Small can be beautiful once again

Good news and bad from the Bank of England’s latest monthly meeting of the Monetary Policy Committee. The disappointment is that the Bank now expects inflation to remain higher for longer than it previously anticipated, one reason why the MPC has raised base rates for the 12th month in a row. More happily, the Bank has changed its mind about the outlook for the UK economy in 2023; it had previously predicted a recession, but now it forecasts modest growth.

One area of the stock market where this shift could play positively is in the smaller companies arena. Conventional wisdom is that smaller companies tend to come off worse when the economic headwinds blow hard; they’re more exposed to the fortunes of the domestic economy than their larger counterparts, and have less size and scale to fall back on when the going gets tough.

What we do know, however, is that over the longer term, smaller companies tend to deliver superior returns. Going back to 1955, smaller company shares in the UK have outperformed, on average, in two out of every three years; they’ve never lost money over a seven-year period.

Intuitively this makes sense. Smaller companies tend to be at an earlier stage of their development. They have more room for rapid growth. And their agility gives them the ability to take advantage of such opportunities. Larger companies, by contrast, struggle to be fleet of foot. Elephants can’t gallop, as the saying goes.

In recent times, however, UK small cap shares have really struggled. Last year, the Numis Smaller Companies Index (NSCI) fell almost 18%; the FTSE 100, by contrast, finished in positive territory. So far, 2023 hasn’t seen much of a bounceback – the NSCI is up by around 1% since the start of the year.

Time for a change of fortune, then? Well, it’s worth noting that small caps often do recover very strongly; the average return delivered by these shares in the year following the past five UK recessions was 42%. And while we may not currently be in recession – or on target to slip into one according to the Bank’s new projection – the recent period might be considered analogous to such a downturn.

That is not to suggest we should expect a 42% surge from small company shares over the next 12 months. But if the UK can begin to move towards positive economic growth, there are good reasons to be hopeful. History, at least, gives rise to optimism.

For those looking at investment companies in the AIC UK Smaller Companies sector, there is another factor to consider. Shares in the average fund in this sector are currently trading at a 12% discount to the value of the underlying assets. And a number of funds are sitting on much wider discounts – more than three times the average in several cases.

That provides the potential for a re-rating bounce. If smaller companies as a whole begin to make progress, we could see these investment companies do even better. As sentiment improves, these discounts should narrow, giving investors a double whammy of upside.

This is one reason why investment companies are a particularly good option for investors interested in small cap stocks right now. But more broadly, the structure of investment companies is also helpful – small cap shares can be illiquid and volatile, so the closed-ended nature of an investment company feels more appropriate than an open-ended fund. The latter may be forced to sell at times of stress.

There are no guarantees here – not least because the economic backdrop still remains so uncertain. However, smaller companies shares may finally be due a return to the sun; if that appeals, investment companies provide an attractive way into this area of the market.