One of the main attractions of smaller companies to risk-conscious investors is that they will have a better chance of outperforming their large-cap peers over the long-term due to having more room for growth.
But in recent years this phenomenon has taken somewhat of a backseat in the UK thanks to overhanging Brexit negotiations.
Indeed, since the EU referendum in 2016 the FTSE 100 large-cap index has outperformed the Numis Smaller Companies ex IT benchmark by 2.89 percentage points.
Performance of indices since EU referendum
Source: FE Analytics
This is partly because many UK large-cap companies are primarily multi-national businesses often deriving the majority of their earnings overseas.
As such they have benefited from a weakness in sterling since Brexit, according to Simon Evan-Cook, senior investment manager of multi-asset funds at Premier Asset Management.
Indeed, sterling plummeted versus the US dollar in the immediate aftermath of the EU referendum result and remains down some 11.54 per cent since June 2016.
“Small-caps tend to be more domestically-focused, which means they suffered more when the currency fell, and have perhaps had more of a Brexit stigma attached to them than the blue-chips,” he said.
“The direction [of small-caps] will probably depend on the sterling-dollar exchange rate, which will, in turn, depend on the Brexit negotiations.
“If we get a clean, soft Brexit, sterling should rise, which will help small-caps and hinder large-caps. Whereas the opposite would probably be true if we got a messy, hard Brexit, or a ‘no deal’.”
While investors that typically focus on the macroeconomics may need to take a stance on which scenario will play out, he added that this is not how the Premier team invests.
“Instead we look at valuations and fundamentals,” he explained. “On this front, there’s not much to separate small- and large-caps. In which case, given the long-term history of small beating large, we suspect it’s a reasonable time to be holding some smaller companies in your portfolio.”
Ultimately, investors should be contrarian, said Evan-Cook: investing in small-caps when they are less positive on the UK equities and selling when they are more positive.
“Given the fact that investors almost always feel they should avoid small caps, this means it’s usually a good time to hold them. And I don’t think today presents us with any exception to that rule,” he said.
Gavin Haynes, managing director at Whitchurch securities, agreed that investors might want to add small-cap exposure, highlighting that the recent underperformance of small-caps has made them a buying opportunity for contrarian investors.
“I believe that for long-term investors the very gloomy scenario priced in to domestically-focused areas of the UK stock markets could provide a contrarian opportunity to invest in smaller companies,” he said.
“Although I acknowledge the political risks of a bad Brexit deal, I believe that good stockpickers can find mis-priced smaller companies that have been indiscriminately shunned due to investor concerns over the UK economy which continues to hold up reasonably despite the political uncertainty.”
However, those investing in small-caps need to know what they are getting into and keep in mind some important lessons, according to City Asset Management research director James Calder.
First is to make sure that for those truly wanting to take on small-cap exposure they do not invest in a manager that is running too much money.
“I think the industry tends to forget that there is a massive difference within small-cap itself. You can get the larger funds that are in small-caps who tend to focus on the top-end or the bottom-end of the mid-caps,” he said.
“To my mind that is not really small-cap investing. When we look at small-caps we restrict ourselves to more what has historically been seen as the micro-cap end of the market.”
Rolling 5yr returns of indices over 5yrs
Source: FE Analytics
The second rule is that investors need to be patient. Indeed, he said that investors need to be investing in the asset class “for five years plus”.
“The other important thing we tend to forget is if you are going to allocate capital to small-caps understand what you are buying but as important is to have a decent time frame in mind,” he said.
This should help to ride out any short-term periods that large-caps outperform, such as the one currently being witnessed in markets.
Looking at the two indices on a rolling five-year basis for the past five years – all data taken at month end – the Numis Smaller Companies ex IT index has outperformed the FTSE 100 in each period, as the above chart shows.
Finally, investors should remember why they are buying small-caps, which is to ultimately capture the superior growth prospects on offer.
“You are buying these things because they are the growth companies of tomorrow. You have got to take on some volatility and time periods that you will not be comfortable with,” Calder said. “We don’t expect – unfortunately – everything to work well over all time periods and in all environments.”
However, valuations being lower relative to the large-cap peers also make them an attractive option in the event of a recession and gives them some insulation in the event of a negative Brexit outcome.
“What you have to remember is if, and when, the next recession comes and small-caps are out of favour they will protect to a degree over the short-term when everything else is falling out of bed,” he said.
The fund he uses is the five FE Crown-rated LF LivingBridge UK Micro Cap fund run by FE Alpha Manager Ken Wotton and Brendan Gulston.
The fund has been a top-quartile performer in the IA UK Smaller Companies sector over the past five years, returning 113.47 per cent, and is in the second quartile over three years.
Performance of fund vs sector over 5yrs
Source: FE Analytics
While “on absolute terms it has been fine but not fantastic” according to Calder, he said that the micro-cap approach to investing is appealing.
The £137m fund has a clean ongoing charges figure (OCF) of 0.99 per cent.