Most markets are dominated by the larger companies, and when markets ‘move’, it is usually in response to the biggest companies’ momentum. By contrast when a recession hits, the big companies often have more reserves, are internationally diversified and generally outperform smaller companies. A blue whale can take a lot more damage than a sardine.
However, that sardine is a lot more nimble and in relation to its size faster than the blue whale. Downturns are traditionally challenging periods for smaller companies, but over the longer-turn – and especially in the recovery phase – UK small caps outperform their larger peers and can offer convincing relative value.
That’s why now might be the time to have a look beyond the big beasts of the market and identify the small caps that will be punching above their weight. The last year has been a punishing one for the whole economy, not only at the smaller end of the market. You cannot avoid the fact that when different market segments are analysed discretely, it’s been the small caps that have come off worst.
Small caps punished
In the UK For the first nine months of 2022 everything in equity was pointing southwards. However, the FTSE100 index only declined 4% over that period, whereas the FTSE250 lost 26.7% and the FTSE Smallcap index was down 19.6%. Inflation, rising interest rates, falling consumer confidence all factored into smaller company performance, especially seeing that the smaller end of the market was more sensitive to the vagaries of the UK market.
By contrast, the FTSE100’s larger companies had access to the kinds of financing smaller companies could only dream of, had an international spread of clientele, so were not as sensitive to the health of the UK economy – an outlier in underperformance amongst its G7 peers – and had significant reserves they could call on.
Road to recovery
But the recession will pass, and by this time next year, the UK economy should be on the road to growth once again and it is traditionally the smaller companies that perform better in these conditions. Markets and companies are subject to the same laws of physics that all other entities are. If a large mass wants to double its size, it has to absorb a huge quantity of resources and expend a vast amount of energy to increase its mass or volume by 100%. However, if a small entity wants to double its size, the resources it has to absorb is much smaller and more available and as we know small children grow a lot quicker than full-blown adults.
Sometimes companies grow so big that they need to split themselves up and each independent part has to grow independently to achieve any meaningful growth. One such example was GSK’s LON:GSK spin-off of Haleon LON:HLN last July. Subsequent to the demerger, the separate entities have had difficulty flying the nest, so there is no sure-fire solution to perpetual growth, especially the larger that you become.
Innovation and flexibility
Undoubtedly, it’s been a hard year for smaller companies (I know, as I have a penchant for them personally) and in many cases its been a sea of red in terms of returns. But there are thousands of smaller companies to pick from, covering every sector of the economy. And its often these smaller companies that are the most innovative, flexible and offer the best prospects in terms of growth.
The biggest of the smaller companies are found in the FTSE250 (which in the first nine months of 2022 lost 26.7%) and are medium-sized companies, more mature in terms of development and growth and less susceptible to volatility to their smaller peers in the FTSE SmallCap and FTSE Fledgling indices, but still offer better prospects of growth than the largest companies.
The AIM index is interesting, in that it is often perceived as a smaller cap index but does host some pretty large companies with a capitalisation of over GBP1bn. However, AIM is often more growth-orientated than other indices.
Tough conditions
From the outset, it will continue to be tough for smaller companies. The Bank of England continued its campaign against inflation by raising interest rates again last week and the cost of funding will make smaller companies more vulnerable. However, the ace in the hand that smaller companies have is that they are more flexible and adaptive than larger companies, and can quickly jump onto market trends, be it the transition to clean energy theme, or an outbreak of a pandemic.
Larger companies take a lot more ‘retooling’ to adapt to new trends, and by the time they have turned the prow of the ship around, the trend has moved on and growth it offers has often already been captured. Moreover, smaller companies are often much more innovative, have more streamlined-decision making processes and can capture market share from the big beasts, which at the outset large companies can ignore, until it becomes an issue, by which time the smaller operators may have already created new consumer, commercial or industrial niches.
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Market capture
On such small company we recently covered was SRT Marine Systems AIM:SRT, which competes with defence behemoths, BAe LON:BA., Northrop Grumman Corporation NYSE:NOC and Lockheed Martin Corporation NYSE:LMT, but has managed to carve itself out a profitable nice in small-boat, maritime civil defence to counteract people smuggling, the smuggling of contraband items and restricted drugs; illegal fishing; the dumping of illegal wastes and sanctions-busting.
