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BLOG: Crystal ball gazing – the future for global smaller companies

Paloma Kubiak
Written By:
Paloma Kubiak

The investment case for having exposure to smaller company shares is well documented, based around long-term outperformance of the asset class relative to larger companies across many global markets.

There are a number of reasons for this, but fundamentally it’s the greater potential for smaller, less mature businesses to grow compared to larger companies.

There are advantages in relation to more entrepreneurial cultures within smaller organisations – smaller companies can sometimes carve out leadership positions in attractive niche markets deemed too small to bother with by larger organisations.

Small caps sometimes find themselves the subject of takeover offers which can also enhance investment returns. These, and other attibutes, have helped us generate 9.6% compound share price returns over 25 years, well ahead of RPI of 3.4%.

We‘re often asked about the challenges of selecting a portfolio of global smaller companies given the breadth of the opportunity set, and the lack of readily available or quality research on small stocks.

While these are fair observations, we see the lack of sell-side coverage of smaller companies as offering our experienced team of smaller company fund managers the opportunity to find some relatively unknown gems, which can be fruitful long-term investments.

We regularly interact with the management teams of the companies we hold and research to build up a strong picture of the core strengths and weaknesses of their business models, and crucially to understand the management team’s quality.

So how have small caps performed recently? Well the truth is that they’ve lagged the broader stock market indices in most parts of the world in the last couple of years. The pandemic, subsequent economic weakness and the surge in inflation, which has driven up interest rates, have been unhelpful for all equities.

Smaller companies are particularly susceptible to economic slowdowns and higher interest rates. In 2023 to date, large stocks in the US are well ahead of the smaller companies indices, with technology leaders like Alphabet, Microsoft and chip companies like Nvidia driving most of the whole market’s gains, particularly as enthusiasm for AI has taken hold.

We’re able to get some exposure to this trend through smaller companies exposed to semiconductor investments such as ASM International and BE Semiconductor Industries, but the mega-cap technology stock surge has been another headwind to the recent relative performance of small caps.

Outlook for global smaller companies in 2023

So what‘s the outlook for the rest of 2023 and how is our portfolio set up for this? It‘s currently a complicated market environment. The pandemic lockdowns and subsequent re-opening of economies has distorted trading patterns, a process extenuated by the Ukraine war and the geopolitical tensions between China and the US.

This means that some companies are presently being affected by de-stocking, especially construction and general industrial companies. Sectors exposed to higher interest rates such as housing, consumer discretionary and real estate are being impacted too.

These pullbacks, however, are offering better value for investors coming in now, with share prices in these areas likely to bounce back if the de-stocking phase comes to an end, or if investors gain confidence that rate rises are ending.

Despite these short-term issues, we believe that it’s important to focus on the long-term potential of any particular investment opportunity. We’re therefore looking at a number of stocks in cyclically impacted parts of the markets, e.g. within building materials, capital goods and also selectively within real estate, where share prices of a number of well-managed small caps appear to offer good value now taking a longer-term view.

We’re taking advantage of share price weakness in companies currently being impacted by weaker trading too, and want the portfolio to retain good exposure to some of the strong medium-term investment themes. For example, many countries will be investing heavily in core infrastructure and clean energy projects and there are a lot of opportunities to gain exposure here through small cap stocks.

Some of our materials suppliers such as Eagle Materials in the US or more locally Breedon in the UK, and equipment rental businesses like Ashtead Technology in the UK offer exposure to the infrastructure spending projects of the future.

We also feel positive about the outlook for defence spending given the geopolitical situation and have added to our exposure here over the last year or so, including taking a holding in US listed Curtiss-Wright which is exposed to both aerospace demand and nuclear power station investment.

Investors can access this trust through saving plans offered on platforms such as Hargreaves Lansdown, etc. In addition, the trust’s parent company, Columbia Threadneedle, offers a range of cost-effective savings plans. Investment in savings plans usually start at £25 per month or a lump sum of £100, with the flexibility to start and stop contributions whenever investors want.

Peter Ewins is portfolio manager of The Global Smaller Companies Trust plc