Further reading : Are small-cap stocks due a revival?
Gervais Williams at Premier Miton thinks they are and that’s because the global economy and financial markets have changed fundamentally in recent weeks and months. RIP Hyper globalisation!
Delivery of our strategy is underway
A few weeks on from resetting our strategy, we're in full delivery mode to grow oil and gas production.
One of the great constants of modern investing – and modern financial theory – is that over time, it's worth taking the risk of investing in smaller company stocks (small companies by market capitalisation) because the extra premium in terms of returns will more than compensate for the volatility. It's behind the adage of from small acorns mighty oaks grow and underlies the rock-solid theory of the small-cap premium or market anomaly. This anomaly has been detected in numerous, diverse national markets over a prolonged (multi-decade) period. The logic is simple to understand: The small-cap effect is proportional - on average, the smaller the quoted company, the better its long-term returns.
Except that in recent years, that anomaly/anomaly/adage has broken down. If we are honest, small stocks in the UK and globally have underperformed large-cap and mega-large-cap (tech) stocks (many of them American). Small caps have been less rewarding and riskier—a poor formula for successful diversification.
Every financial crisis brings with it talk of a new set of rules, which might benefit small caps. And the current bout of Trump volatility is no exception. Take the US asset management firm Research Affiliates, which has a fine reputation amongst many investors for its contrarian thinking. Only a few weeks back, Que Nguyen, CIO of Equity Strategies at Research Affiliates published an article called Small Caps, Big Opportunities: Investing Beyond Large-Cap Stocks,” in which she explored the potential opportunities in small-cap stocks, currently trading at historically steep discounts to large-caps—particularly for active investors who combine valuation, quality, and momentum screens to enhance returns, avoid value traps, and reduce risk.
Nguyen reports that at the end of 2024, the valuation discount of U.S. small caps relative to a portfolio of U.S. large- and mid-cap stocks stood at -40%. This is a deep discount relative to the historical median level of -5%, standing in the bottom 4th percentile since 1990. High-flying mega-cap companies almost certainly influence this valuation gap. However, even when compared with equal-weighted large-cap indexes, which reduce the outsized influence of mega-cap companies, the valuation discount of small-cap stocks remains substantially wider than usual.
Her tips for success?
First, focus on valuation, notably the least expensive stocks in the small-cap universe, which have generated 1.6% outperformance, albeit with higher volatility and episodic performance. Next up, look at what’s called quality: avoiding financially unstable and capital-inefficient stocks improves returns by 1.0% and reduces volatility by 0.5% among the cheapest stocks. Last but not least, think about positive momentum in the stock price: avoiding poor-momentum stocks leads to significant volatility reduction along with higher returns, reducing volatility by 1.7% while increasing returns by 1.1%.
In my view, what's lacking with this technical explanation is a deeper understanding of why mega large-cap stocks have performed so well over the last decade (relative to small-cap equities) and why that might now change. To answer this question, we need to turn to one of the UK’s most successful active fund managers, Gervais Williams, most of whose professional career has been spent investing in smaller-cap stocks and those paying a higher dividend.
Gervais has also spent a considerable amount of time defying conventional investment logic : in a series of books that I still thoroughly recommend, such as Slow Finance, The Future is Small and the Retreat of Globalisation, Gervais has been thinking the unthinkable in an investment world intoxicated on globalisation, passive funds and bigger is better, enabled by tech. For over a decade, he’s been quietly suggesting that we might have hit peak globalisation (we have now), that financialisation has gone too far, too quickly (up for debate) and that the enormous advantages of massive corporate scale might tip into dysfunction (also up for debate).
A new normal for the end of hyper globalisation?
Over the last few weeks, I’ve been corresponding with Gervais, inspired in part by the huge macroeconomic regime change that is constantly in the news, to see why he is now so enthusiastic about the prospects for small-cap stocks. The obvious caveat is that Gervais invests in said small caps (and UK equity income stocks). But he’s also a rare fund manager who tries to think through how regime changes change the ground rules of investing, which they do occasionally. Maybe it is different this time, and small caps will now benefit from the markets’ turmoil.
What follows is Gervais Williams’ thoughts on what might happen next – in effect an essay which argues for profound structural change both in markets and what we invest in. You’ll also see this version as a conversation in a much shorter column in Citywire Funds Insider next week!
A bit of background – Gervais is currently head of equities at Premier Miton and president of the Quoted Companies Alliance. He’s run many investment and unit trusts over his 30-plus-year career (including Gartmore). Currently, he manages The Diverse Income Trust, Premier Miton UK Multi Cap Income and Premier Miton UK Smaller Companies fund.
