Why size matters during an economic recovery

Now is the time for small caps to shine, says David Prosser.

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Is an economic recovery guaranteed for the UK? Well, barring nasty shocks, most economists are more positive about the outlook than they have been for some time. GDP growth of 0.6% in the first quarter of the year was the best figure for two years and well ahead of analysts’ expectations. Indeed, the UK’s performance has consistently surprised on the upside in recent months.

In which case, now might just be the moment to look at UK smaller companies with a fresh eye. Smaller company shares tend to underperform during tougher times because investors regard larger businesses as more resilient and better diversified. Happily, however, smaller companies tend to do better during the recovery. From trough to peak, they have, on average, delivered double the returns of large-cap stocks over the past 25 years.

“If you are looking for micro cap exposure, a collective fund run by a manager who specialises in this area of the market is probably your best option. You’ll get the benefit of the manager’s expertise and diversification advantages from exposure to a broad portfolio of micro caps.”

David Prosser

Man with brown hair in a suit

The good news is that investors don’t seem to have missed the boat. The FTSE Small Cap Index has gained around 9% over the past 12 months, broadly in line with the performance of the FTSE 100 Index. In other words, the outperformance typically seen from small cap stocks during improving periods has yet to materialise.

Where, then, to start with smaller company investment? Well, there are plenty of options, but a recent note advocating for “micro cap” stocks from the investment trust analyst team at Kepler Trust Intelligence makes interesting reading. It’s worth pointing out that the note was published in association with Rockwood Investments, which runs a fund that invests in these very small companies – micro caps are companies valued at less than £250m – so it’s not entirely without an agenda. But many of its arguments resonate.

One point is that this part of the market is the place to find those hidden gems, simply because so few people are looking. The average micro cap company is followed by just four analysts, Kepler points out, compared to 18 for larger companies. In many cases, no analyst at all is looking at these companies.

Also, valuations of micro caps appear to have been hit particularly hard by depressed investor sentiment over the past year or two. That makes sense – if investors worry more about smaller companies, they’re really going to be anxious about the tiddlers. In which case, there should be no shortage of opportunities.

Another point made by Kepler is that there are more companies in this part of the market with exposure to sectors such as technology, industrials and consumer discretionary. These are sectors typically associated with higher long-term growth potential.

Still, there are downsides to micro caps too. You’re often investing in relatively immature businesses just beginning their journey towards viability and profitability; and that comes with risk. The lack of research is also a worry – it means you’re often on your own if you’re hunting out these companies for yourself. Another problem is illiquidity – very often, the market for these shares can be very small, which means it may cost you to buy and sell, or even leave you stuck with a position you can’t get rid of quickly. That illiquidity can also drive volatility.

All of which suggests that if you are looking for micro cap exposure, a collective fund run by a manager who specialises in this area of the market is probably your best option. You’ll get the benefit of the manager’s expertise and diversification advantages from exposure to a broad portfolio of micro caps. Plus, if you opt for an investment trust, you’re less vulnerable to the liquidity issue; the structure of an investment trust, which is a closed-end fund, provides protection.

The aforementioned Rockwood fund is one option in this area – it trades as Rockwood Strategic – but there are several others, including Downing Strategic Micro-Cap, Miton UK Micro Cap and River & Mercantile UK Micro Cap. As with any other sector, these funds won’t be right for everyone – but micro cap stocks are certainly worth considering as a way to play the UK recovery.