Big gains from small-cap stocks

published 26 January 2018

In an environment of middling inflation and low interest rates, small-cap stocks tend to beat big blue-chips, says John Stepek.

Last year was a good one for stockmarket investors, almost regardless of where you had your money. The UK was by no means the best-performing market of the year, but even so, during 2017 the FTSE 100 returned around 11%, while the wider FTSE All-Share returned just over 13% (including dividends). That wasn't bad. However, you could have done a lot better and you wouldn't have had to venture beyond these shores to do it. If you'd shunned larger stocks in favour of investing in the Numis Smaller Companies index (which covers the bottom tenth of the UK stockmarket), you'd have made 18.8%.If you'd invested in Aim, the London Stock Exchange's junior market, says Tom Stevenson in The Daily Telegraph, you'd have made a "stonking" 27.4%.

This outperformance is not a fluke. Countless studies have shown that smaller stocks around the world tend to beat the wider market in the long run. For example, if you'd invested a pound in the aforementioned Numis index in 1955, it would now be worth more than £7,200, says Paul Marsh of London Business School, compared with just £1,095 for the FTSE All-Share. It's widely agreed that the "small-cap premium" is one of the few persistent "factors" (alongside investing in value or momentum stocks) that should enable an investor to earn higher returns than the wider market over time.

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There are myriad explanations as to why the small-cap effect might persist. Some argue that it's because a lack of analysis by big institutional investors leads to the market being less efficient and thus prone to offering profitable anomalies to be exploited. It's also arguably easier for a small company to grow faster than a large one. So why might now be a good time to invest? As Stevenson notes, small stocks tend to beat their larger rivals during "periods of middling inflation and low interest rates" which sounds like it could be a very apt description for 2018.

The investment-trust sector offers several options for investing in smaller companies, and as Ian Cowie notes in The Sunday Times, the typical UK smaller-companies investment trust looks relatively cheap, trading at a discount to the value of its underlying portfolio of around 11%, compared with an average 7.5% for the UK all-companies sector. Options cited by Cowie include the River & Mercantile UK Micro Cap trust (up more than 55% over the last year) or the JP Morgan Smaller Companies trust (up around 40% over the same period).

Listed companies must notify the market in a timely manner of any major developments or information that would, if generally available, be likely to have a significant effect on the company's share price. These rules are meant to prevent insiders from gaining an advantage over other investors by having an opportunity to trade using price-sensitive information before anyone else gets to hear about it.

Some of the major events that need to be disclosed are obvious: mergers, legal decisions that go against the company, and any changes to top management. Another situation where the company may have to make an announcement is if management realises that its profits are going to be significantly lower than the market currently expects. In cases where the company has made official profit forecasts, or implied in conversations with analysts that it expects a certain outcome, the law is clear that it has to notify the market of any major changes. If the company has deliberately remained silent, and analysts have come to their own conclusions, it has more leeway on whether or not to disclose, especially if the new forecasts are themselves uncertain. However, many companies choose to disclose pre-emptively anyway.

Profit warnings can often look to unwary investors like tempting buying opportunities and sometimes they are. But remember that the old City saying "profit warnings come in threes" exists for a reason. The initial profit warning may simply be the start of the revelations a problem that management had originally hoped would go away may merely get worse, and you often have to see heads rolling before a genuine turnaround can begin. So do your homework before you buy a troubled stock (or "catch a falling knife", as the City jargon has it).

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.