Not so long ago, smaller companies were the natural choice for an investor in pursuit of growth. Fast-growing, dynamic, they were petite but packed a punch — the investment equivalent of Mighty Mouse.
The astonishing performance of a handful of mega-cap technology stocks has derailed that view, while economic and financial market conditions have tended to conspire against the little guy. However, after a couple of false starts, small may be mighty once again.
Over the long term, smaller companies have tended to be a good place to invest. Since 1955, small caps have outperformed larger UK companies by almost 3 per cent a year on average, according to the investment advice firm Deutsche Numis. Through the magic power of compounding, a small cap investment would now be worth 400 times its original investment, while a larger company investment would be worth a meagre 60 times.
However, not all of us have 70 years to invest, and more recently, the performance of UK small caps has been grim. Investors in the average small-cap fund have seen a £10,000 investment dwindle to £8,550. Over the past three years, the amount invested in UK small-cap funds has gone from £19.2 billion to £10.7 billion. The stockbroker Peel Hunt warned that the FTSE Small Cap index could cease to exist by 2028 if the present levels of takeovers and buybacks persist and there is no revival in the initial public offering market.
So why take the risk on small caps today? Well, several factors that have left UK smaller companies in the doldrums may be about to change. And when smaller companies turn, they tend to turn quickly and with feeling. The MSCI UK Small Cap index lost about 12 per cent in 2011, but delivered 30 per cent and 37 per cent in the subsequent two years. In 2018 it dropped 15 per cent, only to rise 30 per cent in 2019. Recently, UK small cap has taken a hit, but the bounce hasn’t happened … yet.
Three factors have knocked smaller companies. First, they have been hurt by rising interest rates. There is a lingering assumption that higher borrowing costs equals bad news for the UK’s smaller businesses. It isn’t necessarily true — many listed companies don’t have a lot of debt and fund managers tend to pick the ones with good balance sheets — but nevertheless, the impression remains and the sector tends to sell down.
Then there’s the fact that the fortunes of smaller UK companies are viewed as having closer ties to the UK’s economy than larger ones. Again, it’s not necessarily true — there are plenty of small companies that generate their revenues abroad, but investors haven’t really cared, particularly when there was some juicy AI stock to get stuck into.
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Finally, there’s the thorny issue of sentiment. Smaller companies have been the whipping boy for a broader disgruntlement with the UK stock market. This means investors have overlooked their charms and focused heavily on their faults.
In the meantime, the small companies haven’t had that bad a time at all. The sector is full of examples of businesses doing great things. Stuart Widdowson, the co-manager of Odyssean Investment Trust, points to the distributor Essentra, where the management team has done a great job of re-engineering the business. Other small-caps firing on all cylinders include the respiratory equipment maker Avon Protection, the utilities company Telecom Plus and the energy business Yu Group. There are, of course, pockets of weakness, but with 1,300 or so to choose from, they are easily avoided.
Small-cap fund managers have been telling anyone who’ll listen that the sector is a bargain and there is a yawning gap between the market’s view and the reality for small-cap businesses. This seems to stand up to independent scrutiny. As earnings have improved and share prices have stayed the same, the sector has looked cheaper and cheaper. Not only are they cheap on measures such as price to earnings, but they also pay a decent income. Companies in the FTSE SmallCap index yield an average of 4 per cent — that’s higher than you get in the average stodgy old FTSE 100 company (3.7 per cent), with stronger growth on top.
Naysayers might argue that they’ve been cheap for a while, but add in an interest rate cut, an improvement in the economic climate, and better sentiment towards the UK after a decisive election result, and it’s a potent brew for stronger performance from smaller companies. Merger and acquisition activity may also be a factor as international companies swoop in to pick up small caps.
The sector has battled with persistent outflows, but this also appears to be changing. Widdowson said: “The latest data we have seen suggests that net flows into UK Smaller Company funds were neutral in May and potentially June. What is notable is the significant increase in flows into Vanguard’s FTSE 250 passive fund since the end of March.” This shows growing investor comfort with non-FTSE 100 investments.
Graham Ashby, the UK All Cap fund manager at Schroders, agrees: “Sentiment towards UK mid- and small-cap stocks has markedly improved in recent weeks, boosted by the result in the election and a continued rally in sterling against the US dollar and euro. Total returns over the past three months from the FTSE Mid-250 Index and FTSE Small Cap Index are more than twice that of the FTSE 100 Index.”
It is early days, but any reversal of sentiment could make a meaningful difference. Fewer small-cap shares are traded, which exaggerates share price movements in both directions. James Klempster from the fund group Liontrust said: “Small caps were sold off significantly during the interest rate-rising cycle and are therefore likely to be notable beneficiaries as that trend starts to reverse.However, at a simple level, if buyers and sellers are evenly matched, all you need is one additional buyer for a company’s fortunes to improve.”
But where to buy? Not all small companies funds are created equal. Investors can choose small, very small or extremely small; they can go for growth or income, safe or punchy. Equally, the right option for the past three years may not be the best option for the recovery.
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As for “safe” options, I’ve held the Aberforth Smaller Companies trust for more than a decade. It’s paid a decent dividend (2.6 per cent at present) and has spared me some of the sector’s heart-stopping volatility. In 2022, the worst year for UK small-cap performance, it dropped 10 per cent, compared with 25.2 per cent for the IA UK Smaller Companies sector. I’d rather it hadn’t dropped at all, of course, but I can live with it. Odyssean, which invests in larger, but still small companies, has a similar return profile.
Aberforth tends to invest in well-established businesses such as the legal publisher Wilmington, the retirement specialist Just Group, and the trading platform CMC Markets, while Odyssean invests in the chemicals group Elementis, the printing company Xaar, and the electrical engineer XP Power. These are steadier options.
Adrenaline junkies might want to look at bombed-out micro caps,which are usually defined as companies with a market value from £20 million up to £250 million.They are volatile, of course, but also interesting, exciting and coming from a position of significant weakness. Premier Miton, Liontrust, Octopus, Marlborough and Gresham House all have funds in this area, with Liontrust’s leading the pack over one and three years.
The investment trust sector is also ripe for re-examination, with many trusts trading on a discount, where their share price is less than the underlying value of their assets. If a recovery materialises, investors can get the double whammy of a narrowing of the discount and an improvement in the share prices of the underlying assets. Abrdn UK Smaller Companies Growth, Montanaro UK Smaller Companies and BlackRock Throgmorton trusts may be worth a look.
A final thought. An investment in small caps may be an act of patriotism. Gervais Williams, the fund manager on the Premier Miton UK MicroCap trust, said: “There has been a move to encourage local investors to invest more in UK companies. That pattern is likely to accelerate with Labour in power. That’s good news because I think there are some good returns to be made, but also because you help generate more employment, more productivity, more tax take, so it’s socially useful.”
There: you can make money and do your bit for the UK economy all in one go.
Ian Cowie is away