The long-term outperformance of small caps over large is an evergreen theme in UK equity investing. But due to a confluence of factors, right now could be particularly timely, says Raynar Portfolio Management’s Philip Rodrigs.
The IMF recently predicted the UK will be the world’s fastest-growing advanced economy this year, upgrading its GDP forecast more than for any other country.
In spite of ongoing threats from variants of Covid-19, and thanks to a hugely successful vaccine rollout, both the IMF and the CBI have forecast strong, continuing growth for the UK over the rest of the year and beyond.
Understandably, after a miserable 2020 saw markets dive across the board, investors are now keen to evaluate increasing exposure to equities to continue to benefit from the subsequent rebound. As far as we’re concerned, there’s no better place to begin than at the entrepreneurial end of the market – the UK smaller companies sector.
The Importance of Stock Selection
First, it’s important to acknowledge not every smaller company will prosper over time. After all, there are nearly one thousand listed firms at the smaller end of the market and many are in their nascent stages, with little visibility when it comes to long-term performance.
As you’d expect, this means picking the stocks most likely to prosper is a challenging job that investors focused on the fewer choices amongst generally more established business within the mid and large cap universes choose to avoid. However, investors willing to take on the less-examined smaller companies sector with its lower liquidity and therefore risk premium will find the top slice of winning small cap stocks can generate very attractive returns.
Why? Well, a lot of it comes down to scale.
Scaling business models
The smaller a company is, the greater its potential for growth: it is easier for a company turning over £1 million to double its sales than it is for one making £100 million, for example.
But this doesn’t apply only to sales growth.
Smaller companies also have a greater potential for margin expansion from improving economies of scale than their larger peers. They have greater potential for putting cash into transformational investment opportunities and a greater chance of re-rating as their illiquidity risk premium ebbs as more investors pay attention to the firm as their market cap grows. And, because their audience is typically smaller in the early days, they have a better shot at sustaining an upward trend as their progressively increasing size attracts new interest.
The outperformance these factors can drive is so powerful, that data from Numis Securities found that £1 invested in the Numis 1000 XIC smaller companies index from 1955 to date accumulated to more than £25,000. That’s far larger than the return for any of its equivalent indices for larger stocks over the same period (see chart below).
It stands to reason that investors who can identify a sector-beating small cap stock at a cheap valuation and run that winner into mid cap territory and beyond can generate truly transformational returns.
From consolidation to rapid growth
The long-term outperformance of small caps is an evergreen theme in UK equity investing. However, right now is particularly timely because the sector is in a period of consolidation.
That might sound counter-intuitive, but—in fact—it could represent an ideal entry point.
There’s an old saying, often attributed to American author Mark Twain, that goes “History never repeats itself, but it does often rhyme.”
A look to the past can therefore provide a useful barometer. Previous cycles show an initial phase of very strong market appreciation, followed by a period of consolidation, before a subsequent phase of appreciation.
As data from Numis Securities shows, the surge, pause for breath, continued rally pattern has been a feature of the last two market recoveries from March 2003 and March 2009 following the Global Financial Crisis and the current cycle which started in March 2020 is rhyming with it.
So, in this vein, we can be quietly confident that the chances are good that the second up-phase of a traditional market recovery is potentially around the corner.
While many UK small caps continue to trade at a discount to their global peers, once the true scale of Britain’s economic recovery is appreciated, with the next results season likely to be helpful for this, and firms ramp up the delivery of strong earnings reports—it may well catalyse a move into the next growth phase.
As such, we see a strong opportunity in snapping up quality small-cap names positioned to benefit from a recovery in domestic expenditure – like Safestyle, Brickability, and Studio Retail – ahead of potential catalysts.
Long term outperformance
Sixty five years and counting is more than enough time to put to bed doubts on the veracity of a trend. That is how long UK Smaller Companies have structurally outperformed their larger brethren, so it is arguable that it will always be a good time to make a long-term investment into the sector. However, some good times might be better than others and we believe such a juncture is apparent. Following a summer of consolidation, we look forward to the rest of 2021 and into 2022 with enthusiasm.
Philip Rodrigs is founder, portfolio manager of Raynar Portfolio Management