Buying small caps in the depths of a recession

According to the American Association of Individual Investors, 30.6% of investors believe the stock market will rise in the next six months – an increase of 5.7% on the week before*.

Although still below its historical average of 38%, the number is at least climbing – perhaps buoyed by the performance of the US tech sector: the NASDAQ index is back in positive territory in 2020 (up some 4.4% year to date**), as many of its constituents have actually benefited from lockdown and more people having to work from home.

The S&P 500 hasn’t done too badly either, considering we have just experienced the fastest stock market falls in history: it’s down just over 7%** since the start of the year and is 13.6% off its February peak***.

Smaller companies lag behind

But while larger companies have held up better, it’s in the US small cap space that some Chelsea Selection managers are now seeing opportunities. This part of the stock market fell the most in the crash (34.5%^) and is still down around 18% year to date**.

Mark Sherlock, manager of Hermes US SMID Equity fund said recently: “Today there is an interesting valuation opportunity for Russell 2500 companies vs the S&P 500 – small and mid-caps are cheaper than large caps and compared with their own history.”

High Grieves, manager of LF Miton US Opportunities fund agrees: “For the last couple of years, we haven’t had any holdings in smaller companies. But what we have always said to clients is that in the depths of the next recession, we will be significantly adding to our small cap weighting, because that’s the time when you get the best opportunities to buy some wonderful companies at great prices.”

A world of opportunities

All around the world, smaller companies were hit harder during the crash. In Asia and emerging markets smaller companies fell 8.5%^ more than larger companies and in Europe and the UK they fell 5.9%^ more, while in Japan the gap was narrower at 2.4%^.

And while smaller companies in these regions have rebounded more than their larger peers since the March low, they are still lagging year to date**. So, for long-term investors, is now the time to buy smaller companies funds?

Darius McDermott, managing director of Chelsea Financial Services, said: “Smaller companies can be an excellent investment for investors with a long-term investment horizon and who are willing to take on more risk.

“However, this recession is likely to be very deep, and no one knows how long it will last, so there are bound to be many businesses that struggle and go bust. But there are always winners, and those that do survive could find themselves in much stronger positions going forward.

“As always, good stocking picking skills will be paramount, and investors might like to consider smaller monthly contributions rather than a larger lump sum at this stage.”

Six smaller companies funds to consider:

1. Marlborough UK Micro-Cap Growth

This fund invests in small and micro-sized companies and is run by the very experienced, astute and pragmatic stock picker Giles Hargreave. He is supported by co-manager Guy Feld and a well-resourced team of fund managers and analysts.

2. T. Rowe Price European Smaller Companies Equity

This pan-European fund also invests in the UK, and has a highly experienced manager, with a proven track record managing small and mid-cap portfolios in Europe. Buying early or in a contrarian fashion with a long-term view allows him to compound his winners.

3. LF Miton US Opportunities

The managers of this multi-cap fund have the flexibility and pragmatism to adjust the portfolio to different market environments. It usually has a bias towards medium-sized companies and the managers have recently been adding to small-caps.

4. AXA Framlington Japan

This fund invests in Japanese companies of varying sizes but tends to have a slight bias towards smaller companies (currently 40% of the portfolio^^). The manager looks firms with long-term growth prospects independent of what is going on in the wider economy.

5. Hermes Global Emerging Market SMID Equity

This is a concentrated fund focusing on small and medium-sized companies across global emerging markets. Launched in 2018, its co-managers look for quality companies with talented management, who act responsibly towards clients, stakeholders and shareholders.

6. ASI Global Smaller Companies

Based around ASI’s powerful screening tool 'Matrix', this fund identifies smaller companies from all around the globe - including emerging markets - that the managers believe to have the best growth prospects.

*Source: The Association of Individual Investors, sentiment survey, 29 April 2020
**Source: FE Analytics, total returns in sterling, 1 January to 1 May 2020
***Source: FE Analytics, total returns in sterling, 20 February to 1 May 2020
^Source: FE Analytics, total returns in sterling, 20 February to 23 March 2020
^^Source: fund factsheet, 31 March 2020

Indexes used: FTSE 100, FTSE Small Cap, MSCI Europe ex UK, MSCI Europe ex UK Small Cap, S&P 500, Russell 2500, TOPIX, MSCI Japan Small Cap, MSCI Asia ex Japan, MSCI Asia ex Japan Small Cap, MSCI Emerging Markets and MSCI Emerging Markets Small Cap.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the fund manager or commentator and do not constitute financial advice.

Published on 04/05/2020