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In this month’s column, Ross Garrard from Ravenscroft’s advisory investment team discusses the benefits of smallcap versus large-cap stocks
FOR global equity investors, the recent trend has been “the bigger the better”.
One by one, various US technology companies have surpassed huge valuation levels, with Apple first surpassing the $1 trillion valuation mark in 2018 and last year surpassing $3 trillion, closely followed by Microsoft and Nvidia. This trend has led to a significant concentration in global equity indices, with 72% of the MSCI World Index now invested in the US.
Additionally, all its top-ten holdings are US companies, driven by high growth within the technology sector, crowded investor positioning and an inexorable rise of passive funds or index investing, which mechanically allocate the most capital to the largest companies.
However, with high valuations comes higher risk, and a number of US technology companies are trading at higher price-to-sales ratios of 20x or more – levels reminiscent of the dotcom bubble. The corollary of this has been a prolonged underperformance of smaller companies the world over, as their relative index weight has become progressively smaller.
Over the past three years, UK small-caps have suffered their third-worst performance period this century, surpassed only by the dotcom bubble and the global financial crisis.
When comparing their relative performance against large-caps, this period is by far their worst, with a 57% underperformance over three years (source: Bloomberg/Crux). This underperformance has been driven by relentless redemptions from UK equity funds, which exacerbates price movements in small-caps due to their relative illiquidity and therefore higher price volatility.
But with low prices comes opportunity; smaller companies historically grow faster than large companies (“elephants don’t gallop”) and today are valued more cheaply. We believe this valuation starting point represents a historic opportunity for growth-orientated investors.
The greatest determinant of future equity returns is the starting price one pays (Shiller P/E) and on this basis small-caps look very attractive, with historic regression analysis indicating potential mid-teen annual returns from this valuation start point. At Ravenscroft, we seek to take advantage of this opportunity through investment across multiple strategies, particularly in growth mandates, such as the Ravenscroft Global Growth Fund, which is now invested up to 40% in global small- and mid-caps.
For advisory mandates, we have a range of smaller company investment trusts that have delivered double-digit annual returns over many decades. Often these trusts own shares that are available at a 10% discount or more, and so represent a historic double-discount opportunity, and often a surprisingly high dividend yield from what is traditionally considered a growth asset.
By leveraging these opportunities, investors stand to achieve substantial returns, making small-cap stocks a potentially valuable addition to portfolios.
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FINANCIAL PROMOTION: The value of investments and the income derived from them may go down as well as up and you may not receive back all the money which you invested.
Any information relating to past performance of an investment service is not a guide to future performance and may not be repeated.
