UK small-cap stocks have dramatically outperformed large-cap stocks over the past decade. Over a 10-year period, the Numis Smaller Companies Index has achieved a return of 192%, twice the return of the FTSE 100 index.
The past decade has naturally benefited small-cap stocks as interest rates have remained extremely low. At the same time, the macroeconomic picture has been mixed, with the unprecedented plunge in economic activity experienced in 2020 at the onset of the coronavirus crisis.
Many smaller companies have achieved faster organic growth and higher operational leverage over time versus their large-cap counterparts. The more entrepreneurial spirit of management teams within smaller companies has enabled them to achieve higher margins through lower variable costs by focusing on market niches, offering new technologies and services.
As a result, smaller firms as disruptive innovators can sometimes become the large companies of tomorrow, as they compound faster organic growth over time.
In 2020, the once mid-cap alternative finance provider and asset manager Intermediate Capital elevated to the FTSE 100 – a company that was the Trust's top holding in 2019 and 2020.
Intermediate Capital has distinguished itself as a leading provider of mezzanine finance to leverage buyout markets. It also owns a highly successful mezzanine, property lending and credit fund management operation.
The asset manager's portfolio of investments has performed well, but the primary growth engine of the business has proved to be the fund management operation. This division has enjoyed real success in asset gathering due to the strength of its performance track record, the quality of the team and underlying demand for its product in an income-hungry world.
Some smaller firms have also successfully grown over time by employing their own mergers and acquisitions (M&A) strategy to selectively buy attractive targets with high-growth characteristics.
Others become targets of M&A activity themselves as their larger contemporaries, or the venture capital players have sought to boost their own long-term growth prospects through acquisition.
There's been particularly heightened takeover activity in the UK small- and mid-cap space during the past year, partly helped by the removal of Brexit uncertainty, as global corporates and investors have sought out higher-growth prospects.
Brexit and Covid-19 created risk-off sentiment against UK assets in general. However, the gradual fading of these headwinds has left behind some attractively priced opportunities in the UK equity market versus developed peers, providing a catalyst for private equity and M&A activity.
As a result, several takeover bids have been received: for AA, the roadside assistance and insurance group, from Towerbrook and Warburg Pincus; for Codemasters, the video games company, from Electronic Arts; for GoCo, a price comparison website, from Future; for John Laing, an infrastructure investor, from KKR; for SDL, a language services group, from RWS; for Sanne, an alternative assets fund administrator, from Apex; for Urban & Civic, an urban regeneration business, from Wellcome Trust; and for Vectura, a medical device development company, from Carlyle.
The guiding philosophy for the team is that smaller companies can deliver superior returns over the long term versus the broader market. The team believe that small- and mid-cap stocks have an implicit advantage over large-caps, benefiting from several factors: faster organic growth, higher operational leverage, entrepreneurial management, sources of new technologies and services as well as M&A activity.
Along with these factors, the limited broker coverage enables the team to delve deep into the fundamentals of the somewhat overlooked small- and mid-cap cohort to uncover opportunities that will generate solid returns.
It makes sense to target robust businesses that can weather the storms and can prosper in good times to generate attractive and consistent returns.
Neil Hermon is fund manager of the Henderson Smaller Companies Investment Trust. The views expressed above are his own and should not be taken as investment advice.