Taking advantage of the turn towards Small Caps

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Time to really look into the UK Small Cap Space?

 

“…But one trend seems clear enough: small cap stocks are doing well and seem set to continue to do so for some time. Small companies are also relatively under-researched. Largely companies valued at under £50m, can go unnoticed. Microcaps can be priced very inefficiently, opening opportunities for new shareholders to enter at generous discounts…”

 

Companies mentioned include : #CEY #CRTM #EDL #FFWD #HMI #LEX #LND #LIFE #NTOG #MAST

The markets have been voluble this year in a way quite unlike the spectacular crash and rebound of 2020.

As significant swathes of the global economy gather momentum, buoyed by vaccination programmes and massive monetary and fiscal stimulus, indices have been churned by a turn from the ‘growth’ stocks that powered markets last year towards the ‘value’ stocks that were offloaded when Covid hit, and buffeted by concerns over the possibility of rising inflation and higher interest rates. Those uncertainties have made it rather difficult for investors to calibrate their portfolios so as to take advantage of the somewhat stuttering turn towards value.

But one trend seems clear enough: small cap stocks are doing well and seem set to continue to do so for some time. The course of travel has been particularly evident in UK markets, LSE-listed small caps racing past blue-chip stocks over the last 12 months. The FTSE small cap index has risen by almost 70pc over the past year compared with a 23pc rise in the FTSE 350 index. Bloomberg reports that most of the 10 best performers this year among Western European stock funds with $200m or more in assets are focused on UK small caps. And the AIM market is up 27pc over the year.

Like larger companies LSE-listed small caps are benefiting from the strengthening tailwinds behind the UK economy: the settling of the keenest Brexit uncertainties with the conclusion of trade talks with the EU, followed by a successful vaccination programme that looks set to allow the most onerous pandemic restrictions to be finally removed this summer.

And the particular structure of the domestic market favours a small cap led recovery. UK indices have been subdued in recent years due to their relative lack of the big tech growth stocks that have fuelled global markets. Over the last six years the FTSE All-Share has returned 1pc compared with 206pc, 107pc, 95pc and 26pc for the Nasdaq, S&P 500, Nikkei 225, MSCI Europe indices. So markets finally turn against overvalued growth stocks relatively undervalued UK small stocks finally have an opportunity to shine. But they are just a particularly strong current in a worldwide flow towards value. The MSCI Small-Cap index increased by 14pc in 2021, compared to 10pc for the wider MSCI World index, and in the US the small-cap Russell 2000 has rallied 14pc against 11pc for the benchmark S&P 500.

The small cap premium

 

The shift towards small caps is a reassertion of their long term tendency to outperform larger stocks. Veteran small cap fund manager Gervais Williams marshalls a formidable battery of facts and figures to demonstrate the abiding resilience of smaller stocks in his influential book The Future is Small.

One of the most striking studies presented in the book is a London Business School paper charting the long-term performance of the Numis Smaller Companies Index (NSCI), which covers the smallest 10pc of companies quoted on the LSE by value. The research found that £1 invested in the NSCI in 1955 would have returned £4,907 by 2013, far beyond the £1,070 return achieved by the wider market. Adjusted for inflation the purchasing power of that pound – with dividends reinvested – would have increased 207 times. And the annual percentage return from the investment over the period would have been 15.5pc – more than 3pc better than the market per annum. The same trend is observed in worldwide markets: a pound invested in a global small cap index would have appreciated to £21,585.

Williams cites other eye-catching research showing that the illiquidity of small and microcap shares, a feature usually held against them, is actually a more reliable indicator of better performance than liquidity. Between 1971 and 2012 returns generated by the least actively traded quartile of US stocks performed on average 14pc better per year than their more liquid counterparts.

Williams’ argument that relatively illiquid small cap stocks produce superior long term returns is backed by other surveys.Figures to 31 December 2020 suggest UK small companies outperformed the FTSE All-Share in 15 of the 21 years this century. Whereas the FTSE 100 has made little progress since 2000, the NSCI has risen nearly three times. And the FTSE 250 has returned more than 500pc over the last 20 years, compared with just 150pc for the FTSE 100 index

Research by the broker Winterflood has found that funds focused on smaller companies tend to outperform their benchmark indices by a greater proportion than their large-cap peers over time. The average share price and net asset value (NAV) total returns of UK smaller companies investment trusts increased by 99pc and 68pc respectively, over the five years to 19 March 2021, the equivalent figures for investment trusts focused on larger UK companies being 54pc and 46pc. The Numis Smaller Companies Index – ex investment companies – has increased 51pc over the same period whereas the FTSE All-Share index has returned 35pc.

The pattern is the same globally. Worldwide investment trusts focused on smaller companies made respective share price and NAV total returns of 192 and 183pc over five years compared with 122pc and 115pc for those tracking larger companies. The trend hasn’t been universal: larger caps have outperformed small caps in certain US, Japanese and emerging markets indices in recent years. But the overall bias towards small caps is clear. Why?

Why (the best) small caps win

 

Williams identifies several factors. The best small caps are nimble innovators able to more rapidly adapt to new market conditions and technologies than larger organisations. Over the past year for example many small caps quickly took advantage of cloud-based technologies to reorient their businesses to lockdown conditions. Williams cites as evidence the findings of a Swedish study, which looked at more than 28,000 firms in the country’s mining and manufacturing sector, and found that as companies grow productivity can increase significantly in micro, small and medium-sized businesses due to economies of scale, but turns negative for operations with more than 250 staff.

