How have UK small-caps outperformed post-referendum?
25 June 2018
Darius McDermott, managing director at Chelsea Financial Services, considers why UK smaller companies have performed so strongly since the EU referendum and Brexit negotiations began.
A lot has happened for investors over this time frame – we've had a stream of controversial elections around the world – including the inauguration of US president Donald Trump, inflationary fears which caused global markets to plummet in February 2018 and, of course, the outlook for the UK economy hangs in the balance as Brexit negotiations continue. And yet, in the face of what some investors feared would be adversity, UK equities have performed really quite well.
Weaker sterling bolstered the global-facing FTSE 100 index throughout the rest of 2016 and all of 2017, before reaching an all-time high on 2018's first day of trading. But the winners have been UK small-caps – a part of the market which is more domestic-facing and less liquid on the whole, relative to its larger peers.
Data from FE Analytics shows that, over the two years since the Brexit vote (to 19 June at time of writing), the FTSE Small Cap index has outperformed the FTSE 100 and FTSE 250 indices by 8.04 and 10.49 percentage points respectively with a total return of 38.29 per cent (between 23 June 2016 to 19 June 2018).
So what has caused this?
I asked Simon Moon, who heads up the Elite-rated Unicorn UK Smaller Companies fund, for his thoughts. He said that when investment trusts are stripped out of the small-cap index, the difference in returns relative to the FTSE 100 actually reduces quite significantly.
Nevertheless, he believes there are couple of reasons why UK small-caps have not underperformed their larger and medium-sized peers.
“You can see in the run-up to the referendum there was an increasing domestic risk-off attitude in the market. By May 2016 small caps were sitting at more than a 20 per cent discount to the FTSE 100, whereas they’re now sitting at less than a 10 per cent discount – accounted for primarily by a positive re-rating of small-caps,” he told me.
“This was in part down to the ‘world not ending’ post-referendum, and the market seeing attractive valuations for domestically-focused stocks as their underlying operations continued robustly.
“We also saw a marked increase in M&A [mergers & acquisition] activity over the period, especially from overseas buyers taking advantage of a weaker sterling as well as suppressed valuations. Small companies tend to benefit disproportionately from M&A.”
I also posed the question to Anthony Cross, who runs the Elite-rated Liontrust UK Smaller Companies fund. Firstly, he said that it's important to distinguish between stocks listed on the FTSE Small Cap index, and UK smaller companies generally. The AIM All Share index (which is regarded as holding mostly smaller companies) is up more than 55 per cent over the last two years. In fact, the 100 largest AIM stocks have returned an average of 72.37 per cent – this dwarfs the FTSE Small Cap's returns.
However, he warned against assuming that AIM stocks all have small market caps, with the likes of ASOS, BooHoo, Blue Prism and Fever Tree all boasting larger market caps, but remaining in the index.
“Note that the likes of ASOS and Boohoo are benefitting from the shift to online retailing,” he pointed out. Meanwhile other once much larger companies such as Debenhams has struggled.”
This introduces another reason as to why UK small-caps might have done well; newer companies are indeed often exposed to emerging trends with greater scope for growth. A lot of younger businesses are also on the path to disrupting stale sectors full of capital-intensive businesses. So it's perhaps less to do with Brexit (which has not yet happened and is business as usual with the added benefit of a weak sterling), and more to do with structural and even secular changes to the economic backdrop.
Anthony said a good example of a new fast-growing industry is data services. He explained that many small companies, particularly in areas such as technology and media, now offer state-of-the-art market research, cloud-based company software and data analytics.
“Another point to note is that, while exceptions can always be found, it does seem that smaller companies have experienced fewer structural or self-inflicted headwinds than larger companies over the last two years,” he added. “For instance, construction firm Carillion went into liquidation having suffered significant financial woes, and outsourcing company Capita reached the brink of collapse after making hefty losses last year. It is these struggling areas of the market – outsourcing, construction or retailing – which are found more in the FTSE 250.”
Finally, I asked Ken Wotton, manager of the Elite Rated LF Livingbridge UK Micro Cap Growth fund, for his thoughts on why UK small-caps have held their own since the EU referendum.
He told me that smaller listed companies actually tend to be less vulnerable to macro uncertainties, because they usually operate in more niche areas of the economy.
“Small-caps can also be more agile than their larger peers, allowing them to better react to trends and opportunities, and potentially benefit from any upsides and avoid significant risks,” the manager reasoned. “Micro caps also trade at a discount, but we have seen this narrowing – whilst in June 2016 micro caps traded at a discount of 24 per cent, this had contracted to 14 per cent by March 2018 – this narrowing has contributed to outperformance in the last two years.”
To sum up, I think it's very easy for investors to leave entire market areas out of their portfolios based on whichever macroeconomic risk is dominating the headlines. But nobody has a crystal ball, and perhaps the outperformance of small-caps since Brexit hits the message home that diversification is key.
Darius McDermott is managing director at Chelsea Financial Services. The views expressed above are his own and should not be taken as investment advice.
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