Having set multiple fresh record highs in the year it turned 40, the FTSE 100 has been busy turning heads in 2024.
Performance is strong; a wave of both dividends and buybacks has given investors plenty of reason for cheer, and the market might even be on a firmer footing thanks to the presence of a stable government.
Having said that, there are other reasons to take an upbeat view on the UK market. There are, for example, reasons to hope that the economy might now be in for better things after a difficult period. The Bank of England cut rates for the first time in more than four years at the start of August, from 5.25 to 5 per cent.
Inflation has not gone away but is well below the levels of, say, late 2022, and the UK consumer could gradually start to have an easier time. Earlier this summer the British Retail Consortium saw shop prices fall for the first time in almost three years, for example.
Tentative as this recovery might be, it does shine some light back onto UK small-cap shares, which have rallied alongside the FTSE 100 but only after a period of looking especially unloved.
The FTSE Small Cap index fell by a startling 13.6 per cent in a 2022 that proved especially tough for growth investors, compared with a 4.7 per cent positive total return for the FTSE 100. The FTSE Small Cap index has returned nearly 11 per cent in the first eight months of 2024, putting it only slightly behind the FTSE 100.
But investors who have delved further down the market cap spectrum in recent years will need to see more of a recovery to recoup any 2022 losses.
Rob Morgan, chief analyst at Charles Stanley, argues UK small-cap stocks should look especially interesting from a valuation perspective. “Small cap is an opportunity that stands out currently, both here in the UK and across the globe,” he notes.
“But with the UK market trading at a big discount to others there is a particular reason to be interested in it.”
The current outlook for small cap
To briefly recap what has been a difficult period for the sub-sector, Morgan says that smaller companies have generally tended to underperform since 2022 because they have more debt, something that becomes a serious problem in a period of rising interest rates.
With rates eating into earnings, more nascent companies such as these can struggle. Even those companies that are light on or completely free of debt can get caught up in a shift of sentiment towards the sector.
As such, interest rate cuts can help smaller companies by easing this burden, as well as by providing a boost to the economy. Smaller companies often do tend to get much more of their revenue domestically than the likes of FTSE 100 constituents, meaning they should feel the benefits of an economic uptick.
Small caps do come in many different forms and some sectors might have more appeal than others.
However, there is an argument that a broad improvement for the economy should continue to lift much of the sector.
Filling the well?
Low valuations have made it easy for overseas entities and private equity firms to acquire UK-listed companies on the cheap, and a notable instance of this came in the form of a recent bid for FTSE 100 constituent Hargreaves Lansdown.
However, smaller companies looked like an especially easy target for M&A activity given their depressed share prices. Peel Hunt, for example, has observed that 40 M&A transactions worth £100mn or more were announced in 2023 alone.
Much of this had a small-cap focus: none of the transactions occurred in the FTSE 100, with three in the mid-cap FTSE 250, 13 in the FTSE Small Cap index, 20 on Aim (which contains companies of different sizes) and four elsewhere.
With little in the way of IPO activity, the number of small-cap shares does need to be replenished.
A recovery in sentiment, some new listings and a return of investors (both professional and individual) could help turn the tide here. But small-cap investors may need to be both selective and patient – whether that is in the face of further market volatility or, for example, a private equity group attempting to buy out a promising smaller company.
Georgina Brittain, who runs the JPM UK Smaller Companies fund and its investment trust equivalent, says the Budget on October 30 was an obvious risk for small-cap investors.
She says: "We know that the chancellor will be seeking to raise money, although we cannot yet be certain exactly what changes will be put in place. But there might be a knock on effect to investors in terms of a perceived change to the risk/reward profile of making investments."
Nonetheless Brittain said there were opportunities in the UK small-cap sector, including housebuilders and travel.
She says: "With interest rates on the turn, consumer confidence rising and low unemployment persisting, we expect housing transactions to pick up. And that is before the government initiates its changes to the planning system and impacts the sector with its housebuilding targets.
"On the same theme of a steadily improving outlook for the consumer, the other standout sector is travel and leisure. We expect the consumers’ cautious approach to spending will gradually dissipate, as they grow more comfortable with the outlook, and more confident that the cost of living crisis is well and truly in the past."
Finally, on this front, it is worth noting that the likes of small-cap funds do take markedly different approaches.
Some will tend to hold a high number of positions, and keep position sizes small, as a way to mitigate some of the risks. Others are turning to something of a private equity approach, in that they build up substantial positions in just a few companies and use their clout as a major investor to agitate for positive changes.
These approaches can come with notably different levels of risk and reward.
david.baxter@ft.com
