Which region is best to play a smaller companies’ comeback?

Smaller companies across the world finally appear to be emerging from one of the longest and most painful bear markets in their history. However, just as the sell-off has not been equal, the recovery may be more pronounced in some regions over others. Where should investors be hunting to participate in the recovery?

Some of the reasons behind small-cap weakness are common to all regions. They generally don’t do well at times when interest rates are rising and will also struggle during times of economic fragility. Economists have been fretting over recession for much of the last two years. A final factor has been small caps’ strong run during the pandemic, which left valuations looking stretched. The adjustment has been difficult and prolonged across the globe.

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Nevertheless, there have also been factors specific to each region. In the UK, for example, smaller companies have suffered most from the poor sentiment that followed Brexit. In North America, the biggest problem has been the strength of the large caps rather than the weakness of smaller companies. In Japan, the weakness of the yen has been problematic for smaller companies, which tend to be more focused on the domestic economy. The revival in the Japanese stock market has been concentrated in the large exporters and banks.

There has been a tentative recovery for most smaller companies in recent months. Callum Wells, a fund manager at Castlefield, says a number of factors have come together to raise smaller companies out of their gloom. He says: “The revival has been brought about by a sense of greater financial stability; cost-of-living challenges have abated, inflation is under control and there’s a feeling that interest rates have peaked. Pandemic-related problems such as supply-chain blockages and inventory build-ups, have eased. Corporate earnings reports from smaller companies have generally been encouraging so far this year. There’s also takeover activity; switched-on private equity buyers have picked up some bargains.”

However, there have been regional variations. Neil Birrell, chief investment officer at Premier Miton says: “US smaller companies make up 56% of the world index and they have not yet recovered, which is surprising given the strength of the economy. However, the MSCI Europe ex-UK and the MSCI Emerging Markets Small Cap indices are on the recovery path, while at home the FTSE Small Cap and FTSE 250 (mid-cap) indices have been doing well.”

Broad exposure

Nish Patel, manager of The Global Smaller Companies Trust Ord (LSE:GSCT), makes the case for why the prospects for smaller companies are exciting: “The two time periods most similar today are the 1970s, after the bursting of the Nifty Fifty boom, and the late 1990s after the technology boom. Both of those periods were characterised by narrow leadership. Following those two periods, we had really long small-cap cycles. Following the Nifty Fifty bust, we had a 10-year cycle for smaller companies. Following the dotcom bust, we had an eight-year cycle. This could be the start of a long recovery for smaller companies.”

Individual markets

While a global approach would outsource the country decision-making, some investors may also want to take matters into their own hands by considering the opportunities in individual markets.

Some markets have been hit harder than others and therefore may be due a stronger bounce. James Klempster, deputy head of multi-asset investment at Liontrust, says the UK has been particularly hard hit: “Small caps globally represent an excellent buying opportunity from a valuation perspective and the UK small-cap market is a notably cheap market among a number of cheap markets.

“One of the main determinants of long-term returns for all asset classes is purchase valuation, and over the very long term, the small-cap premium tends to provide a greater return than larger capitalisation companies. This has proved to be the case in a number of different environments. At current valuations, we believe UK small caps are likely to have greater potential for future growth than the FTSE 100 index.”

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David Holder, senior investment research analyst at Square Mile Investment Consulting and Research, picks the Liontrust UK Smaller Companies fund as a good option to exploit the recovery in UK small caps: “Its team of seven investment professionals have complementary skill sets and work collegiately. Their Economic Advantage investment process is well-defined and steers them towards relatively steady businesses with a competitive edge, that are gradually growing and generating high levels of cash. The emphasis is very much on a firm's intangible assets, namely intellectual property, strong distribution channels and significant recurring business.”

In interactive investor’s Super 60 list, which comprises best-in-class fund ideas, are Henderson Smaller Companies Ord (LSE:HSL), an investment trust, and WS Amati UK Listed Smaller Companies. For the Henderson strategy, the investment approach is focused on identifying quality-growth companies and holding them over the long term. The Amati fund seeks businesses that can grow faster than the broader economy over the longer term. These are typically companies demonstrating strong barriers to entry, competitive advantage, strong pricing power and sustainable growth. Our recent Fund Spotlight feature took a detailed look at the Amati fund.

Will smaller companies recover their poise in Japan?

In Japan, the gap between small and large-cap valuations is significant, but it may take a shift in the yen before the gap starts to narrow. Praveen Kumar, manager of Baillie Gifford Shin Nippon Ord (LSE:BGS) investment trust, says: “High-growth small caps have been a notable absentee from the ongoing rally that began three years ago. There seems to be very little interest in this asset class, even among domestic retail investors who have historically been buyers.

“We are now in a situation where numerous companies in the portfolio are growing their sales and profits at well over 20%, but are trading at extremely low valuations. We think this is an excellent starting point for outperformance, as and when they come back into favour.”

What might make that happen? He believes that investors may reappraise the large caps in light of relatively high valuations and weaker fundamentals, diverting capital back into small-cap areas, which are cheap and have better operational performance. Moreover, shifts in monetary policy from the Bank of Japan, and a shift in US monetary policy may finally break the weakness of the yen. Shin Nippon now trades at a 15% discount (as at 24 July), which is wide relative to its history. Performance has started to tick higher since the end of May.  

Political considerations

Investors also need to consider the domestic political and economic landscape when investing in smaller companies. This part of the market tends to be more vulnerable to shifts in sentiment towards individual countries. In this area as well, the UK may have an edge. Klempster points out that the UK has gone from being politically choppy to less tumultuous, “whereas our counterparts across the Channel and the Atlantic Ocean have drifted into the ‘politically uncertain’ territory that the UK has occupied since 2016”.  

European small caps are on a significant discount, and have the advantage that the European Central Bank has already cut rates. However, they must also contend with some political turmoil in the wake of the French elections. There are fears of contagion across Europe, and this may stall the nascent recovery in sentiment towards European smaller companies.

Nevertheless, there are funds such as the Montanaro European Smaller Companies Ord (LSE:MTE) trust, which trades on a -12.4% discount to its net asset value and is managed by a well-established team of small-cap specialists, who should be able to navigate this complexity. It focuses on quality companies that may be less vulnerable to any political difficulties.

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This also makes the US a more complex area for small caps. Investors need to balance the political uncertainty surrounding the election, with the need to diversify their US exposure following the strong performance from the mega caps.

Gavin Haynes, investment consultant at Fairview Investing, thinks there are still opportunities for skilled managers: “US small-cap funds give exposure to high-growth businesses. The small-cap market is less efficient than large cap, providing good opportunities for stock pickers. Valuations look historically attractive versus large cap and they should be a beneficiary of falling rates.”

He suggests a fund such as Artemis US Smaller Companies, run by an experienced management team headed up by Cormac Weldon. “This fund is a good choice for US small-cap exposure taking a core, style-agnostic approach looking for the best ideas in different areas including quality, growth, value and recovery stocks. The portfolio is skewed towards the domestic economy and focuses on profitable businesses - 30% of the benchmark Russell 2000 is unprofitable.” Analysts at interactive investor are also fans of the fund, which is on the Super 60 list.

In Asia, where the interest rate cycle has been different, small caps have continued to perform well. While there are good arguments for an exposure to small companies in Asia, through trusts such as the abrdn Asia Focus plc (LSE:AAS), investors may not get the bounce that is on offer elsewhere, simply because they haven’t fallen as far. To get the best of the small-cap bounce, investors arguably need to be hunting in areas that have been hit hardest.