Why I'm optimistic about small caps

Shares in small-cap companies rebound from recession faster than their large-cap siblings, according to research from data provider MSCI. That’s an encouraging thought. Sure, the prevalence of contradictory economic indicators means we may no longer be sure what actually is a recession; yet consensus opinion suggests that neither the UK – nor any country in the western world – is about to fall into one. That said, global economic growth was anaemic in 2022 and is set to be slower still this year and next (see the table). So there are recession-like features from which a recovery may ensue, starting sometime in, say, the coming 18 months; and – of course – barring the appearance of the unexpected and unwanted.

Hence some optimism about small-cap shares. MSCI’s analysts have trawled through US equity returns over the past 70 years, during which time the US economy has dropped into recession 11 times based on the familiar definition of a contraction in national output two quarters running. On every occasion in the 12 months following emergence from recession, US small-cap stocks have outperformed large caps, where the tiddlers comprise the smallest 30 per cent by stock market value and the big fish are the biggest 30 per cent.

On average, the small-cap outperformance in the 12 months after recession is 17 per cent. The widest margin was 49 per cent following the short-but-sharp Covid-19-induced recession of 2020; the narrowest was not quite 2 per cent back in 1970.

There is a logic to this pattern, which owes almost everything to the respective size of the companies in question. Most of the time the superior performance of small-cap indices boils down to the fact that small companies have more scope to grow revenues, profits and earnings than big ones. Thus, taking annualised returns based on end-month data for the past 48 years, MSCI finds that over one year – and from a global perspective – small caps outperform large caps almost 60 per cent of the time. As the investment horizon lengthens, the amount of time small caps outperform increases. It is 74 per cent of the time after five years, 81 per cent after 10 years and 90 per cent after 15 years. Put that the other way round and bluntly – it is really, really difficult for long-term investors to extract superior long-term performance by favouring big companies over small ones.

For the purposes of this discussion, we can assume that what applies to both global and US small companies also applies to their UK counterparts. Many other studies suggest it does, but this also means UK small caps suffer the vulnerabilities of limited size; in particular, limited diversification of income streams – both by product or service and by country or region – and comparatively weak balance sheets. Meanwhile, big companies will tend to have resilience where the small ones have fragility.

Indeed, vulnerability has been on full show lately, which is illustrated by the chart. The shaded area shows the performance of the FTSE Small Cap UK index relative to the FTSE UK index over the past 20 years. The start date in 2003 is arbitrary, although it probably favours small caps since it roughly coincides with the emergence of equities from the three-year bear market prompted by the bursting of the dotcom bubble. Anyway, the subsequent performance of small caps neatly matches the theory. Rapid initial outperformance was met with an exaggerated correction in 2007-08 as small companies felt the effects of the global financial crisis. Normal service was resumed and ran for most of the following dozen years until stagflation began to confront the western world in the second half of 2021. Within the 20-year span, small-cap outperformance peaked in August 2021 since when this group has lost almost two-thirds of its lead over the whole UK equity market.

But the chart also shows how falling markets have a built-in propensity to correct. Its specific cheapness/dearness indicator is shown by the line for the dividend yield on the FTSE Small Cap index. True, using a more conventional indicator, such as the ratio of share price-to-earnings, would have been preferred, but the long-run data is not available. On a yield basis, the index currently generates 3.3 per cent, which compares with a 20-year average of 2.6 per cent.

Happily, that 3.3 per cent is just on the right side of a familiar cheapness guide, which takes the average for a run of data and adds or subtracts an amount for the typical variation around that average (the standard deviation, in statisticians’ jargon). For a dividend yield, higher is better, so attraction lies above the average plus one standard deviation, which works out at 3.2 per cent on the data sample. So the yield is in territory it could be expected to occupy just one-sixth of the time and which it exits via the mechanism of rising prices.

