Economic uncertainty and rising interest rates are seen as bad news for smaller companies. Investors across the world have tended to act first and ask questions later, selling down small-caps without checking whether they are struggling.
The result has been that, while operational performance has generally held up, it has been a grim period for investors in this segment of the market.
Nevertheless, as interest rates stabilise and there is greater clarity on the economic outlook, smaller companies have started to look interesting once again.
At the moment, investors are tentative. There has been some progress in smaller companies since the rally in November 2023, but many would prefer that someone else took the leap first.
The problem is that it is tough to call the turn in smaller companies, but lower liquidity means those waiting for a clear catalyst may miss the bounce. It is also difficult to know where to direct attention because the fortunes of smaller companies have varied from region to region.
The UK will be closest to many investors’ hearts and here, the scale of underperformance is greatest. Over three years, the FTSE 100 is up 27.5%, while the FTSE Small Cap is up just 2%.
If small-caps are seen as uniquely exposed to the fortunes of the domestic economy, interest rates and inflation, on these factors the UK has seen a worse performance than almost anywhere else and its small-caps have suffered disproportionately.
By almost any measure, they now look cheap. Their plight has even caught the attention of the government, which introduced measures in the latest Budget to try and shore up the flagging sector.
Smaller companies managers point to an improvement in economic outlook, the prospect of interest rate cuts, ever cheaper share prices, and better operational performance as reasons why the sector could turn.
Nevertheless, outflows from the sector continue, even if they have narrowed a little in recent months. Paul Marriage, manager of the TM Tellworth UK Smaller Companies fund sums up the problem: “Much though smaller companies might be getting a bit more airtime, there remain marginally more sellers than buyers. In a market where liquidity has improved, so has efficiency – shares which did well on little news have reverted to unloved status as soon as the tailwind of sector optimism has calmed a little.
“On our recent marketing tour, the mood music of investors waiting to see more evidence before they commit or recommit capital to the sector was deafening.”
Nevertheless, in global funds, where managers have a choice of jurisdiction, many are finding more opportunities in the UK. The Global Smaller Companies Trust, for example, has roughly a quarter of the portfolio in UK.
Japan has been another area where there has been a notable gap between small- and large-cap, though this has had a different background. The MSCI Japan Small Cap index has an annualised return of just 0.1% over the past three years, compared with 3.4% for its large-cap equivalent. Small-caps had almost entirely missed out on the rally in Japanese equity markets, which had focused on index heavyweights.
Karen See, co-manager of Baillie Gifford Japanese Income Growth, says: “In 2023, we saw a lot of market movements driven by macro factors, such as the weak yen, as well as inflation and interest rate expectations. We also saw a very severe rotation from growth to value.”
However, she hints at a reversal of that. “A lot of the index heavyweights that performed very strongly throughout the year have come back quite a bit in the fourth quarter. That’s been helpful for us because we don’t own any of those, such as the big banks or automakers.”
The Small Cap index is still behind in the short-term – 6.7% versus 12.5% over the past three months – but this may start to reverse.
In Europe, small-caps have also underperformed – for all the familiar reasons. Phil Macartney, a manager on the Jupiter European Smaller Companies fund, says: “Smaller companies are often viewed as more domestically orientated, with a higher level of risk around their operations due to size. Valuations of smaller companies have derated to the level that there is no longer a premium for investing in this area of the market.”
As with Japan and the UK, there are clearly opportunities, but investors are waiting on better sentiment before making the leap.
The US is slightly different. Small-caps are the cheaper spot in an expensive market, but that doesn’t mean they are cheap. They have also had a good rally recently and no longer look conspicuously cheaper than their large-cap peers. The MSCI USA Small Cap index trades at 28x price-to-earnings (P/E), versus 26x for the MSCI USA. The gap for other regions is far wider.
Peter Ewins, manager of the Global Smaller Companies trust says: “Our North American weighting has come down a little. We feel that valuations are higher than elsewhere. They always are, and the growth potential and long-term track record has been very strong in US small-cap. It’s not a market where we want to be too underweight, but we do feel that valuations elsewhere look a bit more attractive.”
Amid this complicated backdrop, the temptation may be to leave it to someone else. We continue to like The Global Smaller Companies Trust, which can take a birds-eye view on the landscape for smaller companies in different regions.
Overall, however, we believe smaller companies will have their moment, and are likely to move fast when that moment arrives. They just need a handful of brave investors to go first.
Darius McDermott is managing director of FundCalibre and Chelsea Financial Services. The views expressed above should not be taken as investment advice.