While all eyes have been on the rotation from growth to value at the start of 2022, smaller company investors have had a dire start to the year.
No matter which region they may have invested in, small caps have underperformed large caps year to date, with the widest margin coming here in the UK. The MSCI United Kingdom Large Cap index has risen 7.83% while the MSCI United Kingdom Small Cap index is down 6.76%.
“The intense style rotation from growth to value in January occurred against a backdrop of eroding risk appetite marked by falling equity markets and a sell-off in SMID cap equities in favour of large caps,” commented Montanaro’s Cedric Durant des Aulnois.
“In the past, such periods of intense rotation into value tended to coincide with a ‘risk-on’ backdrop in equity markets. For instance, when value came back to the fore in April 2009, marking the onset of a new bull market, there was a clear shift across all corners of financial markets in favour of higher beta assets such as small and mid cap.”
So, is now the time to invest?
I’ve always been a fan of smaller companies when it comes to long-term investments, because history shows they outperform. And there are three reasons why now may be a good time to invest.
Firstly, they are a lot cheaper than they have been, creating a better entry point. According to Montanaro, global small caps have derated strongly – both in absolute terms and relative to large caps – since the onset of the pandemic. As a result, the MSCI World Small Cap index is now trading on 16.5 forward earnings, below its long-term average of 20x.
And the derating vs the large cap index is even more eye-catching: small cap is now trading on an 8% discount, by far the largest discount in almost 20 years.
Secondly, I’d point out that, historically, looking at data from the UK, small caps have outperformed by 5.6% per annum during bear markets for bonds, when yields have risen from 2% to 15%. That’s not to say I expect bond yields to get anywhere near that – but even when bonds have been in a bull market, small caps have outperformed large caps by 1.7% per annum.
And lastly, with inflation topping 5% in the UK and 7.5% in the US, it’s also relevant that small caps have outperformed in most environments except galloping inflation (when it goes over 12%).
Six small cap funds to consider
Unicorn UK Smaller Companies
This is a very high conviction UK smaller companies fund composed of around 40 stocks. It is small itself and flexible, with a solid investment process and a highly competent team. It’s also a true small cap fund that invests in genuinely smaller companies. Another positive is that the fund avoids low quality, cash-burning stocks. All companies must be profitable at the point of investment and the team looks for stocks with lasting competitive advantages, experienced management teams and strong balance sheets.
Janus Henderson European Smaller Companies
This is pure small-cap vehicle which has a style agnostic approach to investing. The managers will buy growth companies at a reasonable price but are also willing to look at neglected areas of the market. The managers are willing to delve into the bottom-end of the small-cap space with around half of the portfolio in stocks with a market cap of less than €1bn. They also target companies at different stages of their life-cycle, allowing them to diversify their revenue streams accordingly.
T Rowe Price US Smaller Companies
T Rowe Price US Smaller Companies Equity has a flexible approach. The manager looks for both growth and value opportunities in the small and mid-cap space, to build a diverse portfolio of the best ideas from the vast analyst resource at his disposal. The manager will allow his winners to run as long as he still believes there is a return opportunity. As such, the portfolio is likely to have more of a mid-cap bias than its peers and it will also invest in areas such as biotech, which other generalist funds often avoid.
Baillie Gifford Japan Trust
This trust invests primarily in Japanese small and medium-sized companies, which offer exceptional growth opportunities with sustainable business models. The team adopts a high conviction investment approach, typically holding between 40 and 70 stocks. They thoroughly research and understand any businesses in which they invest and are happy to take a long-term view. This means the fund has lower turnover in comparison to other Japanese small and mid-cap funds.
Federated Hermes Global Emerging Market SMID Equity
This is a concentrated fund focusing on small and medium-sized companies across global emerging markets. The managers look for quality companies that are exhibiting compound growth and that earn more than their cost of capital over the long-term. These factors will need to be under-appreciated by the market. They will either be great companies at good prices, or good companies at great prices. Alongside this, the managers will want talented management, who act responsibly towards clients, stakeholders and minority shareholders.
LF Montanaro Better World
This is a global equities fund that follows the same philosophy and process as the other very successful funds in the Montanaro range. The first stage of the process is what differentiates it from the other funds in the Montanaro suite: looking for firms creating a positive impact. To identify these companies, the team has six impact ‘themes’: environmental protection, the green economy, healthcare, innovative technologies, nutrition and well-being. And, in order to stay true to these themes, the team will also exclude companies that are causing harm, such as those involved in tobacco, weapons and fossil fuels extraction.
