Huge waves of liquidity from central banks, improving sentiment, low starting valuations and a recovering economic backdrop have all helped this area of the market to rally hard since the period after the financial crash in 2008.
For example, the FTSE Small Cap index has returned more than 160 per cent over five years while the average portfolio in the IMA UK Smaller Companies sector – which is made up of 53 funds – has made a staggering 195.28 per cent over that time.
Performance of sector vs index over 5yrs
Source: FE Analytics
The sector has returned 53.93 per cent over three years and 35.93 per cent over the past 12 months.
It is not just UK smaller companies that have performed well since the crash. Equity markets across the developed world, especially the S&P 500 and the FTSE All Share, have seen almost interrupted gains since 2009.
However, there has been an increasing divergence of performance between small caps and their large cap rivals.
For example, while the FTSE 100 has only just recovered since the sell-off in May when Ben Bernanke first introduced the notion of QE tapering to the market, the FTSE Small Cap was less affected and has kept moving higher and higher since then.
Performance of indices over 1yr
Source: FE Analytics
While it is understandable that smaller companies will beat larger ones in a rising market, it is also equally understandable that investors should become more nervous when an asset class has delivered such euphoric returns in such a short space of time.
The question is whether or not there is much upside left in the current rally? Or more specifically, should investors have any concerns about buying a small cap fund now or, for those already invested, is now a good time to take profits?
A number of fund managers have told FE Trustnet that 2014 may be a much more difficult year for small cap investors.
FE Alpha Manager Toby Ricketts, for example, says that a number of “bubbles” will begin to deflate this year as the Fed gradually reduces its quantitative easing package, and as a result prices of cyclical stocks and smaller companies will correct.
Mark Harris, who heads up various multi-asset funds at City Financial, revealed he is considering winding down his UK smaller companies exposure as he says they have broken out of their traditional trading range.
“Is that where the risk lies? Small caps are certainly an area that has attracted a lot of money and we have started to review our exposure,” Harris said.
Psigma’s Thomas Becket (pictured) recently told FE Trustnet that he expects a 15 per cent correction in equity markets this year.
Although he is still optimistic on equities in the long-run, he says investors must realise that returns are likely to be a lot lower than they have been over the last few years. Becket says this is especially the case with smaller companies. “The rally in small caps probably can continue, but investors have got to be fully aware that the best returns are behind us,” Becket said.
“There has been quite a lot of money going into UK smaller companies recently and I would expect the best returns may have gone. There are still undeniably good returns to be made from certain areas of the small cap market, but that doesn’t warrant a wholesale asset allocation change.”
Gervais Williams, manager of the now soft-closed CF Miton UK Multi Cap Income fund, is far more optimistic.
When asked whether or not he felt the small cap rally could continue, his response was definitive.
“Absolutely,” he said. “I was just chatting with someone in sales who has worked in small caps for a long time and we were talking about how there are a lot of people who have made money from smaller companies and have said 'thank you' and taken their profits and moved into something like gold.”
“That’s fine, there will always be traders. However, they are going to find it really difficult to get back in,” he said.
The major reason why Williams is bullish is because smaller companies are an under-owned asset class.
He says there are a lot of investors, retail and institutional, who are comfortable not owing small caps as they are too risky. Because there are fewer people in the sector, he says there are also fewer sellers. The manager adds that although a number of stocks in the small cap index are trading on a P/E ratio of 50 times, the market as a whole is trading on a discount. On top of that, he says small caps can make money in any environment.
“For big international companies to deliver growth, they need international growth. Small caps, on the other hand, have a great ability to effectively push water up hill,” Williams (pictured) said.
“The UK economy is picking up for various reasons. However, that is not the reason to buy small caps.”
“Smaller companies can buck the economic trend. During the 50s, 60s and 70s, markets were very stop/go, there was not much economic growth and there were inflationary pressures. However, small and micros still outperformed.”
Of course, small caps haven’t always beaten larger companies.
In the decade between 1990 and 2000, the FTSE 100 beat the FTSE Small Cap by 100 percentage points. However, Williams says that was due to the inflation of the tech bubble, which was largely restricted to the large cap index.
Performance of indices between 1990 and 2000
Source: FE Analytics
Incidentally, looking back at the historical performance of the FTSE Small Cap versus the FTSE 100, an interesting trend emerges. The data suggests that the continuation of the small cap rally depends largely on how large caps perform.
Our data shows that since the dotcom bubble started to deflate in 2000, the FTSE Small Cap index has made at least a 14 per cent return – often a lot more than that – in each discrete calendar year the FTSE 100 has made a positive return.
The only exception to that was in 2007, where the FTSE 100 returned 7 per cent while the small cap index lost 10 per cent.
With two-thirds of respondents to a recent FE Trustnet poll expecting the FTSE 100 to break through 7,000 this year, the signs continue to look good for smaller companies.
At the same time, however, in each of the five discrete calendar years the FTSE 100 has posted a negative return since the turn of the millennium – the exception being 2000 when tech stocks tanked – the FTSE Small Cap has lost 25 per cent on average.
With concerns about over-optimism in the market, the tapering of QE and an unsolved eurozone crisis, large cap equities are by no-means guaranteed a positive year.
Nevertheless, Williams says that investors should not have too many concerns about buying small caps now.
“I’m sure it will pause at some stage, however with the UK economy improving and the sector under-owned, there aren’t any sellers,” he said.
“Markets do what is the most frustrating to people. The fact that small and micro caps are doing so well is highly inconvenient for some of the major houses because they are never going to be able to get money down there.”
“It is inconvenient for people, hence it will continue,” he said.
