The weakness of small cap has not been just a UK phenomenon, but a feature of stockmarkets around the world. Investors assumed that small caps would be vulnerable to higher interest rates and any weakening in the economic environment, preferring to focus on a handful of large cap companies in both the UK, US and Europe. That weakness has persisted in spite of a revival in economic conditions and a stabilisation in interest rates – until recently.
Over the short term, there has been a tentative recovery in some regional small-cap markets. In Europe, for example, small caps (as measured by the MSCI Europe small cap index) have outpaced their larger peers by over 3% over the three months to 31 May. It is a similar picture in the UK, with the FTSE Small Cap and FTSE 250 ahead of the FTSE 100. The MSCI Emerging Markets Small Cap index is also on the recovery path.
Neil Birrell, chief investment officer at Premier Miton, says that US smaller companies have yet to revive, and this is skewing the overall figures. He adds: “US smaller companies make up 56% of the world index and they have not yet recovered, which is surprising given the strength of the economy. It may be partly due to the ongoing influence of the giant companies such as Microsoft and Nvidia and the technology sector more broadly (some of which we think will run out of steam).”
Nevertheless, he is supportive of small caps from here: “We believe the background is in place for a substantial long-term outperformance of smaller companies over large. It’s happening in some regions now and we are of the view the US will join the party, which will carry on for some time.”
This is a view echoed by Nish Patel, manager on the Global Smaller Companies investment trust. He points out that periods of weakness are often followed by lengthy periods of strong performance: “When you’ve had the recovery from this level, it can be quite long.”
He suggests the two periods that are quite similar to today are the early 1970s, following the bursting of the Nifty-Fifty boom, and the late 1990s after the bursting of the technology bubble.
Both of those periods were characterised by narrow leadership of the market. The post-Nifty Fifty period saw a 10-year recovery cycle for smaller companies, and there was an eight year upturn for smaller companies after the technology boom.
Unloved
Patel is confident that investors haven’t missed the bounce, saying global small caps remain widely unloved by investors. This is shown by the latest IA statistics that still show the UK, US and European smaller companies sectors in net outflow. He adds: “Smaller companies tend to be 7-8% of the total stockmarket on average. Today, that number is 4%. Historically, this level has been a low point and the start of a recovery.”
His view is that valuations relative to large caps are at cyclical lows. Partly, this reflects the very high valuation of some of the large caps (notably the technology giants), but Patel still believes smaller companies look extremely undervalued. “If you look at the valuations, the widest discrepancy is in the US market.” Nevertheless, the FTSE 100 is also above the FTSE small-cap index and the same thing is happening in Europe.
In its latest economic outlook JPMorgan Asset Management suggested that the greatest discrepancy was in the European market. It said: “With economic momentum now turning in Europe’s favour, valuation gaps appear too wide. This is particularly true in European small caps, which stand to benefit disproportionately from earlier European Central Bank (ECB) rate cuts given their dependency on floating rate debt and where the usual valuation premium versus large caps has been eroded.”
Catalysts?
Nevertheless, the continued revival in small caps is not assured. They have remained cheap versus large caps for some time, and are still vulnerable to any fragility in economic data, or signs that interest rates could move higher. That said, Patel sees a number of potential catalysts that could mean the improvement in small cap performance versus the wider market could continue.
The first is the potential weakness of large caps. He adds: “The larger companies have been growing really quickly for a long time at elevated rates, particularly the technology companies. A number of them have exceeded a trillion Dollar market capitalisation. It is difficult for businesses to sustain those levels of growth. Competition comes in and it becomes hard to grow at the same rate. There could be a reassessment of the amount of money allocated to those companies.” Even a small amount of money out of the magnificent Seven would benefit small caps disproportionately.
The management teams of small-cap companies are also taking action, buying back shares to support share prices. There is also growing M&A activity. The Global Smaller Companies trust saw seven takeover bids in its last financial year alone. Janus Henderson European equities portfolio manager Marc Schartz says: “M&A has been relatively subdued in recent years, but we see signs of pickup. And M&A has traditionally been a performance driver of the small and mid-cap space.”
The final catalyst would be interest rate cuts. There has already been the first cut in Europe and in Canada. US and UK interest rate cuts have been deferred but are still likely to come later this year. This is likely to be more beneficial to smaller companies than larger companies and small caps have historically led the market after an interest rate cut.
When small caps finally pick up momentum, the early moves can be the most dramatic. The liquidity problems that have worked against small caps on the way down work in their favour on the way up. If the market is turning, investors may need to be quick to participate fully.
