UK Small Caps: It’s The Hope That Kills You

Photo by Colin Watts on Unsplash 


UK small cap managers are an optimistic bunch, with the tide always just about to turn for their asset class.

Over recent years, they’ll have needed that optimism, as the sector returned just 0.19% last year, falling 25.77% in 2022, and underperforming UK All Companies in both. How much the sector has struggled is evidenced by the fact that only the top seven (of nearly 50 funds in total) are in positive territory over three years. What’s more, since I last surveyed the sector in April 2021, economic conditions have whipsawed back and forth, and there are consequently 10 new entrants on the table below.

As the saying goes, it’s the hope that kills you.

However, the longer-term case is rosier: UK smaller companies funds have, on average, outperformed UK All Companies in 12 out of the past 20 years, delivering an additional 73% of the returns of their large-cap peers over the period (486.85 % to 281.14%).

In the current environment, UK small cap investors’ optimism has to overcome two hurdles: the prospects for UK equities in general, and of their small-cap variants in particular.

So, what are the pluses and minuses for UK small caps?

On the positive side, they are attractively valued on a historical basis—as, indeed, are UK equities in general. The IA UK Smaller Companies sector has shed £5.1bn over the five years to the end of December, almost £1.5bn of that over the past year. Unloved assets are cheap assets. The question is, are they a bargain, or are they set to be cheaper still?

Putting one’s faith in reversion to mean is all very well, but it does rather depend on how long that reversion takes. One persistent downward pressure has been that large asset owners such as pension funds have been reducing their UK equity exposure for the past two decades and exacerbating outflows.

That’s generated a negative feedback loop. But it’s important to recognise this loop isn’t a death spiral, and that any number of things could catalyse a revival. Indeed, there are green shoots. For example, FTSE Russell research shows that in the fourth quarter of 2023, cyclicals helped UK small caps’ performance “soar”, driven by overweights to outperforming cyclicals such as Industrials, Discretionary and Real Estate, and underweights to lagging defensives such as Energy, Staples, and Health Care.

Whether these green shoots put down roots or wither in the winter frost depends a lot on macroeconomic conditions.

If inflation continues to fall—so if the December print is a nasty blip, rather than a reversal of trend—this will ease the pressure on companies, particularly smaller caps, which are highly sensitive to rates. They are also more economically sensitive than large caps, so much also hangs on whether the animal spirits of the market revive, and economic growth heads upwards.

But if rates remain elevated, or we tip into recession (a reliable way of bringing them back down historically), then those small caps with weak and/or short-duration cashflows will be at risk as the cost of capital remains elevated.

Despite the (as I write) positive market sentiment, a strengthening economy in 2024 is not a done deal: economic and geopolitical risks abound, and I shall not sour the milk in your breakfast cornflakes bowl by recounting them here.

I read one recent small cap market outlook that countered the fear of recession with the rejoinder that small caps exited such downturns earlier. That is true, but as we’re not yet in recession, it may well be wise to wait for that shoe to drop before increasing your allocation—or, at least, to be convinced we’ve skirted the R-word.

That said, given valuation levels, this is a sector that could have considerable upside when it finds its footing.


Table 1: Top-Performing UK Smaller Companies Funds Over Three Years (with a minimum five-year history)

(Click on image to enlarge)

All data as of January 31, 2023; Calculations in GBP

Source: LSEG Lipper


More By This Author:

Q4 2023 U.S. Retail Scorecard
STOXX 600 Earnings Outlook 23Q4 - Tuesday, March 5
Banks’ Hot New Trade Could Burn Others, For Once

Disclaimer: This article is for information purposes only and does not constitute any investment advice.

The views expressed are the views of the author, not necessarily those of Refinitiv ...

more
How did you like this article? Let us know so we can better customize your reading experience.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.