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04 December 2023

UK Small Caps: The Size Discount

This article was taken from the Autumn 2023 issue of 1875. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.

Over the past year, small-cap companies in the UK have had a tough time, with overall returns of the FTSE Small Cap Index falling by 7%. Large-cap companies have also been hit, but still managed to pull through with an increase in returns of 7.5%. This past year, investors have been playing it safe, maintaining a ‘risk off’ attitude amidst the uncertainty of the economic climate. Instead, they have been gravitating towards large-cap stocks, which hold a stable valuation and dividend growth. This cautious attitude, however, has left small-cap stocks feeling unloved due to their high volatility, limited public information and relatively low liquidity levels.
 
The composition of indices, such as the Financial Times Stock Exchange (FTSE) indexes, highlights the contrast between the difference in markets. The FTSE Small Cap Index comprises of a significant 50% allocation to investment trusts, and an additional 7% to Real Estate Investment Trusts (REITs). Conversely, the FTSE 100, which exclusively holds large-cap equities, exhibits a notable emphasis on energy and banking, while their presence is relatively small in the small-cap index.
 
Right now, the lacklustre performance of UK small-cap stocks is making waves in the world of investments. It’s got investors at a crossroads, trying to figure out whether they should take a leap of faith or play it safe – a classic risk versus reward dilemma. Fever-Tree, known for its premium beverages, has seen its price to earnings (P/E) ratio compress from a peak of 75x in 2020 to 33x currently. It’s not just Fever-Tree, many companies have taken a hit in 2023. Rightmove, the property search platform, also had its P/E ratio compress from 55x in 2021 to a more modest 23x currently, alongside a fall in the share price by 60% over the same period. It is easy to look at this and worry, but this is all part of the natural cycle that small-cap stocks tend to go through.
 
What could the future hold? Small-cap investors remain optimistic with many companies in the sector reporting strong trading updates, showing their resilience against current headwinds. Though share prices have declined, operating performance hasn’t followed suit. Rightmove has seen its share price move lower since 2021 while earnings continue to advance. Other companies, such as the currency services firm, Alpha Group, have experienced similar feats with its share price declining while earnings increase. With resilience being proven, such companies cheapen, meaning that further share price declines only improve optical attractiveness. This is a common discussion point when talking to smaller companies’ fund managers and a key underpinning factor being their optimism.
 
While a common theme within the smaller-cap companies, many names exhibit the opposite trend of declining share prices and earnings. Some common risks that small caps can face include low liquidity, access to capital, lack of history, and limited information. Low liquidity levels can cause trouble for investors when selling or buying shares, as there could be too many or too little available. They can also have trouble gaining access to capital, so when times are hard, it can be tricky to finance gaps in cash flows. Compounded by current interest rates, financing has become very expensive and is not available to all companies. Thus, selectivity remains key and simply buying the index could lead to a missed opportunity, given it includes the good, bad, and ugly. While direct stock picking is one investment option, a potentially more attractive one comes through the purchase of a listed investment company, of which the larger cohort focusing on UK smaller companies trade at discounts to Net Asset Values (NAV) in the mid-teens. The benefit of which comes in specialisation, immediate diversification of exposure and the ability to buy an already discounted area of the market at a further discount.
 
Looking forward, it will be interesting to see what happens to the UK smaller companies sector. Will it remain optically cheap? Or will it experience a resurgence due to a change in sentiment and growth potential? Predicting the catalyst and timescale is impossible, but for anyone who has experienced the sector for a significant period, when it moves, it has the potential to do so quickly.
 
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.
UK Small Caps: The Size Discount

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