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Downturns or recessions are traditionally challenging times for smaller-sized companies. But for investors with longer-term time horizons, UK small caps may offer compelling relative value.
Smaller companies, which tend to be more vulnerable to macroeconomic heavy weather, are feeling the impact of a turbulent backdrop. Despite the gloomy landscape, now might be the time to look beyond the FTSE stalwarts to smaller stature names that can punch well above their weight.
In this article, we explore how cash-generative smaller companies at a discounted value can not only remain resilient in choppier conditions, but capture market share and give investors exposure to future innovation.
In the UK there are thousands of listed small and mid-sized companies, the largest of which are found in the FTSE 250 index. These types of mid-sized companies are usually at later stages of growth and so are susceptible to volatility compared to their smaller counterparts, but still offer higher potential for growth than large companies.
Sliding down the size scale, we discover the FTSE Small Cap and FTSE Fledgling indices. The small cap world is also becoming increasingly diverse in both type and size of company. For example, the alternative investment market (AIM) - a submarket of the London Stock Exchange (LSE) that allows smaller companies access to capital from the public market - has become an attractive listing venue for higher-growth companies at earlier stages of development.
AIM is not just the preserve of smaller companies. It also houses several companies whose market capitalisation is over £1 billion and household names such as ASOS and Domino’s Pizza began their public listing lives on AIM before moving up to the main market.
A challenging backdrop
In an economic downturn, smaller-sized companies have traditionally underperformed compared to their mid and large counterparts. This has largely been due to their cyclical nature, higher growth characteristics and heightened exposure to deteriorating consumer sentiment.
Interest rates are currently exacerbating a difficult macro picture as the rising cost of capital impacts more growth-orientated businesses that have elevated borrowing or funding requirements. As the Bank of England takes more steps to bring inflation to heel, these businesses will become more and more vulnerable.
However, while businesses struggling with the rising cost of borrowing may look less enticing, there remains a strong investment case for investing in a diverse range of robust smaller companies.
These are firms that have been indiscriminately sold off and can not only survive but thrive in the current environment.
Small in size, big in stature
What smaller companies often lack in market stature they make up in agility. They tend to have more adaptable business models which make them adept at change management.
Smaller companies are also often at the forefront of innovation and enable investors to get access to emerging trends in sectors like healthcare, renewable energy and technology. Their agility also means they are inherently disruptive and can steal market share from bigger legacy players or create entirely new consumer, commercial or industrial niches.
Uncovering the giants of tomorrow
The fundamental structure of the smaller companies market also gives them a key advantage. In comparison to FTSE 100 names or even mid-sized firms, there is a lack of sell-side broker research on smaller companies. This opens up 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 investment managers to uncover hidden gems and the potential giants of tomorrow.
Given the inherent risks within the small-cap arena, it is important to seek out relative safety. The wide spectrum of companies means there are varying levels of risk. To mitigate smaller company risk it is prudent to look up the quality scale, particularly during downturns when it is important to identify companies that will be resilient in the face of economic turmoil.
Higher-quality small-cap gems often share a common set of characteristics. For example, they have a competitive advantage, but this advantage is sustainable. They should also demonstrate some persistence in earnings growth – and have business models that are underpinned by structural growth drivers.
Cash generation must also underpin financial strength, which allows for share-buy backs and dividend growth and creates a powerful compounding effect. Companies that can maintain pricing power are also well placed to face inflationary pressures. Finally, if these companies can be found at a discount to intrinsic value, there is strong potential for good long-term rewards.
Case for smaller companies
There is a strong case to be made for investing in smaller companies over the long term. A slew of academic evidence based on long-term returns demonstrates how smaller companies outperform large company benchmarks across the world.
For illustration, in the UK, according to FTSE Russell, over the last five-years, the less well-known FTSE Fledgling Index posted a return of 38%, more than twice the return of the FTSE 100 index. Meanwhile, over the same period, FTSE Small Cap was the second highest-performing index with a return of 29%. This was despite exceptional volatility, including the Covid-19 market crash.
Over the long term, the numbers reveal an even more impressive story. Listed UK smaller caps have recorded higher returns than their larger counterparts over decades. Numis discovered that over the past 67 years this has culminated in an average outperformance of 3.6% per annum. £1 invested in UK large companies in 1954 would amount to around £1,210 today, while £1 invested in UK smaller caps would now be worth £10,139.
Not only do smaller companies outperform over numerous periods, due to recent volatility they could now also be at an attractive entry point to their intrinsic value, although not without risk to capital.
Historically, short periods of underperformance from smaller companies have offered attractive buying opportunities for investors with a long-term mindset. Coupled with the fact that many quality smaller companies are currently trading at a discount, we believe 2022 could be looked back upon as a compelling point of entry.
Find out more about investing in small companies.
Risk warning: 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. Please refer to the latest full Prospectus and KIID before investing, paying particular attention to the risk, fees and taxation factors.
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 this fund should be held for the long term and are higher risk compared to investments solely in larger, more established companies.
Important notice: This document is intended for retail investors and their advisers and has been approved and issued as a financial promotion under the Financial Services and Markets Act 2000 by Downing LLP (“Downing”). This document 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. Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England No. OC341575. Registered Office: St Magnus House, 3 Lower Thames Street, London EC3R 6HD.