In January, commentators began flirting with the prospect of a UK small-cap rally. This burst of optimism followed a difficult period for these stocks: the Numis Smaller Companies Index (NSCI), which tracks the bottom 10 per cent of the UK main market, lost 17.9 per cent in 2022, ignoring the impact of investment companies. The Numis Alternative Markets index, which includes Aim stocks, had an even grimmer time, falling by almost a third.
Seven months later, domestic small-cap outperformance has yet to materialise, but smaller companies across the world are gathering even more interest. Analysts at MSCI noted last month that small-cap firms have “historically outperformed larger ones, especially after recessions and over longer holding periods”. Given the International Monetary Fund is forecasting a global economic slowdown later this year followed by a rebound in 2024, MSCI suggested that this pattern was worth paying attention to.
There are plenty of other pull factors. Using the forward price/earnings ratio of the MSCI World Small Cap Index as a valuation benchmark and the index’s return on equity as a measure of profitability, MSCI concluded that – as of May 2023 – small caps were trading at “a historically cheap valuation while profitability was close to a historical high”. Moreover, earnings per share (EPS) growth is trending upwards, and analysts’ EPS forecasts have also begun to improve.
The US seems to be taking notice. The Russell 2000 index has risen by 14 per cent since January, and small caps outpaced larger peers at points during the summer.
In the UK, however, we are still awaiting signs of life. The performance of FTSE Small Companies index has been fairly flat since the start of the year, while the Aim All-Share is down by 9 per cent. The NSCI did climb by 1.4 per cent between January and June, but growth lagged that of the FTSE All-Share, home to an array of larger businesses.
In a half-year update, the chair of Aberforth Smaller Companies Investment Trust (ASL) – the largest investment trust focused on UK small-caps – said “the valuations of UK equities in general and of the portfolio in particular remain very low, with few buyers of small UK-quoted companies beyond contrarian value investors, such as the managers, and opportunistic takeovers by private equity and other companies”.
Investor hesitation flies in the face of small companies’ balance sheets, which “have not been so strong since around 2014”, according to Aberforth.
“Companies had entered the 2009 recession with too much leverage and spent the next five years repairing their balance sheets. Today, in contrast, companies would be entering a slowdown or recession with healthy balance sheets. Clearly, there are exceptions, but the broad-based balance sheet resilience is an underappreciated feature of small companies at present.”
UK stocks are also very cheap – even by MSCI standards – and stocks with a market capitalisation of less than £600mn trade on “vast valuation discounts to their larger peers”, according to Aberforth. This has not gone unnoticed by private equity firms: six new bids were announced for constituents of the NSCI (excluding investment companies) between January and June, despite volatile debt markets. The average enterprise value/Ebitda for which companies sold was 16.2 times, while the average premium to the pre-announcement share price was 67 per cent.
It only seems to be a matter of time until other equity investors start paying attention. In the meantime, things might not get much worse: Aberforth said it's possible that “much of the risk of an economic downturn is already embedded within share prices” – at least when it comes to its own portfolio.
Timing has proved extremely difficult so far, however, and there are plenty of risks ahead, not least the persistence of UK inflation, tighter monetary policy and mortgage rate pressure. Patience is still crucial in this part of the market.
