The UK Small-Cap Puzzle

Introduction

 
The small-cap premium suggests that small-cap stocks tend to outperform their large-cap counterparts over the long term. Recently, however, this trend has reversed, with large-caps considerably outperforming small-caps across global markets. Interestingly, this year in the United Kingdom, the FTSE Small cap index has marginally outperformed the FTSE 100, suggesting that the small-cap premium may still hold some relevance. This raises several important questions: If the UK is an outlier, are UK small caps worth investing in? Does the composition of small-cap indices limit their ability to fully capture the small-cap premium? And what strategies can investors use to uncover opportunities within this space?
 

Factor Investing

 
Factors are persistent, quantifiable drivers of return that systematically influence equity markets. The small-cap factor captures the premium for investing in smaller companies over their large-cap counterparts based solely on market capitalisation. The factor is expected to yield a positive return over the long term, compensating investors for the higher risks associated with smaller companies.

From the start of 2024 to the end of the third quarter, the small-cap factor in developed markets and the U.S. showed a negative return, indicating that small-cap stocks underperformed large-cap stocks in these regions. In contrast, the small-cap factor in the UK demonstrated positive performance, suggesting that the UK may indeed be an outlier. If the UK small-cap premium has performed so strongly, why has the FTSE Small Cap index barely outperformed the FTSE 100?
 

Index Composition

 
The FTSE Small Cap index outperformed the FTSE 100 by approximately 1% over this period. Both indices include a diverse range of companies, and their performance can be influenced by many factors beyond just company size, such as industry composition, style tilts, and idiosyncratic effects. For instance, while the FTSE Small Cap’s strong small-cap and value exposure acted as a favourable tailwind, the investment trusts tilt hindered overall performance. Investors may not fully grasp the specific factors they are exposed to when investing via an index tracker.

The FTSE Small Cap index his a significant exposure to investment trusts, which make up over 50% of its constituents. While the FTSE 100 and its ex-investment trust version show similar performance, the FTSE Small Cap index tells a different story. The FTSE Small Cap ex-Investment Trusts index outperforms both the FTSE Small Cap index and the FTSE 100 by 5-6%. Given that investment trusts constitute half of the FTSE Small Cap index, is the index truly representative of small-cap stocks?
 

Pure Small-Cap

 
To assess whether a tailored small-cap strategy could have enhanced the performance even further, we constructed a rules-based portfolio exclusively of UK small-cap non-investment companies. Our analysis indicates that a strategy focused on capturing the pure small-cap premium and favouring companies trading at attractive valuations could have significantly improved performance relative to the FTSE 100.

This underscores the potential benefits of active management in identifying and capitalising on opportunities within the small-cap space. By leveraging the expertise of seasoned fund managers, investors can not only harness this potential but also capture additional alpha through meticulous stock selection.

From the start of 2024 to the end of the third quarter, JOHCM UK Growth’s small-cap holdings outperformed the FTSE Small Cap ex-Investment Trusts index by more than 9%, while JOHCM UK Equity Income’s holdings outperformed the index by over 5%. With small-cap allocations of 40-50% and 15-20%, respectively, these funds have effectively leveraged this exposure to capture growth opportunities in the UK market. Year-to-date, JOHCM UK Growth is up 18.44% and JOHCM UK Equity Income is up 18.64%, compared to the FTSE All-Share, which is up 7.89% (source: JOHCM/FTSE as at 30 October 2024).
 

Comments from the Desk

 
Mark Costar – Senior Fund Manager

JOHCM UK Growth Fund
 
“The UK small-cap market is awash with exciting growth companies and significant pricing anomalies. That culmination has, and will continue to offer, very substantial opportunities to add alpha for the active manager. JOHCM UK Growth has a significant allocation to this area, many of which have delivered very strong returns, including Funding Circle, Science in Sport, and Eleco. These names still have substantial upside potential, alongside a host of other high quality, structural growth companies in the portfolio, many of which are world leaders in their respective fields.”
 
James Lowen – Senior Fund Manager

JOHCM UK Equity Income Fund
 
“This article highlights some interesting points, for example, the fact that around half of the FTSE Small Cap index consists of investment trusts. The latter, which largely represents a significant block of beta, is a key reason why asset allocators should steer away from index trackers in this space and instead focus on active managers. We have consistently generated outperformance from our small-cap allocation. Names such as DFS, Wickes, Eurocell, and Forterra are either market leaders or major players in their respective markets. These businesses are led by strong management teams, are gaining market share and trade at compelling valuations. Based on a reasoned central-case view, many of these stocks have the potential to double in value”.
 

Conclusion

 
In summary, the dynamics of small-cap investing have become increasingly nuanced.  While our research suggests that the small-cap premium is still relevant in the UK, the composition of small-cap indices limits their ability to fully capture potential returns. This highlights the challenges associated with passive investment strategies, which do not provide a pure small-cap exposure. To navigate these complexities, investors might benefit from considering the role of active management in exploring opportunities within the UK market.
 
Note: Axioma Size factor is calculated so larger stocks have higher exposures. We have flipped the sign so that small stocks have higher exposures (and therefore called it the Small-Cap factor) for better alignment with our thesis. 
 
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