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Global smaller companies – what are the prospects?

Smaller companies are in the spotlight after a period of high inflation and rising interest rates. What happens now factors are starting to turn?

| 7 min read

Smaller companies have been a weak spot for investors across the globe. An environment of uncertainty and risk-aversion, rising interest rates and higher inflation has knocked sentiment towards this part of the market. However, with many of these factors starting to turn, smaller companies are coming under the spotlight.

There are certainly factors moving in the favour of smaller companies. Falling borrowing costs have typically created a better backdrop for their performance. Many companies have come through this period of weakness substantially unscathed, and a ‘hard landing’ scenario looks increasingly unlikely.

In reappraising smaller companies, it is worth noting that they are not homogenous. A UK smaller company is likely to be far smaller than a US smaller company, for example. Equally, each region will have its own idiosyncratic qualities. In Japan, the smaller companies sector has a tilt to industrial companies, sophisticated technology and financials. European smaller companies are more exposed to the lending intentions of its domestic banks.

Equally, while the weakness in smaller companies has been universal, the degree of underperformance has varied significantly from market to market. This has left some differences in valuations. While most small and mid cap markets look cheaper than their large cap equivalents, some have been sold off more heavily than others.

The UK is the stand-out market on this. It has been the most unpopular sector in an extremely unpopular market. While there has been some recovery in its relative performance more recently, this is more a function of the weakness of UK large caps, than a notable change of heart from investors and valuations still look low relative to history and to the remainder of the market.

There are always risks with smaller companies. Any of the major economies could see a sharp deceleration in growth as the impact of higher-for-longer interest rates starts to bite.

Valuation considerations

By contrast, in the US, the smaller companies segment only looks cheap relative to its expensive large cap equivalent. The price to earnings ratio of the MSCI US Small Cap index is in line with the MSCI USA index [1], although the price to book ratio and forward price to earnings ratio show a discount.

It is normal for US smaller companies to trade at a premium, so this is unusual, but there is not the same glaring valuation opportunity.In Japan and to a lesser extent the US, the relative weakness of small caps has been more a result of the extraordinary strength of each country’s large cap segment.

In Japan, the index heavyweights have been buoyed by various initiatives from the central government, and the support of international shareholders (including Warren Buffet [2]), while US markets have been dominated by the ‘Magnificent Seven’.

In each case, small cap performance hasn’t been awful, but it has paled next to that of larger companies.As such, while the temptation might be to assume all smaller companies will rally at the first sign of a rate cut, the reality is far more nuanced, and it is vital to consider the exposure of individual markets before making a decision on where to invest.

Valuations may affect the speed with which smaller companies emerge in a rally. Where selling pressure has been extreme – as in the UK - the relief rally may be stronger. However, it may also mean that these companies are vulnerable to any lurch down in economic conditions.

US versus UK versus Japan

We see risks on for US small and mid cap companies if growth gets weaker or it gets stronger. It is possible that they will follow the large caps lower if investors start to fret about valuations.

There has already been a major wobble on a number of the Magnificent Seven, which haven’t lived up to the growth expectations placed on them. At the same time, if the US economy continues to ‘overperform’, there is a danger that rate expectations will be re-set and this will hurt smaller companies, which tend to be more exposed to floating rate debt.

The most interesting markets, in our view, are the UK and Japan, and this is where we are focusing our attention:

  • Japan has some attractive sector tilts, with strong companies in growing parts of the market. The small and mid cap sector has been largely overlooked but may benefit from some of the initiatives that have drawn investors back to the Japanese market. Eventually, investors may recognise the opportunity.
  • In the UK, a number of factors are coalescing to create a better outlook. There is growing merger and acquisition activity, with private equity showing renewed interest in some of the UK’s higher quality small and mid-cap companies. There is also considerable buyback activity. While this has been more evident in the largest companies, if it improves sentiment, smaller companies will benefit as well.

There have also been initiatives from the government to improve UK capital markets. From the British ISA to new disclosure rules for pension funds on their UK assets, there is a recognition from policymakers that they need to act to shore up UK stock markets and support this avenue of funding for UK businesses. Labour has also highlighted this as a priority if it gets into government later this year. This may change the dynamics for the UK market.

In general, smaller companies tend to move as PMIs start to accelerate. These have been picking up more recently, suggesting the UK’s recession will be short-lived [3]. The UK, along with Europe, is at a far earlier stage in its economic cycle than the US.

There are always risks with smaller companies. Any of the major economies could see a sharp deceleration in growth as the impact of higher-for-longer interest rates starts to bite. Labour markets are still tight, leaving staff costs more expensive. While in most regions smaller companies have probably suffered disproportionately to their operational performance, there still factors that could hurt sentiment.

There are selective opportunities in smaller companies, but investors should be wary of expecting a boom just because the economic outlook has improved, and rate cuts are imminent. It is still a part of the market that requires nuance and selectivity.

Sources

1. MSCI USA Small Cap Index (USD)

2. Wall Street Journal: Warren Buffett Was There for the Japanese Market Rally

3. Think.Ing: UK PMI suggests the technical recession is over

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