For the time-constrained, I've included a small cheat summary below, helpfully generated by our friends from the AI universe…
Summary: Fund manager Gervais Williams argues that globalization favored large corporations due to their ability to scale and reduce costs, leading to the rise of global champions. The influx of low-cost goods kept inflation in check, allowing central banks to inject financial stimulus during downturns. This led to increased debt availability for large firms, higher corporate profit margins, and a shift in investor preferences towards high-beta large-cap stocks. However, Williams also notes the instability of the current market position, the disillusionment with globalisation, and the potential opportunities for small-cap stocks amidst these challenges. Williams reckons that quoted small-cap companies may have greater opportunities for expansion and acquisitions, potentially leading to significant earnings growth.
Over to Gervais….
Globalisation - corporate scale has been favoured.
As trade barriers reduce, corporations with genuinely low costs can expand to deliver products over an increasingly wide range of countries. As they scale up, their unit costs fall further, putting them in a position where they have an extra commercial advantage over smaller competitors. The outcome is the creation of genuine global champions. Not only low cost, but it also has the marketing scale to wholly dominate the media, greatly restricting national corporations' opportunity to survive.
As low-cost goods surged across developed markets, they more than offset the ongoing inflation of local services, so inflation became benign. Thus, central banks found they could inject additional financial stimulus during economic downturns. Whilst this may have boosted the cost of local services, the extra demand also brought in additional deflating imports. The net effect was that economic stimulus could be used at will, without it driving up measures of inflation. The outcome is that the expansion of the global economy has not only been smoother than previously, but also there has been more of it. The global economy has expanded more rapidly than usual, favouring all corporates. With persistent global expansion and benign inflation, the globalisation years have been a period when corporates can use a much higher proportion of debt in their capital structures.
First, credit supply became increasingly plentiful. With little default risk and investors recognising that inflationary risks were less than expected, there was increased competition to supply credit.
Second, the supply of debt industrialised with the growth of credit markets. In short, investors became increasingly interested in lending £1bn to a corporate rather than lending £10m 100 times to smaller corporates. A £1bn issue on the credit markets had a degree of liquidity, whereas £10m issues were typically too small to be listed.
The net effect is that debt supply greatly increased for large corporates, while simultaneously, many smaller businesses found that debt supply became increasingly difficult. There was financial innovation, increased factoring, etc., but generally, this was not particularly low-cost and left the business at risk if there were a downturn in their customer volumes.
The net effect is that large corporations have been able to fund the expansion of their businesses with increasing volumes of debt, which in turn moves to increasingly low rates.
One of the side effects of the increasing use of debt is that it creates additional demand. Thus, those with productive capacity benefited from the steady expansion of global markets and from additional expansion from using debt to fund the extra sales. So, one of the side effects of the increasing use of debt is that corporate profit margins have also steadily increased. Over the last three decades, they have moved to near record levels, approximately at rates that are double long-term norms. The outcome is that successful corporations, many of them global champions, have grown their sales at rates much faster than prior periods, and those sales have also had increasing profit margins. The net effect is that many global champions are now generating abnormally large sums of cash flow, justifying much higher valuations.
Ultimately, all of these factors have favoured quoted bigness over quoted smallness. Generally, with sales, profits and debt availability increasing gradually, stock market investors have learnt to favour investing in high-beta stocks. Ambitious companies were able to grow sales and profits and use debt at a much faster rate than other quoted companies. During any downturns, they were not at significant risk of becoming insolvent, as central banks and governments injected whatever it took to keep the overall economic momentum going. (UK interest rates were cut from 5.75% to 0.5% in the GFC, and Emergency QE was introduced to inject shock and awe.) Gradually, capital allocation flows started to back large-cap high-beta investments. In time, these flows enhanced the returns of large-cap high beta investments, becoming a self-feeding cycle.
Passive funds have benefited from these global capital markets, and hurt small-cap stocks
Actively managed funds have been a major loser here. Routinely, they underweight the very largest quoted companies in an index. Specifically, they seek to limit stock-specific risk. And otherwise, they seek out promising overlooked stocks that can outpace the majors. When they succeed, they become larger, raising their profile and outperforming as earnings and valuation are enhanced together. With some of the best returns generated by high-beta large caps, most actively managed funds were routinely underweight, so they failed to create the premium returns anticipated.
In time, capital allocators came to use ETFs because, by definition, they had a full weighting in the very largest quoted companies. As capital was gradually withdrawn from actively managed strategies, they found they were obliged to liquidate their small-cap holdings, which over time depressed their share prices and valuations, and thus depressed their returns yet further.
