Unlocking the value in small-caps

Read the headlines and you’d assume investors in UK equities were sitting pretty last year. After all, the FTSE 100 Index ended the year at an all-time high, delivering a 12-month return of around 25 per cent in 2016, and then completing an unprecedented run of 15 successive days of record closes during the second week of January.

Crucially, however, much of that performance has come from large blue-chip companies that have reaped the rewards of the post-Brexit decline in the value of sterling, since such a large proportion of their earnings comes from overseas. By contrast, medium-sized companies have performed less strongly, since they haven’t enjoyed the same currency benefits. The FTSE 250 Index, the benchmark which charts the share price performance of these mid-caps, delivered only just over half the return achieved by its big brother last year. 

That’s still an attractive return, of course, but it does mean that mid-cap stocks have not achieved the same heady valuations as the blue chips – the same goes for UK smaller companies. The FTSE Small Cap Index, for example, remains some 6 per cent off its all-time high.

On this basis, investors and advisers who believe larger stocks are now running out of steam – and the market did drop back during the second half of January – may be looking to reorient their portfolios towards mid-cap and small-cap holdings. In the past at least, these have tended to outperform over longer periods.

How might that rebalancing be achieved? Well, both the open-ended fund sector and the investment company industry offer a number of well-managed collective funds offering exposure to these areas of the stock market, with specialist small-cap and mid-cap vehicles available. There are some excellent options on either side of the divide.

However, a note published last week by the investment company analyst team at Stifel makes the case for closed-ended funds as an interesting route into mid-cap and small-cap assets right now. It points out that last year’s outperformance from large companies adversely affected sentiment towards funds invested elsewhere.

On average, shares in UK small and mid-cap-focused investment companies currently trade at an average discount of 14 per cent to the value of the underlying assets, up from 8 per cent only a year ago. Given that this compares to only 5.7 per cent for the investment company sector as a whole – and that small and mid-cap stocks underperformed only in relative terms last year, many investors will feel such a large shift isn’t justified.

“We think that when a sector has been out of favour for a while and discounts are wide it can often be a good opportunity for investors who are prepared to get on board ahead of any re-rating,” Stifel argues. “Contrarian investors may find some value in the discounts.”

The Stifel note is an interesting reminder of one of the attractions of the investment company sector. The fact that shares in closed-ended funds do sometimes trade at quite wide discounts to the value of the underlying assets is often seen as a negative, adding complexity to the investment decision. Equally, however, investors and advisers understand that stock market sentiment isn’t always well-tuned to the investment case for a particular asset – the discounts that develop when demand and supply for investment company shares slip out of kilter with what’s actually going on in the underlying portfolio present an opportunity to exploit that.