Slowing growth coupled with heightened uncertainty is never a good combination for stock markets. Smaller company shares tend to deteriorate more because their operational risks are seen to be more concentrated versus large-cap peers.

History shows that smaller companies tend to underperform larger ones during economic downturns, so given the gloomy backdrop, many investors will happily avoid smaller companies this year. But dig a little deeper and a surprising conclusion presents itself, claims Anjli Shah, investment director at fund management firm Abrdn.

‘The time to start allocating capital to small caps might be sooner than investors think,’ he says. That’s because the market tends to price in an economic recovery before it happens. ‘We believe this disconnect creates opportunities for active investors,’ says Shah.

‘We’re in the midst of a slowdown deliberately manufactured by central banks to deal with inflation, which is showing signs that it may be peaking,’ says Neil Hermon, director of UK equities at Janus Henderson Investors. If the inflationary picture starts to markedly improve over the coming months, central bankers might change tack or at the very least, not continue to hike base rates, an outcome increasingly being priced in for this year by markets.

‘Given this scenario, we believe there are three reasons investors should be looking to invest in small cap stocks,’ Hermon says - low valuations, strong recovery potential and increasing M&A (merger and acquisition) activity.

OPPORTUNISTIC BUYOUTS ACCELERATING

In just the past few weeks we have seen the latter point play out, with online retail company THG (THG) jumping 44% after receiving an approach from Apollo Global Management. That followed just days after shares in veterinary group Dechra Pharmaceuticals (DPH) soared 33% as it revealed it was in talks with private equity group EQT over a possible £4.6 billion deal.

Also in April, mobile payments firm Network International (NETW) was approached by a consortium of CVC Partners and Francisco Partner Funds while property company Industrials REIT (MLI) backed a £500 million takeover by Blackstone. These takeover approaches join a string of UK-listed companies to see their share prices jump after being approached by potential buyers, including Dignity (DTY), Hyve (HYVE) and John Wood Group (WG.).

VALUATIONS BELOW HISTORIC AVERAGES

The apparent pick-up in M&A is not surprising considering the unstretched nature of UK stocks relative to historic averages. Datastream information collected by Janus Henderson showed the forward PE, or price to earnings ratio, of UK shares was 9.8 at the start of 2023.

The 10-year average was 13.2, while over 20-years, the PE average was 12.9, the data shows. Since then, the FTSE All-Share index has inched barely 2% higher, while the FTSE Small Cap Index has declined 1.6%.

Interestingly, AIC (Association of Investment Trusts) data for the Global Smaller Companies trust sector shows that only Smithson Investment Trust (SSON) has beaten the iShares MSCI World Small Cap UCITS ETF (WSML) over the past year, which tracks the MSCI World Small Cap Index, up 1.34% versus -1.53%, on a total returns basis.

Only six of the 26 UK Smaller Company investment trust specialists have beaten the iShares ETF’s performance, led by Rockwood Strategic’s (RKW) 40% total return, presumably helped by the cash inflow from the sale of its Crestchic holding (worth 28.7% of net assets) to Aggreko (AGK) at a 13% premium to NAV (net asset value).

The AIC data shows that 76% of UK and Global Small Cap trusts are currently trading at NAV discounts that are wider than their five-year average.

EXPERTISE IN YOUR POCKET

Retail investors that have been running their own portfolios for a while know how difficult it can be to pick winners, and this is where small cap investment trusts can help, believes William Heathcoat Amory, analyst at Kepler Research.

‘Trusts in the small and mid-cap sectors have seen significant NAV falls, as well as discounts widening. Managers of trusts investing in smaller companies can pick fundamentally attractive businesses and take long-term views, based on fundamentals and specifics, rather than being dependent on broad economic trends,’ he says.

‘In our view, this is a key attraction, not just for the growth opportunities, but also because of the fact that having a variety of idiosyncratic risks within a portfolio provides genuine diversification, resulting in higher risk-adjusted returns.’

Heathcote Armory points to a recent Factset analysis that there are diverse patterns of circumstances impacting smaller companies in the UK and overseas, and that means ‘the potential for managers to add alpha through stock picking remains undiminished.’

‘ELEPHANTS DON’T GALLOP, BUT FLEAS CAN LEAP’

In investment circles smaller companies have traditionally been perceived to be the stock market’s riskiest companies, but they have always held fascination for investors, professional and retail, because they also tend to offer the biggest capital gains potential.

On the premise that ‘elephants don’t gallop, but fleas can leap,’ to borrow a phrase from British investor Jim Slater, it is far easier for a small company to double its size, and investors’ money, than for a big one to do so.

Using history as a guide, Abrdn’s Shah says smaller companies start to rebound quicker during economic downturns than is widely assumed. ‘With valuations depressed, investors could therefore potentially pick up great long-term opportunities at a discount,’ and, it makes sense to tap into the risk-adjusted, diversification benefits offered by small cap investment trust specialists.

‘Since no one can predict when the current downturn is going to end, we believe investors with a small cap risk tolerance should view the current environment as a potentially opportune time to consider small caps,’ says Janus Henderson’s Hermon.

DISCLAIMER: The author of this article has a personal interest in Smithson Investment Trust

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