David beats Goliath: UK small caps outperform large caps

Since the vote to leave the EU in June 2016 it’s been one challenge after another for UK companies and, as a result, our stock market has underperformed those of other developed countries.

This underperformance has been exacerbated in recent months – first with the onset of COVID-19 and now the new impending Brexit deadline and a second wave of the pandemic. While both the US’s S&P 500 and Japan’s TOPIX are up 5.1%* and 3.1%*respectively year to date and the MSCI Europe ex UK is almost in positive territory (-1.1%*), our stock market, as measured by the FTSE All Share, is still down 21%*.

But while the overhang of Brexit has impacted its recovery from the March lows, arguably the bigger reason is the traditional composition of the UK index. It contains fewer technology companies and has more financials and consumer discretionary stocks than its overseas peers. The UK’s biggest sector overweight, when compared to the MSCI World, is also to the energy sector (10% vs 3%^) – which has its own structural challenges. These are all ‘value’ areas which have lagged in recent years and, with interest rates likely to remain low for the foreseeable future and inflation nowhere to be seen, it is unlikely we’ll see a changing of the guard any time soon.

Smaller companies stand strong

The good news is that the UK’s smaller companies - and those on the AIM index - have fared a lot better than its larger ones. Year to date, the FTSE Small Cap index is down 14%* while the FTSE AIM All Share is down just -0.9%*.

David Stevenson, co-manager of TB Amati UK Smaller Companies, which is on the Chelsea Selection, says that “the significant outperformance of AIM stocks and the dispersion in valuation between the most expensive and cheapest stocks (which has become the widest since the dot com era) reflects a pandemic driven sentiment amongst investors, who continue to favour companies exposed to newer growth areas, such as healthcare, technology, data communications, and other aspects of the online economy, which are expected to dominate into the future: AIM has a high proportion of such companies.”

Anthony Cross, co-manager of Liontrust UK Micro Cap, which is also on the Chelsea Selection, added that “for smaller companies, their ability to trade through a downturn and emerge on the other side in a position to take advantage of any subsequent upturn is important. Businesses that have strong barriers to competition, attractive market positions and a history of higher returns should stand them in good stead – allowing them to take advantage of weaker competitors when the dust settles.”

While this area of the market is vulnerable to uncertainty and market downturns as it tends to get sold off as investors de-risk, it has also been surprisingly resilient, and we have an abundance of top quality stock-pickers in this space who have proven their ability to make the most of opportunities. Each UK Smaller Companies fund on the Chelsea Selection has outperformed both the FTSE Small Cap Index and the peer group average year to date*.

VCTs celebrate 25 years

Another way to invest in the UK’s smaller companies is via Venture Capital Trusts (VCTs). 28 September marks 25 years since the launch of the first VCT and, from humble beginnings in 1995 the sector has grown to back winners from Zoopla to Secret Escapes and cutting-edge UK businesses such as video games developer Frontier Developments.

Annabel Brodie-Smith, from the Association of Investment Companies (AIC), said: “VCTs have come a long way in 25 years. Today they back companies in sectors which would have been difficult to imagine in 1995 such as gene therapies and cloud computing. However, this is really a continuation of what VCTs have always done: provided vital finance to the UK’s most dynamic young businesses.

“VCTs offer a powerful way of bridging the finance gap for budding companies, something that’s more important than ever as the economy faces the challenges of the pandemic. Through supporting innovative businesses, VCTs provide important social and economic benefits.”

Bevan Duncan, manager of Baronsmead VCT commented: “The current market environment, although challenging, is not as bad for certain kinds of small entrepreneurial business as they can adapt quickly - particularly ones that are well funded and already benefiting from long term structural growth changes. A more fragmented workforce, with a lot of people working from home, means there is demand for tech and software apps that ensure they can work efficiently and securely. Regulatory requirements and security concerns are also driving growth (for example GDPR). Covid has accelerated these changes.”

You can find out more about the Baronsmead VCT here and which other VCT offers are currently open, here.

*Source: FE Analytics, total returns in sterling, 31 December 2019 to 21 September 2020
^Source: MSCI Factsheets

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. Darius's views are his own and do not constitute financial advice.