Mega-cap outperformance coupled with underperformance by UK small-caps contributed to a record number of ‘fallen angels’ in 2022, according to Numis’ yearly indices review.
The number of fallen angels, namely companies that have slipped into a lower index, hit an all-time high at the start of 2023, making up 26% of the value of Numis Small Cap Index.
Only three of the 20 largest companies in the Numis Smaller Companies (NSC) plus Alternative Investment Market (AIM) universe were constituents at the beginning of 2022.
Should investors embrace or shun fallen angels?
While eight stocks grew out of the NSC plus AIM index, 45 had their wings clipped which saw then fall from a larger categorisation.
The review’s co-authors, Scott Evans and Paul Marsh of the London Business School, said: “The significantly larger number of companies joining than leaving the index due to size highlights the extent of the fallen angels over the year. The largest of this group is Spirent Communications with a market capitalisation of £1.62bn. Three of the 20 biggest joiners are AIM stocks while the rest are fully listed.
“An influx of fallen angels makes the index more value-oriented, and a bet against momentum, since it has loaded up on underperformers. A key question is whether investors should embrace or shun fallen angels.”
Historically speaking, fallen angels have impacted index returns by an average of -0.1%.
Evans and Marsh added: “Occasionally, however, investors get burned from ignoring fallen angels, most notably in 2010 after the global financial crisis and 1975 after the 1973-74 bear market. A key question is whether we are on the cusp of the third occasion when avoiding fallen angels is the wrong thing to do.”
Attractively priced equities
UK equities are currently valued at a 30-year low in comparison to global markets. Ken Wotton (pictured), co-manager of the LF Gresham House UK Multi Cap Income Fund, expects the recent step up in M&A deals to continue as a result as private equity buyers look to benefit from depressed UK valuations.
“While the market [recently] celebrated the FTSE 100’s record highs, we believe UK equities have much further to climb and will be driven by small and mid-cap stocks trading at a discount to some of the mega-caps that outperformed during 2022.
“By the end of 2022, British stocks were trading on a forward price to earnings ratio that valued the market nearly a third cheaper than global equities – the lowest relative price level I have seen over the course of my career. After a seven-year slide in relative valuations, UK equities have not looked so attractively priced compared to global markets at any time in the past 30 years.
“Market-wide statistics mask wide valuation dispersion at the stock level. Rarely has there been so much disparity between the market value of ostensibly similar businesses – and therefore so much potential to capitalise on discrepancies and mis-pricings. If traditional equity market investors do not take the opportunity then we expect increasing numbers of corporate and private equity buyers to do so.
“It is this simple observation that leads us to conclude that corporate activity will be elevated this year which in turn could be the catalyst for investors to turn attention back to the UK and drive a wider positive market re-rating. But investors must tread carefully. Only the most robust businesses supported by long-term secular growth trends can reliably deliver attractive returns in this volatile market context.”
James Gerlis, fund manager at Tellworth Investments, added: “As always, our Tellworth UK Smaller Companies Fund will take a balanced approach, considering both growthier and more value-orientated investments to give our investors access to the best opportunities we can find – and, with around half the portfolio currently invested in AIM stocks, this market will certainly be a hunting ground for us.”
