Three reasons why small caps offer value

Investec’s Philip Rodrigs says accessing small caps via a specialist active manager could bring value to your portfolio.

Investors have in recent years overlooked the investment potential of UK smaller companies and favoured allocations to UK multi-cap equities.

Any exposure to UK small-cap equities for such investors has been minimal and delegated to their third party multi-cap manager, leaving them underexposed to this potentially very alpha-rich area of equities.

But now is the time for investors to consider a dedicated allocation to UK small-cap equities via a specialist active manager.

The main reasons for our view are:

1. Over the past 55 years, UK smaller companies as represented by the Hoare Govett indices have enjoyed significantly faster earnings growth compared to more mature UK larger companies. High quality, nimble, niche-focused smaller companies can exploit opportunities to grow earnings very quickly, in many cases regardless of the economic back-drop.

2. In contrast to the highly concentrated large-cap universe, specialist active UK smaller companies fund managers can benefit from selecting from a pool over twice as large containing many relatively overlooked businesses with excellent growth prospects, spread over a more diversified range of sectors.

3. Historically, UK smaller companies stocks have performed particularly well during periods of economic recovery and growth, similar to the period we are in now.

UK smaller companies have outperformed large caps over past 50 years. Due to their size, dynamic well-managed businesses generally have the potential to significantly increase their earnings (and share prices) at a rate far beyond that attainable by most mid-cap and large-cap businesses. The chart below shows the stronger growth potential of the shares of UK smaller companies.

The blue line illustrates the relative performance of the Hoare Govett UK Smaller Companies Index (defined as the bottom 10% of market by value) versus the UK’s FTSE All Share, which started in 1962. The red line is the OECD UK Lead Indicator, which is used here as an effective means to illustrate economic activity and recessions.

As the chart demonstrates, since the early 1960s the UK small-cap index has outperformed large caps more than threefold. This is not to mention the continuous opportunity for specialist fund managers to outperform the index via judicious stock selection. The relative performance of small caps versus the wider market also varies depending on different stages of the economic cycle.

UK investors benefit from being on the doorstep of one of the largest and most dynamic markets for smaller companies in the world. The UK market offers investors access to both leading domestic players, global leading British businesses exporting or trading overseas, but also some of the best overseas businesses seeking to list and raise funds from this world class small-cap market, across a range of sectors.

The UK smaller companies sector benefits from having a far greater number of options to choose from than the large-cap sector. While the majority of the FTSE All Share’s market capitalisation is comprised of just 20 mega-cap stocks small-cap fund managers have up to 800 firms to choose from between £30m and £1bn in market capitalisation.

This means there are many overlooked opportunities waiting to be discovered and significant opportunities for an active specialist investment manager to outperform, especially one with a disciplined philosophy and consistent investment process. This significant scope for alpha generation from UK small caps is one of its key draws to an active specialist manager.

Investing in the UK smaller companies sector also offers exposure to a group of businesses which, by comparison with larger enterprises, are driven by different dynamics. Over one third of the FTSE 100 is comprised of commodity-related stocks. By contrast, the largest sector in the FTSE Small-cap Index is the extremely diverse Support Services sector at 16.7%. Therefore the mix of industries and resultant economic sensitivities are different, leading to performance that may be less correlated with the large-capitalisation market.