Banking

Buy small caps for the recession? Yes, really

They have underperformed in the first year of five of the eight economic recessions the UK has suffered since 1950. But other numbers suggest small caps could surprise investors on the upside in 2023.

First, history suggests a very large chunk of the bad news is already in the price.

The underperformance delivered by smaller companies in the UK this year relative to large caps has already exceeded what we experienced in each of those five previous recessionary selloffs.

The Numis Smaller Companies Index, which includes dividends, is down 18% this year; the FTSE All-Share (total return) is down 1%.

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What happened in previous recessions? The worst relative performances were 1990, when small caps underperformed by 15%, and 2008, when they trailed large caps by nearly 16%.

The relative underperformance we are seeing now is worse than in the depths of the global financial crisis.  

Another way of looking at this is through the lens of seven-year rolling returns. Investing is a long-term business.

We expect volatility in smaller companies, so it makes even more sense to look at the long-term numbers for a fair perspective. Seven-year annualised returns are close to the bottom of their historical range – at around 3%.

Better times ahead?

Now look back at what happened to small caps following previous periods of disappointing returns. On the previous five occasions that trailing seven-year returns have been as low as they are today the average one-year return subsequently was 55%.

What happened after trailing returns were as lacklustre as today?

Performance of Numis Smaller Companies Index in period after the recession.

 

A repeat is not guaranteed but is not out of the question.

Long-term potential

Looking back to 1955, smaller companies have outperformed in two out of every three years – and never lost money on a seven-year view.

Though lagging this time, they have also outperformed in all but one of the nine inflationary periods.

Over the long term the average outperformance is around 4%, Numis data reveals.

Naturally, not all smaller companies deliver so handsomely. This is an area of the market where active management really pays.

The typical large-cap fund has struggled to outpace its market benchmark, but small caps have done much better – beating the small-cap indices by around 1% a year after fees over the past 25 years, according to Lipper data.

Searching for value

Where, then, do we think we can find the best opportunities in the small-cap universe right now? We can think in terms of three different types of criteria.

First, market leading businesses find it easier to maintain their pricing power and generate sustainable profits, better cash flows and more attractive returns on capital.

That feels particularly important in the current inflationary environment.

Second, chasing growth at any price is a mistake.

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In the end, investors’ returns on an asset will depend on what they pay to acquire it.

It is certainly important to look for businesses with strong growth prospects, but they also need to be valued at a reasonable price.

Third, debt can be dangerous.

This is true at any time but all the more so when interest rates are rising.

Indebted companies have already paid a heavy price for being over-extended, as investors in companies such as Debenhams and Cineworld know all too well.

Taking a conservative view on indebtedness is crucial right now. (The holdings in the Artemis UK Smaller Companies fund today are forecast to have an average net debt-to-EBIDTA ratio of just 0.2x and boast strong balance sheets to fall back on.)

Using those three overriding investment criteria, it is possible to find UK small-cap stocks with real potential to deliver over the next three to five years.

Pleasant surprises

There is also the potential for unexpected good news. M&A activity in the small-cap space has proven resilient this year, and further deals are likely – particularly as international investors identify bargains courtesy of the weak pound.

Such deals can give investors a welcome fillip – about 1% of total smaller companies returns have historically come from takeovers.

None of this is to promise a period of recovery and outperformance from small caps in 2023, but investors should look past the assumption that recession will bring disaster at this end of the market.

Amid the doom and gloom, small caps may actually offer some much-needed light at the end of the tunnel.

Mark Niznik is co-manager of the Artemis UK Smaller Companies fund

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