Obviously, this is not fool-proof and it would help if the macroeconomic outlook were better. Only last month the International Monetary Fund updated its global outlook with the dull assessment that “the balance of risks is tilted to the downside”. It does not help that equities were surprisingly strong in the first half, implying that most of any good is already in prices. Still, the recovery in equities was driven by the US and in particular tech stocks, which were deemed to be oversold after a miserable 2022.

That may yet leave some scope for small caps. In this context, it is interesting to note the performance of 13 Aim-traded stocks that this column lined up as high-yield candidates 11 months ago (Investors’ Chronicle, 9 September 2022). On average, the price of the 13 is 15 per cent lower than a year ago, much in line with the drop in the FTSE Aim All-Share index (minus 17 per cent). Yet most of the companies have performed much better than their share prices. One year on, their average profit margin is slightly higher at 16 per cent and their return on assets is unchanged (11 per cent). That still feeds through to slightly less cover on forecast dividends for the current year – 1.6 times compared with 1.9 times a year ago – but happily producing a dividend yield 0.7 percentage points higher at 5.2 per cent. Intuitively-favoured stocks among the 13 are floorings provider James Halstead (JHD), plantations operator MP Evans (MPE) and food processor Finsbury Food (FIF); with Anglo-Canadian mini oil-and-gas explorer and producer i3 Energy (I3E) and smart meters installer Smart Metering Systems (SMS) as the high-risk recovery plays.

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The wrong incentives

Give people perverse incentives and it should be no surprise when they behave perversely. That should be especially true of business leaders since, apparently, they sing and dance to incentives like no other class of worker. While you and I are assumed to need little more incentive than the bonus of keeping our job to do our best, it is a given that the boss won’t stir a beautifully manicured toenail out of bed for less than six figures. So incentivise them with the perversities of an environmental, social and goverance (ESG) agenda, which is built on fashionable pseudo-philosophy, disputed science and rent extraction in roughly equal measure, and they are in their element.

Sure, the sight of business chiefs moving to an ESG agenda – and, let’s be clear, this is the sub-plot to the Farage-Rose fandango – is the business equivalent of Dad-dancing. But it is more than just embarrassing. There is a malignancy to it, partly because it ends up costing good people their jobs, but also because – actually – it is business with the moral compass gone missing.

To see why, let’s go back to first principles for which, in the sphere of business, there is rarely a better source than that colossus of economics – all five-foot nothing of him – Milton Friedman. Sure, Friedman’s relentless tone becomes grating, but there is no questioning the force of his logic.

Writing in Capitalism and Freedom, a short work from 1962 which is more about politics than economics, Friedman bemoans the “widespread acceptance that corporate officials have a social responsibility that goes beyond serving the interests of their stock holders”. This view “shows a fundamental misconception of the character and nature of a free economy” since, in such an economy, the sole responsibility of a business is “to increase its profits so long as it stays within the rules of the game”. Which is to say, it must be law abiding, even if the laws are unwise or unjust since “it is the responsibility of the rest of us to establish a framework of law”.

So if, say, business regulations with the force of law tell a company that it must count its scope 2 greenhouse-gas emissions, that must be done, even if it’s glorified guesswork. But, in the absence of law or regulation, business leaders must not make it up themselves because, asks Friedman, “if businessmen (sic) do have a social responsibility other than making maximum profit for stockholders, how do they know what it is? Can self-selected individuals decide what the social interest is?”

No, but nowadays they have an echo chamber or, failing that, McKinsey & Co, telling them the narrative and assuring them that, yes, they are on the right side of history; and yes, this is the way to restore legitimacy to the role of the company in the 2020s.

Except it isn’t. But why should business leaders know that? After all, there is no reason to think their moral compass, either individually or collectively, is better attuned than anyone else’s. It is chiefly their response to incentives that is heightened. So incentivise them to signal their virtue and, sooner or later, they will do something stupid. And don’t imagine Alison Rose will be the last.

bearbull@ft.com