SME (Small and Medium-sized Enterprise)

SME (also known as Small and Medium-sized Enterprise) is a term used to classify businesses based on their size, typically measured by the number of employees and financial metrics like annual turnover or the total value of assets on their balance sheet. These businesses are the unsung heroes and the backbone of most modern economies, creating jobs and driving innovation far from the limelight of giant multinational corporations. While the concept is universal, the exact definition of an SME can be a bit of a moving target, varying significantly from one country or organization to another. For an investor, understanding SMEs is crucial because they represent a vast and often overlooked universe of potential investment opportunities. They are the acorns from which mighty oaks can grow, but they also face a unique set of challenges compared to their larger, more established counterparts.

Pinning down a single, global definition for an SME is like trying to nail jelly to a wall. The thresholds are different depending on where you are. The two most influential definitions for European and American investors come from the European Union and the U.S. government.

The EU has a very clear and widely adopted definition that breaks SMEs down into three categories. To qualify, a company must meet criteria for both staff headcount and either turnover or balance sheet total.

• Micro enterprises: Fewer than 10 employees, with a turnover or balance sheet total of no more than €2 million.
• Small enterprises: Fewer than 50 employees, with a turnover or balance sheet total of no more than €10 million.
• Medium-sized enterprises: Fewer than 250 employees, with a turnover of no more than €50 million or a balance sheet total of no more than €43 million.

Across the pond, the U.S. Small Business Administration (SBA) takes a more tailored approach. Instead of a one-size-fits-all financial threshold, the SBA often defines a small business based on its industry. Size standards are usually stated as either the average number of employees over the past 12 months or the average annual receipts over the past three years. For example, a company in the manufacturing sector might be considered small with up to 500 employees, while a travel agency might have a revenue-based cap of $22 million in annual receipts. This complexity means you have to do a little more homework to see if a U.S. company officially qualifies as “small.”

For followers of value investing, the world of SMEs can feel like a treasure hunt. While large, famous companies are scrutinized by thousands of analysts, many SMEs operate just below Wall Street's radar.

• Huge Growth Potential: A small, nimble company can realistically double its revenue or profits in a way a corporate giant like Apple or Microsoft simply cannot. Their smaller size gives them a much longer runway for growth.
• Market Inefficiency: Because fewer analysts cover them, there's a greater chance of finding an undervalued gem—a great business trading for less than its intrinsic worth. This information asymmetry is where savvy investors can gain an edge.
• Simplicity: Many SMEs have straightforward business models that are easy to understand. This aligns perfectly with Warren Buffett's famous advice to “invest in what you know.” It's often easier to get your head around a regional bakery chain than a global financial derivatives conglomerate.

Of course, it's not all smooth sailing. Investing in SMEs comes with its own set of significant risks.

• Fragility: Smaller businesses are inherently more vulnerable. A recession, a new competitor, or the loss of a key customer can be catastrophic. They generally have a smaller economic moat to protect them.
• Liquidity Issues: If an SME is publicly traded, its shares are often 'thinly traded.' This means there aren't many buyers and sellers on any given day. Trying to sell your shares in a hurry can be difficult and may drive the price down.
• Information Scarcity: The flip side of being under-followed is that it can be harder to find high-quality, reliable information. This means investors have to roll up their sleeves and do more independent research.

For the ordinary investor, there are a few common pathways to gain exposure to SMEs.

• Directly in Public Companies: Some SMEs are listed on public stock exchanges. They are often referred to as 'small-cap' stocks. In the UK, many are found on the AIM (Alternative Investment Market), which has less stringent regulations than the main market.
• Funds and ETFs: A much simpler and more diversified approach is to invest in mutual funds or ETFs that specialize in small-cap stocks. This spreads your risk across hundreds of different companies, so the failure of one won't sink your portfolio.
• Venture Capital and Private Equity: These avenues involve investing in SMEs before they go public. However, Venture Capital (VC) and Private Equity (PE) funds are typically restricted to high-net-worth or accredited investors and are not easily accessible to the general public.