firms, small companies and medium-sized institutions.

Micro-firms, defined as those with less than 10 employees, account for a whopping 92% of all EU firms, 29% of employment but only 22% of total output. The fact that the employment share exceeds the output share suggests that the productivity of micro-firms is lower than larger sized institutions. Sure enough, the larger the company the higher are productivity levels. Thus medium-sized companies, which employ between 50 and 249 employees, enjoy productivity levels some 44% higher than micro-firms, whilst output per employee in large companies is some 19% higher still.

Nonetheless, the SME sector has proved remarkably resilient to the buffeting imposed on the large cap sector over the last few years, having shed proportionately fewer workers during the worst of the downturn. This does, of course, explain why the productivity performance of smaller companies lags that of their larger counterparts although it does mean that they provide more ballast during times of economic slowdown. Indeed, the European Commission reckons that medium-sized firms contributed two-thirds of the increase in value added by SMEs between 2008 and 2013, despite accounting for only half of SME employment. The data certainly indicates that medium-sized companies outperformed all other segment sizes in terms of output and employment in 2014, following a relatively decent performance in 2013.

Medium-sized companies clearly have a number of strengths, which means that they are guaranteed to remain an important part of the economic landscape, but they also suffer from numerous weaknesses which will continue to put considerable pressure on many companies in this segment of the market.

Medium-sized companies: Strengths and weaknesses

Medium-sized enterprises tend to be sufficiently small to be nimble but big enough to be resilient to economic shocks. Indeed, with less than half of all start-up companies lasting for more than five years, those that have thrived sufficiently to reach this stage of development are likely to be fairly robust organisations. Many companies in this segment have carved out a niche role in their market and are unable or unwilling to expand further. On the positive side, this may be due to the fact that their role is so specialised that there is simply no room to expand. A more negative reason may be that such companies are unable to access the funds necessary to fund expansion.

However, other companies in this market segment may simply be “passing through,” being in the early stage of development on the way towards becoming a large cap company. Every company has to start somewhere, even Google, which in February 1999 was a micro-company with just 8 employees although it officially became a small company as employee numbers rose above 10 in the course of the year.

Medium-sized companies are able to reap the rewards from changes in the business environment where new technologies and the rise of globalisation have reduced the importance of economies of scale. In the past, manufacturing companies would generate a lot of their output using internal production processes but today they are likely to outsource tasks to external suppliers in order to economise on R&D and reduce the lead-time for new products. For example, specialist tasks such as 3D printing can be outsourced to small-scale specialist companies, which can quickly produce items for large manufacturers at relatively little cost.

But for all the positives, there are a range of disadvantages which may hamper the expansion of SMEs. As noted above, lack of financing is often a major constraint. This is particularly problematic in view of the fact that smaller companies are reliant on bank finance which has dried up in the wake of the recent banking crisis. Part of the problem in this regard is that financial institutions simply do not have the capacity to assess the creditworthiness of smaller enterprises without incurring significant costs. Moreover banks have become more risk averse as they attempt to rebuild their capital base, and as a result they are unable to differentiate between viable and non-viable firms. Consequently, they tend to treat many medium-sized firms in a similar fashion to smaller enterprises, which represents a lost opportunity for banks and is a source of frustration to entrepreneurs.

Lack of access to finance also prevents many SMEs from generating sufficient scale to be competitive in global markets. Many medium-sized firms thus operate only in domestic markets, which has been particularly problematic for European firms in recent years given the weakness of domestic demand. The regulatory burden on SMEs is also much greater than on their larger counterparts, which can also act as an inhibiting factor for growth. This stems from the fact that the regulatory system is designed to serve the requirements of larger organisations, and SMEs generally do not have the resources to deal efficiently with high compliance costs, extensive paperwork and laws which proscribe certain activities. Governments have acted in recent years to try and reduce this burden but the administrative load is still a common complaint of entrepreneurs trying to expand their business in difficult economic circumstances.