For much of 2019, smaller companies continued to lag larger companies, as they had in 2018. Smaller companies are more geared to the domestic economy than their bigger counterparts and last year many investors were worrying about the outlook for the UK. What’s more, the Woodford fiasco raised concerns about the liquidity of open-ended funds, causing many of them to reduce exposure to small-cap stocks.
But in the last quarter, and especially in December, the clouds lifted and share prices surged. Over the whole of 2019, the Numis Smaller Companies index (NSCI), comprising the bottom 10% of the UK market, returned 22.3%, 5% ahead of the FTSE 100. But if investment companies are excluded – a gauge known as the NSCI (XIC) – the gap increases to 7.9%. The Aim market returned 15%.
A shrinking market
The NSCI comprises all 696 companies (of which 350 are investment companies) with a market value below £1.68bn and has a total value of £261bn. Including Aim, the number rises to 1,547 companies with a total value of £345bn compared with the £2,018bn value of the FTSE 100 index.
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Over time, the number of companies has been shrinking, but the size of the companies has become larger. The 346 NSCI (XIC) companies have an average market value of £444m compared with 1,067 companies and an average £24m in 1987. In 1955 the respective figures were 2,517 and £0.4m.
The small-cap investment manager has more – and riskier – companies to research than the large-cap manager, each with far less coverage and less accessible management. It wouldn’t be worth bothering unless smaller companies outperformed larger companies over the long term. And they do.
According to research by Professors Paul Marsh and Scott Evans of the London Business School, the long-term outperformance of the NSCI (XIC) is an annual 3.3% over the 65 years since 1955: 14.8% per annum versus 11.5% for the All-Share index. This outperformance is replicated in most countries. The global small-cap outperformance has averaged 4.2% since 2000.
Following such strong performance, UK smaller companies ceased to be undervalued in 2019. The professors estimated that their price/earnings multiple had increased to 14.9, well above the long-term average of 12.8 and only slightly lower than the multiple for the All Share index, though low bond yields justify higher multiples. The valuation of smaller companies relative to larger ones had not reached the extremes seen in 2007, but continued outperformance needed superior earnings growth.
Discounts have fallen fast
Investors in small-cap investment trusts benefited in 2019 from falling discounts to net asset value. These averaged over 10% at the start of the year, but the mainstream trusts, such as Aberforth, BlackRock, Throgmorton, Henderson, Invesco Perpetual, JP Morgan and Standard Life were trading at, or very near to, premiums to asset value at year-end, as were the three mid-cap trusts.
Moreover, their net assets continued to outperform the NSCI (XIC), often by large margins; in Standard Life’s case by 19% and JP Morgan’s by 25%. Of the 16 trusts in the UK mid-caps and small-cap sectors, 11 returned over 40% and five over 50%.
The upshot? Liquidity worries are making it difficult for open-ended funds to own the smallest companies and Aim stocks, giving closed-end funds (investment trusts) a competitive advantage. Throw in continued strength in the NSCI (XIC) and at the start of this year respectable, though lower, returns from the mainstream mid- and small-cap trusts looked likely. And now, after February’s sharp setback, the sector again looks good value.
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