The case for small caps

Andrew Holt speaks to Gervais Williams, award-winning fund manager at London-based Miton Group, about the markets in 2018, the easing of QE, Brexit and why shareholders should be looking to small caps

Looking back on 2018, what were the trends early in the year?
The first three quarters of 2018 were dominated by the consistently strong performance of growth stocks. This trend has been in place for several years, and is related to the policy of quantitative easing (QE), which tends to boost market liquidity. It also tends to favor growth stocks as they often look particularly undervalued when bond yields are ultra-low.

How does QE affect stock markets?
To some degree, QE works by distorting market prices. While this was part of the solution in 2009, the problem with the persistent use of QE thereafter has been that price distortion tends to lead to less effective capital allocation. In time, the plentiful market liquidity of QE has come to be linked with the stagnation of productivity and wage growth. Therefore, central banks around the world have generally been winding down the policy over recent years. During 2018, the last phase of QE in Europe came to an end, while in the US, the opposite policy – quantitative tightening – was introduced.

What did this mean for markets?
During the first quarter of 2018, a rise in US bond yields unsettled the market for a couple of months. Although they regained their poise for a period, the end of 2018 was marked by a more pronounced setback in markets.

The share prices of UK quoted companies reflected the market switchback. Generally, for most of the year, smaller growth stocks tended to perform strongly, though they did suffer a slight interruption to service during February and March. In the final quarter, however, as markets have suffered a setback, the share prices of many of the smaller growth stocks have fallen back very abruptly.

Overall, then, what has been the impact of removing QE?
The phasing out of QE has generally depleted market liquidity. Marginal borrowers of all types have found it a little harder to access lenders. This has been a feature of various nations such as Turkey and Argentina. It has also been a feature of certain quoted companies, such as Carillion, which unfortunately led to its demise.

The same trend has also made it somewhat harder for companies seeking a new listing on the exchange to attract sufficient interest, and quite a few floats were pulled during 2018. At present, secondary issues by existing listed companies have still been funded, but often the pricing of these has been at a slightly lower level than expected.

Have you seen an impact due to Brexit?
Most asset allocators scaled back their UK weightings following the Brexit vote in June 2016. It is hoped that in time, when there is greater certainty about the UK’s trading relationship with the EU, there will be scope for these to normalize once again. But the growth of the UK economy may moderate over the coming year, and the government suggests it might remain sub-normal for an extended period.

That said, international politics has become more nationalistic generally, which is raising concerns that international growth may not be especially buoyant elsewhere, either. Both Asian and European economic indicators have been weak over the recent quarters.

Within all this, is there a case for small caps?
Interestingly, we believe this is a moment when a portfolio accessing a vibrant universe of small and micro-cap stocks, along with many well-established majors, may become of greater relevance to shareholders. Specifically:

• In times of economic slowdown, an investment strategy investing in quoted companies may have the advantage. Sustained access to risk capital becomes commercially more valuable at times when finance is scarce, as competition for the best deals from debt-funded businesses falls back
   
• In times of change, corporate agility becomes more important. Frequently, this is found among the management teams of smaller quoted companies. Therefore, a strategy of investing across the full universe, including all smaller companies, has scope to deliver attractive returns. Note that prior to globalization, smaller quoted companies as a group had a long history of outperformance of the mainstream indices
   
• Mainstream equity indices comprise a relatively limited range of industry sectors, with duplication overseas as well. Therefore, actively selecting for industry sectors that buck the broader trend is easier within a more wide-ranging investment strategy. Importantly, returns from a broader range of sectors tend to be less closely correlated with the daily or monthly moves of the mainstream indices, so a small-cap strategy has scope to deliver both diversification and outperformance to investors
• Selecting for quoted companies with resilient balance sheets can be disproportionally advantageous at a time when those with the heaviest borrowing burden may be forced to prioritize the needs of their lenders over their commercial interests.

So is there a case for UK small caps?
The UK exchange is distinctive from others, in that it still retains a vibrant universe of smaller and micro-cap stocks. So while the UK economy may have specific challenges over the coming quarters, we continue to believe that renewed capital allocation to UK smaller companies may be rather more persistent than might be assumed.

Naturally, smaller company share prices won’t be immune to the wider fluctuations of the market, but they might persistently surprise in terms of their ability to find ways to generate productivity improvement at a time when others are really struggling.