SRT spent eight years concentrating on its knitting, and as Simon Tucker, the Bath-based engineering firm’s CEO explained, developed its products specifically for maritime small boat civil defence use. SRT now finds itself eight years ahead of the likes of BAe in the development curve and has the flexibility to customise its products according to its clients’ needs, something the larger contractors can’t as they follow the Henry Ford principle of: “Our customers can have a car painted any colour that they want, so long as it is black.”
From small acorns
All big companies started off small. Steve Jobs and Steve Wozniak started Apple NASDAQ:AAPL with a second-hand toolbox and soldering iron in Jobs’ garage in 1976. Investing in smaller companies means that you could uncover the titans of tomorrow. Smaller companies, by their nature, are under-researched and far from household names. This opens opportunities for investors who are willing to carry out their own due diligence to identify future outperformers that have historically been ignored. This more fertile hunting ground allows active investors to uncover hidden gems and the potential giants of tomorrow. It also means that smaller companies can be picked up at a discount – many are ‘penny stocks’ and can be bought, for well, pennies.
Nevertheless, the smaller cap market is a minefield. Business failures at this end of the spectrum are much higher than with established companies (that’s not to say that big companies are immune to failure, see: FTX, RBS, Washington Mutual, Lehman Brothers and Enron). There are literally thousands of smaller companies, and as mentioned above one benefit is they are under-researched, but one drawback is also that they are under-researched, so it’s sometimes difficult to know what you are getting yourself into.
For the nervous or unsure, one way to get into the market is through a managed investment fund.
Listen: Ivan Sedgwick on smaller companies and the AIM market
Managed fund option
One such fund is the Jupiter UK Smaller Companies Fund, managed by Daniel Nickols and team of Jupiter Asset Management. Nickols has just celebrated his 19th year in charge of the fund.
The fund aims to achieve capital growth, net of fees, greater than that of the Numis Smaller Companies Index excluding Investment Companies over rolling 3-year periods. The Jupiter UK Smaller Companies fund invests primarily in UK company shares and invests at least 80% in smaller companies, which are defined as those companies quoted on a regulated market and that are no larger than the largest company in the Numis Smaller Companies Index at the time of investment. The fund has the flexibility to invest up to 10% in unlisted companies, and may use derivatives with the aim of reducing overall cost and risk.
Nickols, who was recently initiated into the FEFund Info Hall of Fame actively manages the fund and its index is a broad representation of the fund’s investment universe and as such is a point of reference against which the performance of the fund may be measured. Although a large proportion of the fund’s investments may be components of the index, the fund has the ability to deviate significantly from the index.
Originally launched on 9th February 2001 as a UK-domiciled open-ended investment company, the fund has GBP622m assets under management spread amongst around 60 holdings and has a two-star rating from Morningstar.
As at the end of 2022, the fund’s top five stocks were:
Gamma Communications LON:GAMA 3.9% (Telecoms)
Telecom Plus LON:TEP 3.9% (Telecoms)
OSB Group LON:OSB 3.7% (Financial Services)
Vesuvius LON:VSVS 3.3% (Basic Materials)
Alpha Group International [LON:ALPH] 3.3% (Financial Services)
With the Industry breakdown being:
Industrials 27.6%
Financials 19.4%
Consumer Discretionary 14.6%
Technology 14.2%
Telecoms 10.6%
Turnaround
The fund had a disappointing 2022, returning -33.8% against a benchmark return of -17.9% and industry average of 25.6%, finding itself in the bottom quartile. Cumulatively, over three years the fund also performed poorly, returning -18.3% against a benchmark return of -4.2% and sector average of -4%, also depositing it in the 4th quartile although since the start of the year the fund has started to face in the right direction, returning 3.4% against a benchmark return of -1.8% and sector average of 0.1% according to Morningstar.
The fund is available to invest from Jupiter directly, but also appears on all the usual platforms. Hargreaves Lansdown charges 0.855% for accumulator units, derives from a 1.03% ongoing charge less discount of 0.175%. Income units are also available from HL.
Now might be time to pick up small cap bargains as across the index, despite the prevailing economic headwinds, small-caps by and large have strong balance sheets and historically low valuations. Current performance might be anaemic, but historically strong returns can be found in this end of the market.
Over three, five and ten years, smaller companies will do well, and so the poor performance in the short-term creates an opportune buying opportunity. While market turmoil has impacted sentiment and valuations over the last year, the structural growth drivers for the types of businesses in the smaller end of the market remain intact. If the last year is anything to go by, its clear that we need cleaner energy sources, more sustainable methods of transportation and building and it is the smaller, more flexible and innovative companies that will be delivering these solutions over the next decade.