This self-feeding cycle has accelerated over recent years, such that even when quoted small caps succeed, their valuations don’t appreciate as much as previously. In a very large number of cases, the valuation of small-cap stocks has actually fallen, whilst the valuations of megacap stocks have increased. Ultimately, the low valuations of small caps restrict their ability to fund deals to enhance their growth. Meanwhile, for some high-beta megacaps, the cost of capital has spiralled down, such that they acquire promising novel companies and grab all of their future growth in earnings-enhancing deals.
One of the unintended consequences of globalisation is that with the enthusiastic adoption of more and more debt, the hard currency money supply has grown dramatically. With this pattern accelerating, all the usual disciplines imposed by financial markets have been absent. Overall, everyone has been able to game globalisation. In terms of governments, this has been reflected in extra tax take and the ability to run very high budget deficits. In the case of private equity, the growth of debt has allowed them to pass the parcel, with corporates being passed from one house to another with deals that involved extra debt, typically at lower cost, apparently yielding extra cash back to the early investors. In the case of equity markets, it has meant that the returns of megacaps have risen such that investors need no longer worry about investment Alpha, as the returns on investment Beta were increasingly strong.
BUT the bottom line is that the current position is now highly unstable
As recently as 2021, global credit has reached near-zero cost. Corporate profit margins are double historic norms. Both factors have meant that many corporations are generating much greater cashflow surpluses than usual, boosting stock market returns further by buying back their shares in great volume. Whilst giant stimulus during Covid did lead to a spike in inflation, and global interest rates did rise considerably, in the first instance, central banks have felt obliged to try and ensure the setback didn’t lead to a disorderly liquidation of assets. Hence, when some of the more leveraged US banks started to fail, the Fed injected additional financial stimulus. The US government also wanted to keep US economic growth going, so it significantly increased the US budget deficit ahead of the US election in 2024. All fine and dandy in the short term, but overall, these kinds of actions yet further reduce the margins of safety.
Alongside, the global electorate has increasingly become disillusioned with globalisation. QE effectively distorts market prices, and since 2009 this has led to a misallocation of assets. This, in turn, has led to very poor productivity outcomes, and as such, much less wage progression than hoped. Alongside, COVID-19 underlined the risks of offshoring supply. The net effect is that the electorate is voting against globalisation, not just across Europe, but in 2024 with the re-election of Trump on a more aggressive anti-globalisation agenda.
Trump is acting with great purpose.
He has withdrawn from numerous international organisations, such as the WHO, etc. He seeks to dissemble many of the checks and balances in the US state and rule by Executive Order. At this stage, all that is known is that global trade will almost certainly diminish in future, scaling back the surge of low-cost goods into the US. If he runs a large budget deficit, US inflation may be more persistent. If he manages to reduce the US budget deficit somehow, then it may be that the trade tariffs ultimately lead to a reduction in US demand, and he sparks deflation. Either way, it seems likely that corporate cash flow will come under pressure. The cost and availability of corporate debt may worsen, and/or global profit margins may collapse as debt is repaid due to deflation.
While these effects will challenge all companies, quoted companies have some advantages. Generally, they often have less debt within their capital structures. At a time of reduced cash flow, they are not as vulnerable as private companies. Second, if the management spots the problem early, i.e., whilst their share prices are still relatively high, they can raise additional equity from the asset markets.
Public market corporates will now benefit from more uncertain capital markets
Specifically, quoted companies with robust cash flow have the advantage. Equity income stocks, for example, tend to generate surplus cash flow, so if there were to be a major downturn, they start with the advantage that they may still have surplus cash flow even after the reduction. But better still, as other competitors retrench, they may have the potential to fund expansion into the vacated markets, because they continue to have surplus cashflow when most others do not. If numerous corporations become insolvent, resilient quoted companies can acquire the overindebted but otherwise viable corporations from the receiver, debt-free, sometimes for as little as $1. In general, there are few other buyers, as usually such acquisitions need working capital to keep going after the acquisition, and very few private companies are well placed to fund this. The net effect is that the most highly leveraged companies, or those with persistent negative cash flow due to their growth ambitions, are very vulnerable beyond globalisation. In contrast, corporations generating surplus cash flow have the advantage, and those that are resilient and hence continue to generate surplus cash flow through the downturn have a great advantage.
Across the global equity markets, there will be numerous losers. But amongst them, there will be some winners. And the more those expand into the vacated markets or buy overindebted but viable corporates debt-free for $1, the more their earnings will expand. At a time when most corporates are suffering downgrades, these groups will be driving upgrades.
Small caps might also benefit from these dislocations
But what about quoted small caps? As mentioned above, there will be some winners and losers. However, when it comes to expanding into vacated markets, small caps have the potential for much greater expansion opportunities compared to their core operations. In short, they can significantly accelerate their earnings growth. In the case of insolvent, yet otherwise viable acquisitions, the same pattern will be evident. While the acquisition of SVB UK by HSBC for £1 was a brilliant move—perhaps adding £5bn of value—the key point is that HSBC already had a market cap of £120bn at the time. In summary, it enhanced earnings growth.
