Is the tide about to turn for smaller companies?

The past 18 months has been particularly uncomfortable for this part of the market, but within this weakness may lie an opportunity.

Over the long-term, smaller companies have a well-established track record of outperforming their larger cap peers. Since 2000, the MSCI World Small Cap Index has delivered an annualised return of 8.91%, compared to 7.04% for the MSCI All Companies World Index (MSCI ACWI). It is worth noting that the performance of the MSCI ACWI includes the astonishing run for technology giants, such as Amazon, Apple, Microsoft and Alphabet.

While it is impossible to pin down the exact reasons behind this ‘small cap effect’, there are a number of likely explanations. Smaller companies tend to be more adaptable and less bureaucratic and are therefore able to react faster to changes in the business environment. They can exploit emerging opportunities quickly, unencumbered by legacy systems and processes.

It is also easier for small caps to show strong growth because they start from a smaller base. If a large cap and a small cap are tackling the same addressable market, it will make a big difference to the small company but may not move the dial for the larger company, with its many other business lines and products.

Navigating a tougher economic climate

That said, small caps tend to struggle in certain environments. In particular, they are seen as being more vulnerable to rises in the cost of borrowing, as has been seen over the past 18 months. They may also suffer when the economic environment is uncertain. They are seen as more exposed to the local economy in which they operate. This has been a particular problem in markets such as the UK, where the domestic economy has been weak.

In many cases, this weakness is more imagined than real. At abrdn, our matrix approach directs us to higher quality smaller companies, with lower debt and a strong pathway of growth. It also steers us to companies that are exhibiting momentum, such as seeing upward earnings revisions. We find that businesses with these characteristics have generally been able to navigate rising interest rates and a tougher economic climate successfully. This means their businesses have remained sound, even if sentiment has hit their share prices.

Historically cheap valuations

We believe this persistent poor sentiment towards smaller companies represents an opportunity, and that investors will ultimately recognise the mismatch between the operational performance of smaller companies and their share prices. Recent research from Morningstar shows that, compared to the last 15 years, small caps are trading at historically cheap valuations, while profitability is close to historic highs. The research also showed analysts’ Earnings Per Share (EPS) forecasts for small caps began to improve at the start of 2023. Importantly, it found that smaller companies typically outperform after a recession – exactly the type of environment we are in today.

Against this backdrop, a recovery for small companies across the world could be imminent. We have two trusts that are focused on this part of the market – abrdn Asia Focus and abrdn UK Smaller Companies Growth Trust. There are different dynamics for each. In the UK, smaller companies have been the most unpopular part of an unpopular market. Beaten-up valuations suggests there could be a significant relief rally ahead if there are signs of life in the UK economy. We see signs of data tentatively improving, with the UK economy returning to growth after a short-lived recession and Purchasing Managers’ Index (PMI) data – a forward-looking measure of economic confidence - improving. Sentiment may benefit from a range of government initiatives announced in the recent budget to improve participation in UK equity markets.

In Asian markets, the situation has been slightly different. The magnitude of underperformance has been lower. There has been a strong performance from some Indian small caps, but also less exposure to the weak Chinese markets. China only forms around 8% of the MSCI Asia ex Japan Small Cap Index. Smaller companies have also had greater exposure to popular segments such as technology. Nevertheless, valuations are still low relatively to history and to large caps, and there is still a potential catch-up trade should sentiment improve.

Looking ahead

Smaller companies are still the place to find the most dynamic and exciting growth opportunities in individual markets. They have struggled with poor sentiment, but as the interest rate environment starts to reverse, and economic conditions start to improve, we believe investors will start to appraise this part of the market.

Important information

Risk factors you should consider prior to investing:

The value of investments and the income from them can fall and investors may get back less than the amount invested.
Past performance is not a guide to future results.
Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
The Company may charge expenses to capital which may erode the capital value of the investment.
Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘sub-investment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
Yields are estimated figures and may fluctuate, there are no guarantees that future dividends with match or exceed historic dividends and certain investors may be subject to further tax on dividends.

Other important information:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

MSCI information

The MSCI information may only be used for your internal use, may not be reproduced or disseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis, should not be taken as an indication or guarantee of any future performance analysis forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI” Parties) expressly disclaims all warranties (including without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages (www.msci.com).