Though they have enjoyed a strong rebound over the course of 2017, uncertainty continues to dog UK smaller companies as a result of increasingly poor economic data and ongoing – and seemingly futile – Brexit negotiations.
Smaller companies were the hardest hit segment of the market in the immediate aftermath of the EU referendum – with the Numis Smaller Companies ex IT index falling 13% between the 23 June and the 27 June 2016. This was primarily due to the adverse effect the vote was expected to have on the UK economy, but also because – unlike the FTSE 100 – they weren’t expected to be beneficiaries of sterling’s nosedive against nearly all other major currencies.
The root cause of these concerns towards UK small-caps therefore appears to be their domestic focus. According to a recent study from JPMorgan, 71% of revenues across UK small and mid-caps are generated from within the UK (which is considerably higher than the figure for UK large-caps) while only 18% of revenues are generated internationally. Therefore, taken on average, UK smaller companies are more exposed to the strength of the UK economy and sentiment among UK consumers than their larger counterparts.
However, so far during 2017, the Numis Smaller Companies ex IT index has powered forward with total returns of 16.5% to the 20 October 2017 – almost doubling the returns of the FTSE 100. Few trust investors, however, are getting carried away with the recent rally. The dichotomy is highlighted by the average NAV total return across the AIC UK Smaller Companies sector which has been 24.6% – but the average discount across the sector (currently c 13%) has remained wider than its longer-term average – as the chart below shows. In fact, 75% of trusts in the sector are now trading on wider discounts than their five-year average.
DISCOUNTS
Source: Morningstar
Many smaller companies continue to trade on high P/E multiples (both compared to large-caps and their longer-term averages) despite the potential doom and gloom surrounding the outlook for the UK economy, and so investors could be forgiven for avoiding small-caps at this juncture. However, despite the headwinds, there are certainly reasons why investors may consider smaller companies over the long-term.
A long-term case for smaller companies
The research team at JPMorgan set out their long-term case for small and mid-caps in a report last month entitled ‘The Case for SMid’. Though it focused on the attractiveness of small and mid-caps from a global perspective, the majority of their arguments focused on the UK market.
For example, the team noted that UK SMid-caps have and continue to offer stronger earnings growth and have healthier balance sheets; have the consistent tailwind of M&A activity; are far less covered by brokers than large-caps and therefore can offer better opportunities for active managers; and are backed by a shareholder base with a bigger vested interest in delivering strong and sustainable returns (as shown by the percentage of insider/stakeholder holdings). Their analysis argues that small caps haven’t simply been a higher beta play given they have historically carried lower beta (or sensitivity to the index’s returns) than large-caps during short-term corrections (they argue this is because investors tend to sell their most liquid holdings during temporary pullback to avoid higher trading costs) and because they have posted higher Sharpe ratios (a measure of risk-adjusted returns) over the longer term.
MAJOR FINDINGS OF THE JPMORGAN REPORT ON UK SMID-CAPS
Source: JPMorgan
Furthermore, JPMC analysts argue that UK SMids are far better placed to deal with (or putting it differently, are more shielded against) political trends of the 21st century than large-caps due to their more domestic nature. These include the need for greater fiscal spend, the potential for greater protectionism and the rise in populism as “they represent a larger part of the voting population than large-caps … but make up a far lower percentage of the equity market capitalisation”.
The findings of the report led the team to conclude that “the returns of SMid-caps will dwarf those of cash, bonds, real estate and large-cap equities for decades to come”.
A long and consistent track record of strong returns
Obviously, this conclusion is by no means guaranteed and only time will tell as to whether this will indeed be the case. Our research does show, though (again with the usual caveat that past performance is no guide to the future) that small-caps have been a highly-profitable area of the market for long-term investors – though they will have had to stomach considerable levels of volatility.
For example, over rolling 10-year periods (priced monthly) over the past 25 years, the Numis Smaller Companies ex IT index has always delivered a positive total return (41% being the worst ten year period), and has delivered an average 10 year return of 152%. On the other hand, there have been six ten-year periods in which the FTSE 100 has lost money over the last 25 years, and has delivered an average 10-year return of 75% over the same period. This data is shown in the table below, which illustrates the returns of both indices over the following 10 years from the starting month and year.
Furthermore, smaller companies have consistently outperformed over the long-term. Over the past 25 years, in nearly 98% of the 10 year periods we analysed, the Numis Smaller Companies ex IT index beat the FTSE 100.
