Now in their 32nd year live (and back-tested further to 1955), the Numis indices have become an important benchmark for monitoring aggregate performance of smaller UK companies. The recent annual review by London Business School academics Scott Evans and Paul Marsh looks at how the small-cap universe outperformed, once again, over the past 12 months and provides useful insight for investors in 2018.
The Numis Small Company Index (NSCI) covers the bottom tenth by value of the UK equity market, with a ceiling of £1.53bn set at the start of 2017. Over the course of past year, the NSCI made total returns of 18.8 per cent versus 13.1 per cent for the FTSE All-Share, a substantial risk premium for investing in smaller companies. Globally since 2000 the annualised size premium has been 5.2 per cent, although these higher returns are the reward for braving greater volatility than large-cap indices.
Nevertheless, the Numis indices provide a tool for studying and understanding the behaviour of smaller companies’ share prices. Highlights of this year’s review included a drill-down into the strength of well-known factors such as momentum, lower volatility, size, income and value. Looking at the version of the NSCI that excludes investment companies (NSCI XIC), the most powerful factor in small-cap performance is shares with momentum. The companies with positive price movements over previous periods continued to be the stars of the NSCI XIC in all bar two of the past 10 years. On a cautionary note, however, in the two years where the momentum effect was negative, the strategy saw losses of 51.1 per cent and 23.7 per cent in 2009 and 2016, respectively.
The study does shine light on the conditions in which we might expect positive momentum for small-caps to continue. When there are conditions of lower volatility, growth is normal, rates are low and inflation is middling, the NSCI has done well compared with the FTSE All-Share – and it has even fared better in bear markets. The worst conditions for NSCI-listed shares have been in economic recessions, when real interest rates have been high and in rate-tightening cycles.
Interestingly, this year’s study included a segment on the effect of UK politics on returns. The team found when there was a Labour government – or at least under New Labour – smaller companies did relatively better than large-caps. Overall, in absolute terms, both small and large companies did better under the Conservatives. In fairness, over the period of the study, Labour were in power in the 2000-03 and 2007-09 bear markets and the Conservatives have held office during the quantitative easing (QE) bull market for equities.
There were notably better returns from NSCI XIC companies with an overseas focus in 2017, and while it is important not to confuse correlation with causation, it is inevitable that the effect of the Brexit vote in 2016 will be debated. The cumulative return of overseas focused companies was 27.1 per cent versus 14.6 per cent for domestic orientated businesses. While this was a year when emerging markets did very well and Europe came to the global recovery party, there is a theory that Brexit uncertainty has weighed on smaller companies that rely on UK revenues.
The sterling devaluation after the UK’s referendum in 2016 had an effect on FTSE 100 companies, where the share price suddenly became cheaper relative to their international revenue streams. For smaller companies with a domestic focus, the effect of sterling’s fall was less pronounced than in previous devaluations. This may suggest that any bargain potential was offset by the fears for growth of UK-focused businesses. That said, the conclusion from the 2018 review must be that for investors with the appetite and capacity to take risk over a long time horizon, small-cap investments offer a worthwhile premium over their larger counterparts.