Small caps often operate in tucks and folds of the market that help them sustain growth even in times of economic stagnation. They tend to have modest market positions that allow them to grow even at a time where the market itself is declining, or they serve fast emerging immature markets which can continue to grow even through recessions. Being small they only need to make modest gains in market share to grow quickly relative to their larger counterparts.

Small companies are also relatively under-researched. Legions of analysts subject larger stocks to daily forensic scrutiny. But those too small to feature in the FTSE SmallCap index, largely companies valued at under £50m, can go largely unnoticed. Microcaps can be priced very inefficiently, opening opportunities for new shareholders to enter at generous discounts. Lack of research is linked to low liquidity: because they fly so far below the radar smaller stocks might trade just a handful of times a day, so their prices do not reflect recent news flow anywhere near as precisely as heavily traded larger companies.

During an interview earlier this year Williams remarked on the exceptionally low valuations of UK microcaps: ‘The UK is so lowly valued at the moment, it is quite absurd. Especially the sort of the companies we’re investing in. I can hardly believe how cheap it is … What’s amazing, and this is probably the most attractive moment in my entire career, is the valuation dichotomy between a lot of the long-duration technology-led ‘potential’ companies and the current cash-generative grubby things like mining companies and slightly difficult-to-understand financials. I’ve never known such a disparity between those two … It is quite honestly astonishing. The risk/reward ratio is sensational.’

Taking advantage of AIM – carefully

 

The AIM market offers the most obvious opportunities for UK investors seeking to take advantage of the supercharged returns successful small companies can offer. The index, established in 1995, is now so familiar that it can be taken for granted. But there are few markets worldwide offering accessing to such a broad and deep range of smaller companies and microcaps. Over the past 25 years AIM has helped more than 3,865 companies raise over £115bn and is now home to more than 850 companies with a combined market cap of £104bn. The market has nurtured big winners like the fashion portals ASOS, now a £4.9bn business, and Boohoo, valued at £4.4bn: an investment in ASOS worth £1,000 when it first listed on AIM 20 years ago would now be valued at more than £160,000, an annualised return of 45pc. Today more than 20 AIM companies are worth more than £1bn. And as well as presenting investors with a wide range of ambitious startups the market offers investors certain immediate benefits. AIM investments are exempt from inheritance tax relief and stamp duty, and since 2013 can be included in stocks and shares ISAs.

As already noted the market has performed strongly through the pandemic. But as we discussed in our series on investment basics investors must do their homework before diving in. For all of its tantalising promise AIM has actually considerably underperformed worldwide small cap indices. A frequently cited London Business School study published on AIM’s 20th anniversary in 2015 found that of the nearly 3,000 companies to have listed on AIM some three-quarters have never produced a return for investors. Shareholders lose 95pc or more of their initial investment in a third of AIM companies. And less than 40 companies in the 20 years from 1995 – just 1.4pc of the historic total – have secured multiyear returns in excess of 1,000pc. Before its 2020 rally AIM had seen some lean years, its list of companies falling by half from 1,600 in 2007 to less than 900 12 years later. £100 invested in AIM back in 1996 would be worth just £89 in 2014.

The market’s most exciting feature, its capacity to serve as a vehicle for speculative stocks, is also its most dangerous. AIM is continually washed by waves of misplaced enthusiasm for clusters of unproven technology, resources and financial services startups. A series of mini-booms have generated inflated valuations, stocks peaking before entering extended periods of underperformance. Indiscriminate stockpickers have paid too much for growth shares, underestimating how difficult it can be for companies to grow. As we’ve seen, startups have the advantage of flexibility but many fall by the wayside or stagnate, production bottlenecks impeding sales, underpriced products failing to capture worthwhile market share, and new, more effective rivals, muscling in on the scene.

There are also structural issues to be aware of. Though AIM companies must report regularly on material changes to their circumstances the relative lack of analyst and media scrutiny they receive can make it difficult for private investors to know who or what they can trust. And as observed, AIM shares can be tricky to offload: substantial holdings in smaller AIM stocks do not always find ready buyers.

How TMS can help

 

The TMS platform is designed to help you navigate the market’s many promising but potentially hazardous opportunities. The AIM article in our investment series emphasised the risk management techniques investors should bear in mind when engaging with the market. It’s important to take the time to understand what a company does, to assess its prospects for generating cash, to look into its assets, and the scale of any debts. To decide how much you are prepared to trade, the proportion of your portfolio you are prepared to lose if the investment doesn’t work out. And to design an exit strategy, some idea of how much are you prepared to lose before selling a share that isn’t working out, and how much profit you want to make before selling one that is. 

And our CEO interviews and TMS Reach service try to go beyond the noise and suggest companies we think worth considering. In the past few weeks we’ve picked out several companies whose share price has subsequently risen. See for example our features on gold and battery metals miners Lexington Gold (AIM:LEX), Landore Resources (AIM:LND), and Centamin Plc (LSE:CEY), strategic metals investment vehicle Critical Metals (LON:CRTM), fertiliser producer Harvest Minerals (AIM:HMI), and cannabis and health investment fund FastForward Innovations (AIM:FFWD). We also think Love Hemp Group (AQSE:LIFE), another cannabis-related company, miner Edenville Energy (LON:EDL), energy producers Nostra Terra Oil and Gas (LON:NTOG), and reserve power innovator Mast Energy (LON:MED) are well worth keeping an eye on, to pick out just some the many other companies we have covered this year.

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