The small cap bull market was on a high from early summer of 2012 until mid-2014. During this period, many small cap stocks enjoyed a dramatic re-rating.
However, in the past couple of years the relative performance of these stocks has been more muted. Despite this and increased macroeconomic uncertainty in the UK and beyond there are still many reasons, such as attractive valuations, a large investable universe and resilience to economic adversity, which demonstrates the value of the small cap sector.
Investors have been concerned that the UK economy is starting to slow down. UK consumers have yet to see the effect of inflation really starting to bite, despite the Brexit vote leading to an immediate currency reaction; a depreciation of sterling against the US dollar and the Euro.
Even without further oil price increases in the year ahead, oil is also likely to contribute to inflationary pressure in the short term because of comparisons with historically low prices at the beginning of 2016. As these factors start to flow through, it must be assumed the spending power of the UK consumer will decrease as real wage growth fails to keep pace with a spike in inflation. These assumptions have led to a sell-off in UK domestic consumer stocks.
Slow growth
The UK was on course to be the fastest-growing economy among the G7 group of advanced economies in 2016. Despite the tailwind of growth heading into 2017, the Organisation for Economic Co-operation and Development (OECD) is predicting slower growth for the year ahead. This could present difficult conditions for small cap stocks, which tend to underperform in more difficult economic conditions.
2016 saw a divergence in performance between companies with international earnings and more domestic sectors such as retail, leisure, home and housebuilding, which de-rated through the latter half of the year, reflecting the inherent uncertainty of the political and economic situation in the UK.
Companies with overseas earnings have performed well owing to the devaluation of sterling. It is important to remember, too, that although the UK small cap environment is exposed to domestic stocks, about 40 per cent of small cap index revenues are in fact generated overseas. As such, there are many areas of the small cap sector that are doing invariably well. The de-rating of the domestic sectors has also presented attractive valuations.
There will always be stocks that perform well in any environment and grow irrespective of how the economy is doing. This is particularly true of companies that operate in niche and structural growth markets. For this reason, many small cap stocks are still worth investors’ attention and while the second half of 2016 saw retail asset outflows from the small and mid-cap sector, there has been no blanket sell-off.
Value gap
The good news for investors is that the recent underperformance of UK small companies against the FTSE100 index means an attractive valuation gap has opened up, with the FTSE small cap index on average trading on a 10 per cent to 15 per cent valuation discount compared with their larger peers. The valuation gap can be partly explained by a number of factors, the most obvious of which are the liquidity premium for larger companies and the greater domestic content in small cap earnings at a time of heightened uncertainty regarding the UK economy. However, this disparity in valuations creates opportunities for the small cap investor.
Why do small cap stocks offer investors an attractive opportunity in a lower-growth environment? First, one of the prime attractions of the small cap asset class is the sheer breadth of opportunity. There is an investable universe of more than 1,000 stocks. Many of these will flourish regardless of the macro backdrop. The asset class will, however, be much more interesting and potentially more profitable for investors if business leaders are still making decisions, buying and selling businesses, and moving forward with investment plans. This will only happen if confidence holds up.
Second, small caps are a dynamic asset class and this again is very attractive to investors. New listings can provide interesting investment opportunities and takeovers enable value to be realised. We see the new issue market becoming busier in 2017 after a post-Brexit hiatus and believe the relatively low valuation of small cap stocks may well herald a period of increased M&A activity in the New Year, with the end of 2016 seeing a marked increase in activity.
Eyeing inflows
In addition, while fund flows have provided a headwind in the second half of 2016, we are hopeful that we will see a return to net inflows in 2017 as asset allocators become more comfortable with the economic outlook and focus more attention on the valuation opportunity.
Furthermore, we must not forget that many business leaders of small cap stocks have faced uncertainty before. The 2008 recession means many management teams of smaller companies have worked through tougher times and are therefore well placed to tackle the challenges that lie ahead as we untangle ourselves from EU law.
Ultimately, small cap investing has always involved a trade-off between greater risk and greater reward. This remains as true today as ever but we are optimistic that, following a somewhat difficult 2016, there are better times ahead.
Richard Bullas is portfolio manager of Franklin UK Smaller Companies fund
Key points
There are still many reasons, such as attractive valuations, which demonstrate the value of the small cap sector
One of the prime attractions of the small cap asset class is the sheer breadth of opportunity from an investable universe of more than 1,000 stocks
There is likely to be a return to net inflows in 2017 as asset allocators become more comfortable with the economic outlook
