History of small-cap strength through recoveries

The experiences of UK equity investors over the last quarter-century were shaped by major episodes of market stress – the Russian debt default, the dot-com bubble, the global financial crisis, and the Covid-19 pandemic, to name a few.

Amid market fluctuations, the psychological frameworks through which investors perceive risk and reward often shift in kind. Allocation weightings towards larger-cap companies generally increase in periods of economic weakness, as lower betas and relatively stable earnings appeal to a larger pool of investors in depressed market conditions.

Risk-off market sentiment has prevented investors from capitalising on the attractive fundamental opportunities available in the small-cap space. Our historical review of UK equity performance illustrates how under-allocation to small-cap stocks has resulted in UK investors foregoing superior returns in the aftermath of market turmoil.

Today, we see near-term catalysts for a small-cap revival and encourage investors not to miss the opportunity.

History does often rhyme

Small caps weaken in line with the wider market’s performance during downturns, but history proves they bounce back with a vengeance, tending to outperform large caps during recovery.

In each of the five market slumps between 1998 and 2020, the small-cap drawdown has roughly paralleled the broader UK market. For instance, during the Russian debt default of 1998, the Numis Smaller Companies Index fell 33%, compared to 25% for the FTSE All Share. Similarly, during the global financial crisis of 2008-09, small caps dropped 59%, while the FTSE All Share fell by 49%. Lastly, during the pandemic sell-off of March 2020, the 41% small cap decline trailed the FTSE All Share’s 34% slump. In one instance following the bursting of the dot-com bubble in 2000, small-caps were marginally more resilient than the wider market, peak-to-trough.

However, small caps shine when looking through the lens of trough-to-peak recoveries, approximately doubling the returns of larger UK equities over the last 25 years. For example, as Russian fiscal balances stabilised between 1998 and 2000, the Numis Smaller Companies Index rebounded 102%, compared to 58% for the FTSE All Share. This pattern repeated as the world economy bounced back from the depths of the great financial crisis until 2011, with a small cap return of 137%, ahead of 77% for larger peers. Finally, smaller companies surged 121%, compared to 58% for the broader stocks, as markets reversed lockdown-induced losses and thrived into 2021.

Following the mini-budget hysteria of October 2022, the last twelve months mark a break from history. The initial drawdown of the Numis Smaller Companies Index dwarfed the FTSE All Share, at 31% versus 14%, and the recovery to date has trailed the wider UK market. The drivers of the intensified sell-off are complex, but the unique short-term effect of the LDI crisis on floating rate debt yields played a significant role. Simultaneously, a high volume of small-cap redemptions in a narrow timeframe pushed the supply of small-cap stocks far past demand equilibrium, and valuations have not materially recovered from the shock.

The opportunity is now

Despite this, if history is any guide, the market landscape looks ripe for an accelerated small-cap recovery. Importantly, market valuations continue to lag recent precedent transactions, exposing the asymmetry between trading multiples and company fundamentals across various sectors. We expect private equity to sustain M&A activity across UK public markets as lowly valuation multiples compensate for higher interest costs. At some point, investors must consider this growing body of valuation evidence and bridge the arbitrage.

Positive news on inflation and base rates holding steady over the last two meetings may also help build confidence in UK equities. After the mini-budget, rapidly increasing bond yields and decreased prices prompted investors to reduce exposure to equities to meet target asset class weightings. An expected fall in risk-free rates next year could trigger another round of portfolio rebalancing, but this time more favourable for equity flows.

While geopolitical tensions and an evolving humanitarian catastrophe in the Middle East will compound volatility and uncertainty in the near term, we encourage investors to unmask the valuation opportunity disproportionately stacked at the lower end of the UK market-cap spectrum at present. In our view, the potential for medium-term value creation is compelling.

Ken Wotton Managing Director, Public Equity