A taste of things to come

I t’s been a challenging time for investors. The twin factors of inflation and geopolitical unrest with the tragic Ukrainian situation have sent shock waves through equity markets.

And the story in US technology this year has been tough, with recent corrections in the valuation of stocks such as Meta and Netflix. In the meantime, after years in the wilderness, the UK has started to look more attractive to investors.

Since Brexit, the UK stock market has been undervalued compared with its US and European counterparts. And looking at the FTSE 100, you can understand why.

New narrative

As home to the oil majors, banks and utilities, it’s not what you might call a hotbed of innovation. But when you examine the UK small and mid-cap sector, the narrative is very different.

In a nutshell, smaller companies tend to outperform larger ones, a phenomenon often referred to as the ‘size effect’. Relatively speaking, UK small caps are much more likely to double or even triple their value than the FTSE 100 behemoths. And this is borne out in the research.

According to Lipper, since 2003 when the FTSE launched, the FTSE Global Small Cap Index has returned an additional 193.9% compared with Global Large Cap. Of course, investing in small caps doesn’t come without risk. As a sector, there is much more volatility than in larger-cap investing. But there are a lot of small and mid-sized companies with strong balance sheets, robust margins and bright futures.

Careful analysis and due diligence will help you find them.

Value opportunity

What is it about smaller companies that make them compelling to investors? Consolidation is an interesting area. There tends to be a lot of merger and acquisition (M&A) activity in small caps, companies buying competitors to build out their expertise, diversify or enter new geographies.

For small-cap investors, M&A can increase the value of their holdings. Initial public offerings (IPOs) are another opportunity for investors who want to ‘get in early’ and benefit from companies transforming from being privately to publicly owned.

Not all IPOs are successful but most flotations tend to help companies raise capital, improve their valuation and increase brand awareness, which is good for business and attracting and retaining employees. Small companies are also more nimble. They can adapt more swiftly to changing market conditions than their larger counterparts, due to their size and the relatively smaller administrative burden that comes with running a smaller company.

Another benefit is the impact on inheritance tax (IHT) for investors in the alternative investment market (AIM). Some companies qualify for business relief and investors often put AIM stocks in their ISA as a way of reducing their IHT liability.

Hidden gems

Another point investors should remember is that small-cap investing isn’t just about big or recognisable brands. Certainly, companies such as Fever-Tree have done remarkably well in the past few years, correlated to the UK’s resurgent love affair with gin, but niche markets are worth exploring, too.

Investors should remember the services sector constitutes 80% of the UK economy and much of small-cap investing is about companies that satisfy specialisms, particularly in the business-to-business space. Having a look at growth areas, industries that are innovating and expanding and the companies that are flourishing within these areas, could unearth some hidden gems.

Small caps can be more vulnerable to market volatility. In times of strife, investors tend to flee from growth markets into larger value stocks they regard as safer havens. This can mean temporary lower share prices for these smaller growth stocks which may represent a good window for investment.

Look out for robust balance sheets and a sector that has the potential for substantial growth. For those with long-term investment horizons, you need an eye on the future and to find companies that are building businesses that can last the distance. Will that be an oil major in the FTSE 100 or a smaller business operating in an industry that has a sustainable future and lots of potential?

Euan Fraser is CEO of Alpha FMC

See also: AIM’s larger caps have had a smoother ride but small caps still have bite

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