10 YEAR ROLLING RETURNS
Source: Morningstar
Even on a five-year view, returns from smaller companies have been consistently strong. Though smaller companies largely underperformed FTSE 100 in the early 90s (as the chart below shows), they outperformed in 75% of the rolling five-year periods we analysed over the 25 years as a whole and only posted a loss in 4% of them. The largest potential loss on a five-year view over that time was between April 1998 and April 2003 when the Numis Smaller Companies ex IT index fell 18.17%. Nevertheless, the FTSE 100 fell 30% over that period.
5 YEAR ROLLING RETURNS
Source: Morningstar
As the next chart shows, the likelihood of smaller companies outperforming large-caps also steadily increases as you extend the rolling return timeframes over the past 25 years – further highlighting how important it has been to hold onto small-caps during periods of volatility rather than capitulating.
LONG-TERM SMALL-CAP OUTPERFORMANCE
Source: Morningstar
A new dynamic?
Clearly, though interesting, historical performance doesn’t automatically translate into future returns. An important factor for future performance, though – and specifically in the UK – may be the increasing number of income opportunities within the small-cap space.
We have already written about the dwindling levels of dividend cover across the FTSE 100 – a problem that few smaller companies have to deal with (dividend cover across the Numis Smaller Companies ex IT index more than twice as large than across the FTSE 100). As such, dividend growth has been far stronger further down the market-cap spectrum – the average annualised five-year dividend growth across the AIC UK Smaller Companies sector has been 11.5% pa against the AIC UK Equity Income sector of 4.1%.
Small-cap trusts do tend to yield less than those within the UK equity income peer group (2% compared to 3.6%), which often have significant weightings to large and mega-caps, however the effect of this dividend growth is clearly shown in the table below, which illustrates the average annual dividend payments on an initial £10,000 investment across the two sectors over the past five years. As we show, the gap between the average dividend distributions between the two peer groups has narrowed substantially over recent years. Who knows what the future holds, but the recent underlying income generation of trusts such Standard Life UK Smaller Companies, BlackRock Throgmorton, Rights & Issues and Invesco Perpetual UK Smaller Companies (all of which we have covered this month) is testament to this new income dynamic within the smaller companies space.
5 YEARS OF UK EQUITY INCOME DIVIDENDS VS UK SMALLER COMPANIES DIVIDENDS
Source: FE Analytics
It’s not been easy, though
However, while investors have been rewarded for holding smaller companies over the long-term in the past, it is clear they have – and are likely to continue to be – considerably more volatile than their larger counterparts and have the potential to cause far more pain to a portfolio. The events of the 2008 global financial crisis are testament to this.
For example, our analysis shows that if investors bought smaller companies at the worst possible time of the past 25 years – 18 May 2007 – they would have had to wait 43 months to December 2010 before the Numis Smaller Companies ex IT index was back in the black (and 45 months before it was outperforming the FTSE 100). However, if they had held out for 10 years, they would have witnessed a return of 120% compared a return of 63% from the FTSE 100. So, though they offer long-term rewards, investors needed a great deal of bottle to not capitulate.
One could argue that the small-cap sector’s stronger dividend growth, and underlying company’s dividend cover puts means they are different entities to this time 10 years ago and that, over time, (and assuming it continues) this income element may dampen down overall volatility. Again, though, there is no way of guaranteeing that will be the case and given current discounts, investors are not ignoring these shorter-term risks or headwinds.
So, what are the shorter-term forces that may prove problematic for small-cap investors?
A potential pounding
Our research suggests, for example, that the short-term fortunes of UK small-caps are tied to the performance of sterling. The chart below shows the performance of sterling against the dollar over the past three years (in blue), while the orange line shows the relative performance of the Numis Smaller Companies ex IT index against the FTSE 100 – so when it rises, small-caps are outperforming and when it falls, they underperform.
THE IMPACT OF POUND WEAKNESS
Source: FE Analytics
The chart clearly demonstrates that when the pound has experienced sharp declines, small-caps underperform (which is understandable given FTSE 100 stocks largely global multinationals that either report in dollars/euros or do the significant proportion of their business overseas). Therefore, for the outperformance of small-caps to continue over the shorter-term, it appears that the pound needs to either strengthen or at least maintain its value – which doesn’t seem particularly likely given continued Brexit uncertainty.
In the absence of sterling strength, managers themselves are trying to reduce the risk from further sterling weakness, with many the AIC UK Smaller Companies Trust sector gradually shifting their portfolios towards more internationally-focused companies over the past 12 months.
