The IA UK Smaller Companies sector was the best performer in the open-ended fund universe in May, as inflation fell, sentiment towards risk assets rose, and M&A activity boosted returns, according to Ben Yearsley, investment director at Fairview Consulting.
The IA UK Smaller Companies sector returned 6 per cent in May - comfortably the best performer in the sector - with the next best being the European Smaller Companies sector, at 3.95 per cent.
Yearsley said: “A combination of factors have helped the smaller companies sector. In the UK, inflation is coming down while the growth outlook has picked up, with the most recent GDP number being 0.6 per cent. The number of UK small caps being taken out at a premium has also helped.
Gervais Williams, who runs a range of smaller company funds at Premier Miton, said: “After a period of inflation, as the pressures dissipate, central banks seek to slow the recession, and look to start a new period of economic recovery via a series of interest rate cuts.
"The small cap sector traditionally underperforms as economic growth slows and starts to outperform, even prior to the end of the recession, in anticipation of economic recovery. With the surge of megacap outperformance this cycle, smallcaps have underperformed in even greater magnitude than usual, and hence their outperformance upside potential is even greater than usual.
"The big question is: when will that outperformance start? Normally it coincides with the cuts in interest rates, but just occasionally it can start earlier. Famously, in the case of the dot com bubble at the millennium, small cap outperformance started even prior to the recession in 2001/2.”
He added that often quoted companies with operations benefitted from interest rate cuts first. This might include those involved in the housing and property sectors, along with some consumer and service sector businesses.
"But ultimately, often the very best returns are made on those small caps that greatly enlarge their recovery potential by acquiring formerly overleveraged, but otherwise businesses debt-free from the receiver, sometimes for as little as £1," Williams said. "We favour some of these deals, as the company concerned often states that they can deliver ‘transformational’ upside potential.”
Victoria Bons runs a global smaller companies fund at Van Lanschot Kempen.
She said small-caps had underperformed large-caps since the first Fed rate hike in March 2022, while still outperforming large-caps since the inception of the MSCI World Small-cap index in 2001.
Bons added: "The small-cap valuation premium has whittled away to a discount. The discount appears to exist across the board, across sectors. The underperformance can be intuitively explained since this basket of smaller companies operates with slightly more leverage and a higher cost of debt, making them more susceptible to market weakness in periods of meaningful interest rate hikes.”
Martin Frandsen, a global equity manager at Principal Asset Management, said that while falling interest rates often were good for small caps, it could also been seen as a negative.
