When stocks fall out of favour like smaller companies have been for the past few years, they need a catalyst to revive their fortunes. A spark that lights a fire under their share prices.
In the case of smaller companies, they’re at a low point in terms of relative valuations similar to what’s happened only twice before in the last 50 years – during the Nifty Fifty era in the 1960s/1970s and in the 1990s dotcom boom. Then their fortunes revived with a long period of outperformance.
Nish Patel, The Global Smaller Companies Trust fund manager believes there are three potential catalysts that could trigger a smaller company stock revival:
- A switch in sentiment away from large companies. These large companies have been growing very quickly, especially the US tech businesses. Given how big they now are, several surpassed a market capitalisation of $1 trillion, history would suggest that it ill be harder for them to sustain those levels of growth. Competition will naturally come into their markets and it will become hard for them to continue to expand at the same rate. Yet these businesses are not valued for a slowdown in growth. If there’s any disappointment in growth, investors could well reassess how much money they should allocate to those companies. Should this happen, it would disproportionately benefit the rest of the market. Take the US ‘Magnificent Seven’ giant tech stocks: together they’re worth over four times as much as the entire US smaller companies market. Just a small switch in percentage allocation away from them could result in a sizeable amount of money flowing into small stocks and pushing up their values.
- Share buybacks and increasing takeover activity. Managers of smaller companies are frustrated with their languishing share prices and are reacting by buying back their own shares. They genuinely believe that their shares are undervalued. But the other form of powerful cashflow deployment comes from acquisitive companies. They’re taking advantage of low valuations to snap up smaller companies at low valuations. There were takeover bids for seven of the Trust’s portfolio companies in the financial year that ended on 30 April 2024. We think that low share prices are likely to attract more acquisition activity. The combination of share buybacks and acquisitions are likely to help smaller companies return to favour.
- Interest rate cuts. After many months of anticipation, central banks have started to cut interest rates. The European central bank and Bank of England have already cut rates. At the time of writing, declining inflation and a cooling economy is leading market participants to expect that the Federal Reserve will cut interest rates in September. Notably, smaller companies benefit more than others when interest rates fall. That’s because smaller companies have less access to credit. What’s more, they often borrow at floating rates that move in line with central bank rates. When interest rates have been cut in the past, smaller company stocks have tended to return to favour. Turning to history as a guide, smaller company stocks have outperformed larger companies by 10% in the 12 months following the first cut in interest rates.[1]
There’s every possibility that these three factors could lead to a revival in smaller company stocks. Historically, the subsequent periods of outperformance have lasted up to 10 years but the biggest share price moves have happened at the beginning.
In the UK, for instance, the earliest part of the small stock recovery cycle has tended to be the strongest, according to research from Singer Capital.
Should these catalysts lead to smaller companies’ long-awaited revival, they will spark a re-rating of their valuations and a period of outperforming larger companies.
The Global Smaller Companies Trust is managed by an experienced team of investors, it has a strong long term track record and is well placed to benefit from a long-awaited revival in this exciting asset class.
Investment risks
The value of your investments and any income from them can go down as well as up and you may not get back the original amount invested. Gearing is used for investment purposes to obtain, increase or reduce exposure to an asset, index or investment. The use of gearing can enhance returns to investors in a rising market, but if the market falls the losses may be greater.
[1] Source: JP Morgan Securities. 31 May 2024.
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