Do the best things come in small packages?

Over the last two years, bigger has undoubtedly been better for investors. Larger companies have outpaced their smaller rivals in the US, UK and Europe, as investors have gravitated to safety and predictability. However, with the interest rate environment shifting, economic growth stabilising and market sentiment turning, small caps have started to revive. Is it time to rethink?

There is a well-worn narrative for smaller companies versus large companies. Smaller caps tend to be faster-growing (outpacing their large cap peers by an average of 3.3% per year over the longer-term*), but are also prone to periodic – and painful – falls when investors fall out of love with them. This usually happens when the economic environment is weaker, or when investors are feeling nervous.

Certainly, smaller companies will have vulnerabilities at times of economic stress: they tend to be focused on a handful of product lines in a smaller range of markets, or in a single country. Equally, higher interest rates may hit smaller companies harder because they are considered riskier by lenders, who then charge them higher rates.

However, often these weaknesses are more imagined than real. Fund managers specialising in smaller companies say that the operational performance of the companies they hold has generally been good and that share prices have ‘over-corrected’. The strong bounce back in small caps in November and December of last year** gives some weight to this view.

Large cap dominance

This strong run at the end of 2023 reversed a two year stretch when larger companies had fared much better. In 2023, the FTSE 100 rose 7.93%, against a rise of 7.89% in the FTSE UK Small Cap and a fall of 2.47% in the FTSE Fledgling***. Small caps didn’t regain any of the ground they had lost in 2022, when large caps outpaced their smaller peers by an eye-watering 25.9%****. This pattern has been replicated across most of the world.

Partly this was investors’ preference for the solidity of large caps in a tougher market environment. Larger companies will have more diverse revenue streams, better-established markets and a lower cost of capital. They may also pay higher dividends and be exposed to a broader range of geographic regions. This gives them more resilience at times of economic weakness. They are also more liquid, which means any selling pressure doesn’t hurt as much.

The sector make-up of larger companies has also been an advantage. In the US, all attention has been on artificial intelligence (AI). There have only been a handful of large companies with deep enough pockets to exploit the AI trend and this has been reflected in the dominance of the ‘Magnificent Seven’ technology giants. In the UK, a number of mining and energy companies did well in 2022 in the wake of the war in Ukraine, and in 2023, companies such as Rolls-Royce, M&S, Centrica and Sage took up the baton. In Europe, it was a year for the luxury goods companies.

Better signs ahead

Smaller companies always tend to struggle when interest rates are rising, but this factor is reversing and is part of the reason investors have been more disposed to small caps since late 2023. Cormac Weldon, manager of the Artemis US Smaller Companies fund says: “The Federal Reserve has indicated that interest rates are likely to decline in 2024. This is generally an environment that favours US smaller companies.” The same is true for UK or European smaller companies.

Smaller companies also look cheap relative to the growth they can deliver. Their recent run of performance has narrowed valuations slightly, but smaller companies still trade at a discount to large caps. The MSCI Global Smaller Companies index trades on a forward price to earnings ratio of 16x, versus 16.5x for their large cap equivalents**. In the UK, the gap is even wider.

Many also pay a high and growing dividend without really trying. WS Amati UK Listed Smaller Companies, for example, has a yield of 2.4%, while Unicorn UK Smaller Companies yields 2.3%^. These managers are not necessarily trying to achieve a yield, it’s just thrown off by their process.

Recession remains a key variable and even if a weak outlook is already in the price of smaller companies, it doesn’t mean they can’t get cheaper. If a small cap fund still feels a little risky, there are multi-cap options, where fund managers will move flexibly between large and small cap depending on where they see the opportunity. The IFSL Marlborough Multi Cap Growth or WS Montanaro UK Income funds have the flexibility to adapt to different scenarios.

Larger companies are more likely to prove more defensive if financial markets wobble and for those who prefer to invest in bigger firms, funds such as Schroder Recovery have a strong track record in finding value in large cap companies. Among the current top 10 holdings are Rio Tinto, Barclays and Hammerson^^.

In the question of big versus small, the answer is, unfortunately, it depends. The last two months of 2023 shows how fast small caps can rally given the right environment, but there are still a lot of variables. There is room for both in a portfolio, giving you a stake in a rising market, but some protection if recession bites.

*Source: Numis Indices, January 2023
**Source: MSCI index factsheet, 29 December 2023
***Source: FE Analytics, total returns in sterling, 2 January 2023 to 29 December 2023
****Source: FE Analytics, FTSE 100 versus FTSE UK Small Cap index, total returns in sterling, 3 January 2022 to 30 December 2022
^Source: FE Analytics, 16 January 2023
^^Source: fund factsheet, 31 December 2023

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 author and fund managers and do not constitute financial advice.