Expertise is still to be valued regardless of what the populist rhetoric of MP Michael Gove might have suggested during the EU referendum campaign. This is especially so when trying to make head or tail of where risk premiums are to be found in an increasingly complex investment landscape.
For investors prepared to accept the additional risk inherent in smaller companies, Brexit and currency fluctuations have created a degree of uncertainty. The past isn't a guide to the future, but the recently published annual review of the Numis Smaller Companies index (NSCI), conducted by London Business School academics Dimson, Evans and Marsh, lends welcome rigour to the analysis of company size as a factor in driving UK equity returns. The NSCI ended 2016 at 16,866.82 - a record high - as small companies started to recover after the shock of the leave vote; although the 12.8 per cent annual total return lagged behind indices including blue-chip shares.
The NSCI was launched by Professors Elroy Dimson and Paul Marsh in 1987, with data starting from 1955, and now the index has a combined back-tested and live history of 62 years - making it an authoritative tool in assessing the performance of UK smaller companies.
Made up of the smallest 10 per cent of the main UK equity market by market capitalisation (the size cut-off for 2017 was £1.4bn), the NSCI is currently comprised of 701 companies. Stripping out investment companies (which often hold large-cap shares) the NSCI ex-investment trusts index (NSCI XIC) has 349 constituents whose £157bn total value is less than Royal Dutch Shell (RDSB) alone.
Smaller companies fared worse than the rest of the UK equity market in 2016, with the NSCI XIC producing total returns of 11.1 per cent in 2016, compared with 16.8 per cent for the FTSE All-Share. The academics have looked into some of the circumstances behind this underperformance, but first it is worth noting that over time the NSCI has delivered stellar returns. The compound annual growth rate (CAGR) for the NSCI XIC over the past five years has been 16.5 per cent, comfortably outstripping the All-Share (10.1 per cent). Going further back, the NSCI has achieved a compound return of 15.1 per cent a year, which is 3.4 per cent more than the All-Share, annually.
The team's research confirms that, post-referendum, themes relating to currency and overseas earnings underpinned the preference for larger companies (the FTSE 100 beat the overall FTSE All-Share index by 2.3 per cent). Within the NSCI XIC, it is also evident that companies with a large proportion of overseas sales have done better. The cumulative return in 2016 for those smaller businesses with 70 per cent or more of sales occurring outside of the UK was 30.2 per cent, although there was not much difference between companies with moderate (less than 70 per cent) overseas sales and 100 per cent domestic sales, with cumulative 2016 returns of 1.5 and 1.3 per cent, respectively.
Sensitivity to the sterling/US dollar exchange rate (GBP/USD) is also analysed in the review. Since the Brexit vote, the returns of the NSCI XIC has had a correlation with GBP/USD that is two-and-a-half times greater than the correlation between the FTSE All-Share and GBP/USD.
Overall, much of the movement in the NSCI since 24 June 2016 has been positive. Despite an adverse reaction initially (-13.1 per cent between 23 and 27 June), the index rebounded 23.8 per cent after 27 June to the end of 2016. This was stronger than the FTSE All-Share, but was still not enough to compensate for NSCI's weaker performance in the first half of 2016 and in the referendum's immediate aftermath.
Its powers of recovery are encouraging. While small-caps' risk-reward premium over large-caps can't be consistently promised, the report's authors are confident that the way small-caps perform over the long term creates the potential for higher returns over their larger brethren.
Source: Numis Smaller Companies Index and Dimson, Evans & Marsh, London Business School
For further information on the Numis indices, see http://www.numiscorp.com/x/numis-indices.html
