Looking for further upside from resilient small-cap shares

Remarkably, despite falling by 40 per cent in March, the Numis Small Companies Index (NSCI) ended 2020 above water. Its outperformance of the large cap-oriented FTSE All Share index, is further testimony to the capacity of smaller companies to reward their investors.

Launched in 1987, and back tested to 1955, the main NSCI index is comprised of the bottom 10 per cent of UK main market-listed equities by market capitalisation. The annualised rate of total return is 14.6 per cent over its 66-year history: that’s 3.4 per cent greater than for the FTSE All Share.

Failure to out-smart beta

Understanding the drivers of these returns can provide investors with pointers to the next legs of upside for the exciting small-cap space. This year’s NSCI index review, conducted by Scott Evans and Professor Paul Marsh of the London Business School, noted the outperformance of investment  companies last year, but that so-called factor investing strategies (choosing companies based purely on characteristics of size, low volatility, value, income or momentum) did badly.

Excluding investment companies, the NSCI still beat the FTSE All share by 5.5 per cent last year but including the listed closed-end funds, the outperformance was 10.9 per cent. This reflects the success of underlying strategies the funds invested in, with global equities leading the way.

For the first time in the history of the NSCI index, the five traditional factors the academics have data for, all failed.  Since 1955, small-cap momentum stocks (those that have seen price increases often continue to do so as more investors pile in) have made an average annual return of 16.9 per cent but 2020 was a negative year (-9.5 per cent).

Frequently in stock market history a negative correlation has been observed between momentum and value shares (value traditionally refers to companies whose share price looks cheap relative to the book value per share of their assets). Yet last year value also underperformed at -13.2 per cent. Of course, correlations in factor performance are not totally consistent and, despite a 3.4 per cent long-run rate of return, value has done terribly across the market in recent years anyway.

More of a surprise is the failure of value and momentum coincided with stocks with less of a history of volatility (a style that has made 3.8 per cent a year long-term) being -19.2 per cent relative to the rest of the NSCI last year. Going long smaller companies and short larger ones, to measure the size premium (which has been 0.7 per cent annually long-term), was -3 per cent relative to the index. Finally, income stocks (which have provided a 3.2 per cent annualised premium historically) were -6 per cent compared to the main NSCI.

Those NSCI companies that pay dividends slashed them by almost 33 per cent – the deepest annual cut on record - so in that context the underperformance of the income factor was mild. Excluding investment trusts, the figure was -52 per cent. But, in the time of coronavirus, companies that just maintained a dividend saw share prices rewarded by the end of the year.

Even companies that cut their pay-out slightly were up, perhaps reflecting the extraordinary situation for the economy and investors’ appreciation of clear guidance and prudent financial management. Although, ‘income’ stocks are likely to have had more to cut and therefore the underperformance of the style is understandable.

Does the uptick for styles at the end of 2020 bode well?

Overall, UK main market small caps did worse than similar sized companies listed in other developed countries, but the underperformance was less marked than for the UK’s large cap stocks. The twin challenges of Covid-19 and Brexit negotiations clearly dragged on the UK last year. With some hope of vaccine roll-out and greater clarity on Britain’s trading relationship with the European Union, these headwinds should be lessened in 2021.

Will a subsidence of such macro tribulations mean some investing styles could again start to outperform?  The academics aren’t quick to jump to conclusions from the end of year uptick observed in value, income, and size factor performance. They attribute the late improvement in value stocks to the general switch in both the UK and US from growth to value, although they highlight it is impossible to predict this will be sustained; or to imply that small caps are generally undervalued.

One problem with trying to pick where the market will perform strongest in 2021, say the academics, is that large caps underperformed last year. Also considering the Aim market (the Numis Alternative Markets Index, which is Aim stocks, made 19.3 per cent in 2020), small caps did outstandingly well, so the real recovery potential could be for large cap stocks. Yet, as the report authors note, in the case of the UK that would require sectors hit badly in 2020 like oil & gas, traditional retail, travel and leisure to enjoy a reversal in fortunes.

Arguably, more of the companies that will grow fastest as the economy recovers from the pandemic are to be found further down the current market capitalisation scale. Nothing is certain, of course, but the long-run reward of taking a chance on some smaller companies, was once again attested to in one of the strangest years any of us have lived through.