Why UK small caps are primed for a comeback

The UK’s small-cap stocks might just be poised to come back into favour. There is no doubting they should have the scope to do so. In the past two years, small caps – as measured by the FTSE All-Small index – have markedly underperformed the FTSE 100 index. While the large-cap index has crept upwards, the All-Small index has dropped 20 per cent, for a 25 per cent relative underperformance.

As to why small caps may be on the cusp of something better, let’s begin with a diversion to the subject of Pareto distributions, just the mention of which can give many investors the heebie-jeebies. Sure the maths of a Pareto distribution is a bit forbidding. However, call the distribution by its common-or-garden name, the 80-20 rule, and suddenly the world seems calmer. Intuitively, we can grasp that, say, 80 per cent of Tesco’s profits may be made by only 20 per cent of its stores, or that 80 per cent of London’s traffic clogs just 20 per cent of its roads.

In the world of money, Pareto distributions abound. We keep being told, for instance, that 20 per cent of the people possess 80 per cent of the wealth. The distribution of stock market value among the components of the FTSE 100 index doesn’t quite match 80-20 – the 20 biggest currently account for 66 per cent of the index’s £1.9tn value – but it’s heading in that direction. More to the point, a portfolio’s returns are likely to follow an 80-20 rule – in any given year, an outsized proportion of its overall gains will come from a smallish fraction of its holding.

And therein lies a difficulty or, at least, potentially a difficulty, which small-cap stocks tend to sidestep. It goes by the label of ‘concentration’ and so-called concentration risk arises when a big part of a portfolio ends up being invested in comparatively few holdings, which tends to be the natural outcome of Pareto-style investment returns. The point is that often the most successful holdings in an equity portfolio may also be the most volatile ones. So, in contributing to a portfolio’s success, they also add to its risk.

In respect of equity indices covering the US, the world ex-US and emerging markets, research by index provider MSCI shows that, over the past 20 years, the concentration risk to small-cap indices contributed by their 10 biggest constituents was consistently less than the risk contributed by the 10 biggest in the parent indices. While that finding might be counter-intuitive, its important implication is that adding small-cap investments to an equity portfolio – especially one weighted towards blue-chip holdings – should be a good risk-reduction plan.

MSCI’s research does not include UK indices, so we don’t know that what applies to those global and regional indices also applies to the UK. However, for argument’s sake, we assume it does; and it’s tempting to do so because it complements other bullish factors.

The first of these is dealt with in Chart 1, which is a bit complex because it illustrates a cheapness/dearness indicator as it applies both to the UK and to the US. This is important because the case for UK small caps proceeds in three steps and the first is that UK equities are cheap relative to their US equivalent. The indicator shows the relationship between returns from equities and government bonds as measured by the ‘yield spread’, which is quantified by taking the earnings yield on equities and subtracting the redemption yield on 10-year bonds. So, the bigger the spread, the more attractive are equities.

For the exercise, the earnings yield – the reciprocal of the ubiquitous price/earnings (PE) ratio – is a more appropriate yardstick than the dividend yield. Effectively, it proxies the total return available from equities with the redemption yield – or yield to maturity – from bonds because its calculation includes all the net profit that a company makes and not just the portion distributed to shareholders.

Anyway, the chart lines, using colour coding (orange for the UK and blue for the US), juxtapose the yield spread over the past 20 years with its average level for that period. The further the spread drops below its average value, the more expensive equities become. On that basis, UK shares are a bit expensive, but US shares are horribly so. As the table specifically quantifies, against an average spread of 3.7 percentage points, US shares currently offer just a one-point advantage. Meanwhile, against their 5.5-point average, UK shares offer a 5.1-point spread.

If that implies investment money might leave US equities and head elsewhere, then the question arises, if it makes for the UK, on which market segment might it alight? Chart 2 suggests UK small caps would be the target. Relative to their big brothers, they look cheap when comparing the market value of the FTSE All-Small index, a 297-constituent index that’s an amalgam of the FTSE SmallCap and FTSE Fledgling indices, with the market value of the FTSE 100, whose constituent number does not change.

As Chart 2 indicates, the value of small-cap shares was traumatised first by the effects of the 2007-08 global financial crises, from which they eventually recovered – and sharply – in mid-2013; second, by fears of likely stagflation from mid-2021 onwards. With a current aggregate value of just 2.8 per cent of the FTSE 100’s, the All-Small index is close to its 20-year low. Barring the extremely unpredictable, it looks unlikely to drop much further. Sure, a nasty winter made nastier by energy prices bounding up again is a predictable uncertainty that would penalise small companies much more than blue chips. Aside from that, it seems reasonable to conclude that the so-called ‘unknown unknowns’ are already factored into share prices. After all, if they weren’t, small-cap prices would be higher. It’s a hindrance that the All-Small index, much like the better-known SmallCap index, does not come with a PE rating. However, its historic dividend yield – currently 4.1 per cent – is well towards its upper (cheaper) boundary. Only twice in the past 20 years has it exceeded 5 per cent – from late 2008 until early 2009 and very briefly in early 2020.

Chart 3 is where we come full circle. We said earlier that adding small-cap investments to an equity portfolio might be a good risk-reduction plan. In other words, small caps are a good way to diversify a portfolio. True, diversification benefits shouldn’t be overstated. After all, small caps, just like blue chips, are all equities and equity prices tend to move in the same direction. Sure, there will be some months when they move in opposite directions. For instance, in four months in the past 12, the month-on-month changes in the Footsie and the All-Small indices have tracked away from each other. Nevertheless, most of the time – and over the long haul – they will follow the same path.

This is measured by their ‘correlation’, some maths that quantifies the extent to which two variables move in the same direction. Perfect correlation, where the variables always move together, generates a value of 1.0. Variables always doing the opposite produce a value of minus 1.0. In practice, the correlation of a pair of equities – and especially equity indices – will be both positive and well clear of zero. Even so, within a narrow band there can be a significant diversion over time, as Chart 3 shows with respect to the FTSE 100 and the All-Small.

The significance here is that over the past 18 months or so the two indices have been moving especially closely together. Based on their five-year rolling average correlation, this is as close as they are likely to get. So it would be no surprise if the trend changes and, as Chart 3 also shows, when a change in trend comes, it can come pretty rapidly.

Of course, come that change, there is no certainty which index will be rising and which falling. It could be that the Footsie prospers and the small-cap index suffers still more pain. Yet if what we’ve just said makes any sense, most likely it will be the opposite. In which case, equity investors may want to think in terms of ‘small is beautiful’ and take a close look at the diversification of their portfolios by size. For instance, in the Bearbull portfolio, the median market value of the 15 companies in the portfolio is £1.6bn, and just four are less than £1bn.

bearbull@ft.com