Talking Point  

Small caps may be cheap for a reason

Small caps may be cheap for a reason

Smaller company shares look very cheap relative to their large cap counterparts, but that may not be a reason to buy, according to James Sullivan, managing director and fund manager at Miton Optimal.

Mr Sullivan said: “The valuation differential between traditional small cap and large cap indices is stark; the disconnect accelerated due to the rally since 23 March 23 2020.

"Therefore it is understandable why some start to view this argument through the same lens as the ‘value versus growth’ debate.

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"I spoke to an associate about investing in small caps recently, and how some are now looking very cheap by historical standards; his response was ‘…that’s because they’re all going bust’.

"He clearly was exaggerating to make a point, but I’m not sure tarring all lowly valued smaller companies with the same brush is quite fair either. There is a misplaced perception that small companies means high street shopping.”

Mr Sullivan added that rather than debating whether small caps or large caps are more attractively priced, or whether value stocks are cheap versus growth stocks, the key question investors need to be asking is whether a company can thrive, or will struggle, in a more digitised world.

Mr Sullivan said: “Liquidity and economic factors will at times have an overbearing influence on the behaviour of smaller, less liquid, companies. 

"While some smaller companies will adapt and thrive, others won’t, and identifying and backing such companies is clearly a more challenging task. After such a long period of underperformance of both small cap and value as investment styles, there is a plausible argument suggesting we will witness a reversion to mean, and we should be long on value stocks.

"However, I’m not convinced that the old rules apply as simply in a world that has moved on so dramatically in recent years. There has been a gargantuan shift in consumer behaviours, and the consequences for companies unable or unwilling to embrace those changes, will struggle.”  

Simon Edelsten, who runs the £333m Mid Wynd investment trust, said: "I have heard various propositions about small companies and the cycle over the years, mostly claims by small company specialist mangers. 

"They tend to say they are extra cyclical, but that may not be correct as the universe is low oil and banks, but it might be as the universe has a lot of restaurants, leisure, and less well funded industrials. 

"So I wouldn’t say small/large shows where the strain is as much as cyclical/less cyclical and that is today banks/oil/leisure/travel vs tech and health mainly.