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The underdogs fight back: Can small caps defy the odds against the Titans?

Mike Clements
Mike Clements

Fund Manager

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I'm unstoppable
I'm a Porsche with no brakes
I'm invincible
Yeah, I win every single game
I'm so powerful
I don't need batteries to play
I'm so confident
Yeah, I'm unstoppable today

                                   - Sia

My colleague, Alex Paget, recently wrote a fascinating piece about the unstoppable rise of the Global Titans - the largest stocks in the world that have come to dominate indices. After 14 years of rise, their outperformance over the rest of the market has reached the widest margin it has ever been. As Alex points out, the consequence of this incredibly narrow market is that almost no active manager (just 2.5% of his 1700 fund sample!) has managed to beat the Global Titan Index over the last 12 months.

If you can't beat them, join them!

So what did a fund have to do to beat the Titans? Simple - just own those same Titans but in even greater weight than the index. 

The table below is unashamedly stolen from Alex's article - it shows the most popular stocks held by those rare funds that managed to outperform over the last 12 months.  Microsoft, Nvidia, Amazon, Alphabet, Meta … forget about diversification, that foolish notion would have only diluted returns!

Source: Morningstar, 29.02.2024. Past performance is not a reliable indicator of future performance.

Will the Titans hit an iceberg or “will their performance go on”?

From our European perspective, this domination of returns coming from a small group of stocks is something that we have also seen here. The FTSE 100 has risen by just over 21% since the start of 2021, easily trouncing the 2% return from the FTSE Small Cap index over the same period. Quite rightly, our UK-focused fund managers such as Rosemary Banyard, Judith Mackenzie and Josh McCathie have been shouting about how cheap UK smaller companies have become.

In Europe, it has been even more extreme. The largest 50 stocks in Europe have risen by 32% since the start of 2021. This is an astonishing 37% better return than the small cap index which actually lost you money in absolute terms over the last three years.

Source: Bloomberg 1 January 2021 to 18 April 2024. Past performance is not a reliable indicator of future performance.

Fool me once…

We discussed this extreme difference with some of our clients last November, suggesting that the degree and longevity of small-cap underperformance must reverse at some point. Small caps promptly outperformed in December, our fund had one of its best months of performance and we felt like market timing heroes.

Since then, however, it has been one-way traffic. The Stoxx 50 rallied hard into the year-end and then has continued to power ahead in the first three months of the year. Small caps, conversely, have done nothing but give investors a fresh headache.

Looking for lifeboats?

Suitably reminded that we should stick to stock picking rather than macro predictions, the chart below illustrates how we view the current market situation. The data looks back over the last 24 years and plots the return an investor would have received on a rolling three- year basis from a small-cap portfolio relative to its large-cap equivalent in both the UK and European markets.

    Source: Bloomberg 1 January 2003 to 29 March 2024. Past performance is not a reliable indicator of future performance.    

Interestingly, UK small caps have been here before, most notably during the financial crisis in 2008/9 when they had a torrid time.

In Europe, however, we are in uncharted territory. Small caps have pretty reliably outperformed their larger brethren over every three-year period for much of this century, including even (more or less) during the financial crisis.

Not anymore. Whether it is liquidity or interest rates or passive flows or something else, European small caps have never been so far underwater before, nor for such a long time.

Our conclusion is simple - whilst many of the European mega caps that have performed so well are undoubtedly great businesses, in many cases their valuations look pretty stretched. Perhaps small caps could be the lifeboat that is needed if (or maybe when?) mega caps hit the proverbial iceberg and start taking on water faster than Celine Dion can write another hit song?

This article was written by Mike Clements, Manager of the VT Downing European Unconstrained Income Fund.

Important notice

Risk warnings: Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Investments in our funds should be held for the long-term and are higher risk compared to investments solely in larger, more established companies. Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice.

Important notice:
This content is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. This content contains information that is believed to be accurate at the time of publication but is subject to change without notice. Whilst care has been taken in compiling this content, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is a trading name of Downing LLP. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England and Wales (No. OC341575). Registered Office: 6th Floor, St Magnus House, 3 Lower Thames Street, London EC3R 6HD.


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