Page 22 - DIY Investor Magazine | Issue 41

CATCHING THE WAVE
· August 2024 22
DIY Investor Magazine
WHY THE EARLY BIRD INVESTORS IN THE UK SMALL-CAP SECTOR HAVE BEEN HISTORICALLY WELL REWARDED... BY JO GROVES
Sometimes there’s no point in sugar-coating the truth:
UK small-caps have endured the longest cycle of underperformance in several decades. A challenging macroeconomic environment and investor pessimism have taken their toll on UK equities and stellar returns on the other side of the Atlantic have only served to accentuate this disparity.
That said, investors taking a longer-term view have historically been well rewarded, with the FTSE Small Cap Index chalking up a 25-year total return of 430% leaving the 215% return for the FTSE 100 in the dust and, for completeness, not far off the 450% (USD) return for the high-growth S&P 500 (as at 04/06/2024). What’s more,
‘IF YOU WAIT FOR THE PERFECT WAVE, YOU RISK MISSING OUT ON THE BEST ACTION’
the worst periods of perfor- mance have historically led to the strongest subsequent periods of returns in the UK
THE CLOUDS ARE CLEARING
Macroeconomic issues have undoubtedly weighed on the valuation of UK equities, with investors taking fright at stubborn inflation, rising interest rates and falling GDP but the current outlook is starting to look more positive. The UK exited one of the shallowest recessions in history with a return to growth in the last quarter, business and consumer confidence have improved and inflation is nearing its
2% target.
This leaves interest rates as
‘CORPORATE AND the final hurdle and the UK
PRIVATE EQUITY small-cap sector has historically
BUYERS HAVE SEIZED shown an inverse relationship
THE OPPORTUNITY TO to interest rates. While the era
SNAP UP UK COMPANIES of ultra-low rates is firmly in the
AT BARGAIN PRICES’ rear-view mirror, Bank of England Governor Andrew Bailey recently announced that rate cuts are “likely in the coming quarters”, which may provide the catalyst to a sustained recovery in UK small-caps.
Indeed, an improving macroeconomic backdrop has helped to drive the FTSE 100 to record highs in recent weeks and investor enthusiasm is starting to trickle down the market cap spectrum. While small-cap valuations remain below their decade average, the FTSE Small-Cap Index (ex-ITs) has delivered a year-to-date total return of 11%, exceeding the 9% return of its large-cap peer (as at 04/06/2024).
Investors may have been eschewing the small-cap valuations on offer but corporate and private equity buyers have seized the opportunity to snap up UK companies at bargain prices, with Peel Hunt reporting that 10% of the FTSE Small-Cap Index was acquired by number
(and 30% by market cap) in 2023.
small-cap sector, as my colleague noted last year.
A strong finish for the UK small-cap sector at the end of last year raised hopes that the long-awaited recovery was underway but optimism dwindled when the sector headed down in the new year. Although the FTSE Small Cap Index has ticked up again in the last month, investors may be tempted to wait on the sidelines until a sustained recovery is underway. That said, to use a surfing analogy, if you wait for the perfect wave, you risk missing out on the
best action.
The chart below looks at trough-to-peak gains in the FTSE Small-Cap Index following significant downturns. This shows the benefit of being an ‘early bird’ (or, indeed, long-term) investor with trough-to-peak gains of up to 45% within the first three months of the subsequent recovery period.