- Small caps could get rate pause boost
- Mid-sized and smaller companies often outperform after recessions
One of the most distinct market trends of the past few years has been the lagging performance of small-cap shares. These companies traditionally commanded premiums of up to 50 per cent over their larger cousins, but now find themselves at a global valuation discount.
For instance, no one could accuse the FTSE 100 of outperforming in 2023 with the index returning 4 per cent for the year, compared to the Dax on 19 per cent or S&P 500 on 24 per cent. However, this weakness is nothing compared with the lagging performance of UK small-cap shares, traditionally a source of alpha for investors with a greater appetite for risk. Yet the FTSE Small Cap index is now worth 1 per cent less than at the start of 2023. The Aim 100 fell 7 per cent last year.
So the idea that investors should start to look seriously at small caps as a source of above-average returns may feel difficult to stomach at the moment. However, if enough goes right with the global economy this year, and the inflation peak has passed, then small-cap companies should start to see an expansion in their profitability.
A few things need to go right first. For instance, small-cap companies are at a significant disadvantage to their mega-cap peers in that their market power often isn’t enough to enable them to pass on price increases onto customers, while the cost of capital has a greater impact on businesses with millions rather than billions in revenues. Over the past three years, UK small caps have underperformed large-cap equities by 28 per cent, as per Winterflood data.
This is driven by both investor sentiment and weaker operating conditions, the impact of higher rates having taken its toll both at a business level and on company valuations.
Tilmann Galler and Natasha May at JPMorgan note that small-cap debt tends to be floating rate and is highly geared to the level of interest rates – around 38 per cent of small-cap debt has floating interest rates on the Russell 2000 index compared with just 7 per cent for the S&P 500. The direction of inflation this year will be critical in determining overall small company profitability.
Analysts are currently expecting that the year will be very much a story of two halves, with better profits coming through in the second half, according to Peel Hunt. So, while doom and gloom might be a rational response, macroeconomic factors, combined with the cheapness of small-cap shares could offer a value opportunity that goes against the current trend.
The long decline
One impact of all this, as noted by the JPMorgan analysts, is that small-cap shares have lost their traditional premium to the large asset class market over the past decade. For example, the MSCI World Small Cap index now trades at a forward PE of 15 times, a discount to the general world MSCI index of 16.9 times and the long-term average of 17.7 times.
The other problem that JPMorgan highlights is a “negative selection bias” to small-cap shares that was less of a factor in the past. The interest of private equity in smaller companies and the involvement of more investors in private funding rounds means that greater numbers of companies have decided to remain in private hands rather than go public. Good small caps are also being bought out, further slimming the number of equities available. But this trend in itself could drive shares up, said Winterflood analysts. “An increased level of takeovers of UK small-cap companies, by both private equity and trade buyers, demonstrates the value that exists in the sector,” they said.
Still, the shares that are available on the small-cap market might not be the best-in-class. For example, heavily cyclical and capital-intensive sectors such as industrials and real estate make up nearly a third of the MSCI global small-cap index, according to JPMorgan, with a dearth of technology start-ups compared with large-cap markets. This trends also shows up in statistics for profitability.
In the US, where larger data sets are available, 27 per cent of the companies on the Russell 2000, the equivalent US small cap index, were unprofitable before the financial crisis. The proportion now is 45 per cent. Therefore, it is no surprise that investors are demanding a greater risk premium from smaller companies, thus impacting valuations. Indeed, no one expects that small-cap shares can return to their historic 50 per cent valuation premium to rest of the market, but this does not rule out the possibility of a rerating.
Value again?
There are two more reasons why small caps could be of interest. To begin with, the dispersion of quality companies throughout various global small-cap indices means that active stock selection is an interesting and viable strategy, particularly at a time when a series of modest forecast recessions could change the dynamics of monetary policy in a way that benefits small companies. There are also precedents that investors can draw on. For instance, of all the recessions since 1979, in the three following years, small-cap shares have outperformed large-cap indices by 22 per cent, according to JPMorgan. “Buying small caps during recessions has historically been a winning strategy,” said Galler and May.
