Will Small-cap Stocks Recover?

UK smaller companies have delivered excellent long term returns which have outpaced the FTSE 100 over the past 60 years - but since the Brexit vote large caps have rallied

External Writer 2 February, 2017 | 9:31AM
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Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, portfolio manager Guy Anderson, The Mercantile Investment Trust gives his view on the outlook for small and mid-sized stocks.

The UK mid- and small-cap market has delivered excellent long term returns which have outpaced the FTSE 100, two years out of three, for the past 60 years. However, more recently, this trend has reversed, with the FTSE 100 posting the stronger performance in the immediate aftermath of the UK’s referendum to leave the EU.

This change is due to a combination of factors, the most significant of which being the greater exposure of mid- and small-caps to the UK economy, compared to the highly international nature of the FTSE 100. Interestingly, however, while perceptions may have changed, the UK’s economy reality has stayed robust since the EU Referendum, with growth actually outpacing forecasts, as consumption held up better than anticipated.

Uncertain Time Ahead

It goes without saying that the UK faces a period of uncertainty ahead in terms of how the eventual relationship with Europe will be structured and what impact this may have upon economic growth. This is likely to lead to oscillations in sentiment between periods of calm and periods of worry but, ultimately, there are many other factors that will influence the direction of the market – including the potential resurgence in global economic growth.

The indicators for global growth are looking promising and, with increasing signs of inflation, the outlook for equities should be positive too.

Looking forwards, we will have to see how the UK consumer adapts to the inevitable inflation in living costs that is just beginning to be seen but, unavoidable, given the fall in the value of sterling. With this imported inflation lurking around the corner, the outlook for the UK consumer is therefore no longer as strong as it once was, say, one or two years ago.

However, that does not preclude maintaining selective exposure, where the investment case remains compelling. For example, the consumer services space includes of a number of attractive mid-cap opportunities relating to online market places, with businesses that are disrupting existing markets and thriving in the process.

Small Companies Can be Global Too

Alongside these, investors would do well to seek out some internationally exposed companies that can tap into improving growth in overseas economies, and the increasing inflation. There are many such opportunities in the UK mid- and small-cap market. It is also worth reminding ourselves of the very first point: why has exposure to the mid- and small-cap market been so beneficial over the long term and, can this be sustained in the future? In our mind, there are three key structural drivers and, whatever the outcome of the Brexit negotiation process, these will remain true:

Higher growth: smaller companies by their nature are better able to generate higher growth which is not as dependent upon the strength of the economy, unlike their large cap counterparts;

Nimble businesses: this segment of the market can adapt to most forms of change. There are many  examples of disruptors in this part of the market, who can challenge incumbents and find creative ways of growing even when external forces may be changing and/or stacked against them;

M&A: the UK is one of the most open markets in the world. According to the OECD, it is one of the easiest markets for foreign firms to do business, and the UK mid- and small-cap market is often viewed as a place to find attractive bolt-on acquisition opportunities. Sterling’s depreciation should also offer a helpful boon to this trend. Investors could see an uptick in M&A coming from a period of depressed activity in 2016 as a result of Brexit uncertainty. There has been a healthy amount of corporate activity in recent months with Phoenix Group (PHNX), Greencore Group (GNC) and RPC Group (RPC) having all completed acquisitions during this period.

The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Greencore Group PLC128.00 GBX-1.39
Phoenix Group Holdings PLC481.20 GBX0.38

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