With U.K. economic data showing resilience after the Brexit referendum and the Bank of England boosting stimulus, small-cap companies are in the sweet spot.
An index tracking them has rallied to a record, rising 4.1 percent since Britons voted to leave the European Union and outpacing mid-cap shares. Their appeal: a higher dividend yield and lower valuations than the FTSE 250 Index or FTSE 100 Index of large exporters.
Smaller British companies, such as electronic-component maker Premier Farnell Plc, quickly recovered from the record slump that followed the Brexit vote as economic data avoided the Armageddon scenario that many had feared. Quite the opposite: recent reports have beaten forecasts, with retail sales actually having their best July growth since 2002, while the BOE cut its benchmark rate and expanded its balance sheet.
“In the aftermath of the Brexit vote, there was a period of resetting of expectations,” said Guy Foster, head of research at Brewin Dolphin in London. His firm manages about 33 billion pounds ($43 billion). After the initial shock, investors soon began to return to smaller companies amid “the unwinding of that shock factor, combined with better economic data and the fact that the large caps were starting to look extremely expensive.”
Companies in the FTSE Small Capitalisation Index Ex Investment Trusts, which have a market value of about 320 million pounds on average -- compared with 1.6 billion pounds for the FTSE 250 -- trade at 14 times estimated earnings, more than 10 percent lower than the measure of bigger firms and the FTSE 100. Their dividend yield of 3.2 percent compares with less than 3 percent for the gauge of mid-sized companies.
Members of the small-cap index are also relatively international, with JPMorgan Asset Management’s Guy Anderson saying they may get as much as half their sales from outside the U.K. -- similar to mid caps -- and therefore also benefit from the weaker pound. The gauge of smaller firms has gained 3.7 percent in 2016 through Monday, compared with a 2.5 percent increase in the FTSE 250, heading for a fourth year of outperformance in five.
“While a lot of the time people will use it as a proxy for the domestic economy, there are actually a huge number of international opportunities,” said Anderson of the small-cap index. He helps manage $1.7 trillion for JPMorgan Asset in London. “There’s been a pretty substantial increase.”
The biggest companies in the small-cap measure -- investment firm Melrose Industries Plc and Premier Farnell -- get almost 70 percent of their sales from abroad, data compiled by Bloomberg show. Since the vote, more than half of the small-cap index members have climbed, with Ferrexpo Plc surging more than 150 percent as Fitch Ratings upgraded the iron-ore supplier’s credit score amid higher prices for the metal. The company’s biggest markets, China and Austria, make up about 43 percent of its revenue.
Of course, with Britain yet to start its negotiations with the EU, the economic effects of the vote are still unclear, putting U.K. stocks at risk for the future, according to JPMorgan Asset’s Anderson. Economists forecast the country will suffer a brief recession in the second half of the year, and the BOE lowered its 2017 growth projection to 0.8 percent from 2 percent. So far, property companies are among those that have been hit the most, with broker Foxtons Group Plc still down more than 30 percent since June 23. Countrywide Plc expects the London housing boom will end next year.
Brewin Dolphin’s Foster, a long-term investor, still sees an opportunity in smaller firms.
“The immediate economic impact on those domestically-focused stocks is probably less or at least more uncertain than was immediately assumed,” he said. For small caps, “the growth is typically significantly higher. The other final really important thing is that small caps are much more likely to be acquired, and the weakness of sterling makes that acquisition significantly more likely.”
(Updates with Tuesday trading in second paragraph.)
To contact the reporter on this story: Justin Villamil in London at jvillamil18@bloomberg.net. To contact the editors responsible for this story: Cecile Vannucci at cvannucci1@bloomberg.net, Sofia Horta e Costa
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