In the sweet spot for global small caps? Investor questions answered

Over the longer term, smaller companies (small caps) have consistently outperformed their large cap counterparts when held for any significant period in portfolios. But why? This was the subject of a recent panel session hosted by our small cap experts, including Richard Brown, Neil Harmon, Rory Stokes, and Nick Sheridan.

Why does small outperform big?

Why do small caps outperform their larger counterparts over the long term? The answer lies in their higher growth potential and room for expansion. Small caps have more room to grow as they are less mature, not as globally present, and have not yet fully explored adjacent product markets.

For example, the challenge US tech giant Apple has in doubling its US$400 billion in annual sales is far greater than a German industrial company with a strong product and newer markets aiming to double its US$2 billion in revenues. Simply, the different scales highlight the mathematical advantage smaller companies have over their mega cap counterparts over the long term. This trend holds true globally (Figure 1) and is evident for the UK and Europe too. The US has bucked this trend, with small caps neglected due to the influence of mega-cap technology stocks like Nvidia and the prevailing artificial intelligence (AI) narrative.

Investor question: Where’s the actual catalyst in terms of capital flowing into small cap in the UK? Everyone agrees the small cap space is cheap and attractive, but there feels like there are headwinds that are almost unabated.

 

We’ve observed a variety of sources thinking about allocating in the UK space, including pension funds, private individuals, private clients, and wealth managers. There’s also hope and an expectation that the government might promote and increase the ownership of UK equities by pension funds. This direction of travel backs up our view that there is a significant opportunity for investors in this sector, as it’s currently very undervalued. The mix of fear and greed has also influenced the market; not being involved in UK small cap in the last couple of years hasn’t been an issue. However, as we start to see profits generated again, I anticipate much more interest in this area. – Neil Hermon, Portfolio Manager

Diversification benefits

Diversifying into small caps benefits investors due to their different sectoral exposures. It also plays into the geopolitical shift to nearshoring of previously global supply chains (Figure 2). Smaller companies tend to have more exposure to sectors such as industrials and materials, and less to technology. This contributes to their cyclicality. Despite current uncertainties in the economic cycle, this has historically worked in small caps’ favour over the long term.

Many investors are heavily invested in the S&P 500’s top companies. By adding small caps to the mix, investors can gain exposure to different structural themes such as nearshoring, deglobalisation, and the rebuilding of production lines, potentially offering something unique to portfolios. Put simply, adding small caps to an equity portfolio can result in more balanced returns over time due to their differing performance cycles.

M&A tailwinds

Another compelling reason to invest in small caps is the mergers and acquisitions (M&A) tailwind, which is prevailing and persistent across different regions. The vast majority of M&A activities involve a small cap being acquired, usually at a bid premium, which has averaged 38% in 2024. Further, about 95% of all deals involve the purchase of a small cap stock.¹

Investor question: Janus Henderson owns smaller companies based on the belief that they have strong potential. But if you get takeover offers and accept them, aren’t you missing out on future gains?

 

It’s about relative valuations. If you can take that premium and reinvest it elsewhere, there’s more upside potential in the portfolio. However, we have turned down a bid that offered a 30% premium in recent months because we believe the company is worth twice that amount, and as a result, that bid failed. You experience a bit of pain on that day, but fundamentally, we’re trying to maximise the value of the assets for our clients. – Rory Stokes, Portfolio Manager

Undervalued and out of favour

Looking at small cap valuations, based on 12-month forward price to earnings, it’s clear that small caps are currently undervalued and out of favour. This divergence in returns through the summer suggests a pent-up demand for small caps, which are trading at significant discounts compared to their long-run averages: 10% in the UK, 17% in Europe, and slightly less on a global stage at 5% (Figure 3).

These valuations versus large caps shows that small caps are trading at substantial discounts, indicating a potential catch-up trade once there is some level of stabilisation in the economy.

Rate cuts are also good news for small caps. Historical data from the US shows that small caps have typically seen a 26% return in the 12 months following the first rate cut of a cycle (Figure 4).

Why does this happen?

1. P/E expansion due to expectations of profit growth from small caps which is more sensitive to GDP.
2. A disproportionate reduction in borrowing costs for small caps relative to large caps.
3. Lower market volatility/business uncertainty is reflected in reduced liquidity concerns, which stimulates institutional demand in a more illiquid asset class.
4. Lower borrowing costs stimulate M&A activity.

Investor question: What keeps you up at night? What do you worry about most from a small cap investment perspective looking ahead over the next 12 months?

 

Whatever we worry about is not likely to be the thing that ultimately impacts us, because it’s unlikely we, and the wider investing world, will actually see it coming. We have to be ready for surprises. However, I am concerned about policy issues and the loss of the peace dividend, which doesn’t seem to be resolving itself. AI, I think, is incredibly worrying for the employment of a certain generation, even though it might be beneficial for another. Ultimately, share prices climb a wall of worry because people stand back. Fear and greed, by definition, dislocate share prices away from their fundamental value. Therefore, the more fearful people become in the short term, the better it can be for long-term investment, provided you’re prepared to put your money where your mouth is. We believe an active management approach to small caps puts investors in a strong position to benefit. – Nick Sheridan, Portfolio Manager

IMPORTANT INFORMATION

References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.

Past performance cannot guarantee future results.

There is no guarantee that past trends will continue, or forecasts will be realised.

Smaller capitalisation securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalisation securities.

MSCI Europe Small Cap captures small cap representation across the Developed Markets (DM) countries in Europe. The index covers approximately 14% of the free float-adjusted market capitalisation in the European equity universe.

MSCI Europe Large Cap captures large cap securities exhibiting overall value style characteristics across 15 developed markets countries in Europe.

Deutsche Numis Smaller Companies (ex-Investment Trusts) is a measure of the combined performance of smaller companies (the bottom 10%) listed on the London Stock Exchange excluding investment companies. It provides a useful comparison against which the Fund’s performance can be assessed over time.

FTSE 100 is comprised of the 100 most highly capitalised blue chips listed on the London Stock Exchange.

Russell 2000 is a stock market index that measures the performance of the 2,000 smaller companies included in the Russell 3000 Index.

S&P 500 is a market-capitalisation-weighted index of 500 leading publicly traded companies in the US.

MSCI World Small Cap captures small cap representation across 23 developed markets. With over 4,000 constituents, the Index covers approximately 14% of the free float-adjusted market capitalisation in each country.

MSCI World Large Cap captures large cap representation across 23 developed markets countries. With 614 constituents, the index covers approximately 70% of the free float-adjusted market capitalisation in each country.