10 years of UK small cap investing

Henry Lowson, Senior Fund Manager

5 October 2017

While no one would suggest that the last decade has been plain sailing for equity investors, looking back it is clear that UK small cap investors have enjoyed significant outperformance over the last 10 years overall versus the large-cap UK equity universe.

Surprising as this may be to some, there are obvious reasons why UK smaller companies have generated stronger long-term performance than their larger counterparts, adding weight to the argument that UK small cap should be considered as part of any investor’s long-term asset allocation.   

Small companies, large universe

The UK small cap universe comprises over 1,250 companies, and spans a variety of industries and sectors. Compared to the FTSE 100, the FTSE Small Cap ex-IT Index has a lower concentration in mining, oil & gas and financials sectors and a greater concentration in industrials and information technology, and so is arguably a more diversified benchmark. In addition, concentration risk is lower, with the largest stock in the FTSE Small Cap Index typically less than 2% of the index, whereas Shell, the largest stock in the FTSE 100, comprises around 7.5% of the index. The small cap universe is large and offers a wide spread of differentiated business models, providing ample opportunity for active small cap managers to diversify their portfolios and discover hidden gems.

Capped in the UK?

It is a common misconception that UK smaller companies only offer exposure to the UK domestic market. In fact, nearly half of the sales of FTSE UK Small Cap index companies have overseas market exposure. So, while the UK small cap index suffered in the immediate aftermath of Brexit, with investors favouring large caps stocks with greater weightings towards overseas earnings, the index rapidly made a strong recovery, led by industrials, healthcare and technology, as companies continued to report positive earnings results and upgrades.

An inefficient market

Market inefficiencies, particularly within the small cap market, have been compounded by the structural decline in analyst research and resource. As regulatory pressures result in shrinking commission pots for investment banks, dedicating resource at the smaller end of the market can be deemed less commercial, as share volumes and liquidity are traditionally lower than in the large cap arena. The result is that some stocks undervalued simply because they are relatively unknown. This creates attractive opportunities for bottom-up, active stock pickers. At the same time, a structural shift out of UK small cap has meant that, despite its performance, the asset class is still relatively under-owned, with assets under management in the smaller companies sector declining over the last ten years, if one strips out the impact of the positive performance.

A big future for UK small cap?

Smaller companies tend to be younger and at an earlier stage of their growth trajectory. This means they have greater potential for growth; financial physics also means that it is easier for these firms to grow quickly compared to large companies. Innovation in terms of the product or service they provide remains critical to the success of smaller companies, as it is this that will allow them to compete effectively with incumbents, to take market share and to grow in less supportive economic conditions. This is also what makes smaller companies attractive targets for merger and acquisition (M&A) activity. Indeed, amid sterling weakness since the Brexit referendum, UK companies have become more attractive to overseas firms, resulting in flurry of M&A activity, which looks set to continue. Recent examples include workwear rental supplier, Berendsen (target of a bid by French rival Elis) and Zegona Communications (whose asset, Telecable, was bid for by Spanish company Euskaltel).

Brexit and other geopolitical events will continue to create uncertainty for UK investors and consequently the market backdrop is likely to be characterised by volatility. It is impossible to predict he likely trajectory of the market, but over the last twelve months the correlation between stocks has fallen significantly, creating a fertile environment for active stock pickers. For active managers, attractive returns will depend on picking high quality, innovative smaller companies with robust cashflows and strong balance sheets, which will be able to weather short-term volatility far more successfully than their peers.

Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice. Investment in smaller companies may be riskier and less liquid than larger companies, which could mean that their share prices and therefore fund performance is more volatile. All rights in the FTSE® Small Cap (ex Investment Trust) Index (the “Index”) vest in FTSE International Limited (“FTSE”). “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE under licence. The Royal London UK Smaller Companies Fund (the "Fund") has been developed solely by Royal London Asset Management. The Index is calculated by FTSE or its agent. FTSE and its licensors are not connected to and do not sponsor, advise, recommend, endorse or promote the Fund and do not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b) investment in or operation of the Fund. FTSE makes no claim, prediction, warranty or representation either as to the results to be obtained from the Fund or the suitability of the Index for the purpose to which it is being put by Royal London Asset Management.