In the case of quoted small caps, some of the acquisitions they will be making will have similar dynamics, but they will be doing so in a corporation whose initial valuation is a tenth or a hundredth of that of the HSBC example. In short, the enhancement uplift on the deals will be much greater. In some cases, the acquisitions will deliver transformational uplifts.
Perversely, as this pattern becomes established, my working assumption is that equity markets globally deliver subnormal returns. Whilst there may be some extra corporate sales growth, even as demand falls, because of the impact of inflation, in general, profit margins will also be under pressure. So, the absolute growth of corporate earnings will be modest, or worse. Alongside, equity valuations will come under pressure to return to past norms. My working assumption is that global equity markets flatline for an extended period.
Meanwhile, I also think the acceleration of small-cap earnings growth will drive outperformance. Better still, it will drive outperformance after a long period of underperformance caused by all the selling from actively managed funds. So, they have two reasons for outperformance: extra earnings growth and a recovery from subnormal valuations.
UK small caps benefited back in the 1970s from a more volatile market environment
The scale of this potential outperformance is hard to understate.
During the 1970s/80s, the UK economy was very weak during the 1970s, due to excessive taxation and the three-day week. During the early 1980s, due to UK interest rates being high to squeeze out inefficiency, it is interesting to note that UK quoted majors may have outperformed other markets. Being dominated by equity income stocks, fewer of them went bust, and those that did not enhanced their earnings growth. The FTSE All Share Index didn’t just keep up with the S&P 500 Index - it outperformed.
At the same time, even though sterling was known as the sick man of Europe in the 1970s (hence, many of the UK majors with significant overseas operations had the advantage of earnings growth enhanced by Sterling's weakness), UK-quoted small-caps nevertheless outperformed.
In effect, the equity income bias of the FTSE All Share Index at a time of tight global liquidity gave it the advantage and outperformed others vulnerable in those conditions. Besides, despite the weakness of sterling, the UK exchange's best part was UK small caps: the generic small-cap index (ie the bottom 10% of the universe rebalance annually) significantly outperformed the FTSE All Share Index, which outperformed other global markets. Better still, with the smallcap effect in operation, UK microcaps (ie the bottom 2% of the universe rebalanced annually) outperformed by an even larger quantum.
The net effect was that actively managed strategies needed to move down the market capitalisation range to access the best outperformance. And with small caps, the smaller the company, the narrower its market liquidity. So, with many quoted small caps potentially generating transformational earnings, there was a market squeeze regarding institutions getting hold of stock in the best deals.
In those days, shareholders who had bought their holdings in the market and were significant shareholders before the deals got the first part of the placement of the additional shares - pre-emption rights were jealously guarded in those days. All the core institutional shareholders were allocated shares proportionately to the existing shareholding. Then, the remaining unplaced shares were assigned to the rest of the demand, which was typically in line with demand. In other words, the existing shareholders got pre-emption shares and then more shares if they wanted them in the remaining placing.
This time might be different – maybe we are approaching another huge regime change in markets and economies
I cover all this because if we are now at a multi-decade turning point, if small caps are now better placed than the majors to drive earnings growth, we can expect capital to be allocated down from the megacaps into the small caps.
This pattern amplifies the small-cap effect.
If small caps are defined at the bottom 10% of the universe, then this pattern involves selling part of the 90% to invest in the 10%. The amplification effect is 9x. If investors want the best of the upside potential, then this involves selling part of the top 98% of the universe to invest in the bottom 2% of microcaps. In this case, the amplification effect is 49x!!
And global small caps might also benefit, while the Megacap Mag7 might be victims.
Circling back to global small caps. I anticipate the same pattern for the same reasons. Generally, global small caps are somewhat larger than UK small caps. Typically, global small caps are defined as those outside the most significant 80%, ie, within the bottom 20%. Furthermore, in the case of the US exchange, for example, the largest 80% includes numerous megacap stocks, and hence their supersonic scale means that the 20% cutoff comes at a larger market cap than expected.
But even so, even at a time when global asset allocators have greatly increased their weightings in US equities, the bulk of that has gone in via ETFs, which by their nature have the largest weightings in the stocks with the largest market capitalisations. And like other exchanges, U.S.-actively managed strategies have lost market share to passive strategies. As such, this has meant that numerous US small caps have suffered excess institutional selling even as the US exchange itself has generated robust returns.
The net effect is that while the Magnificent Seven stocks have generated quite exceptional returns over the last ten years, US small caps have underperformed by very substantial percentages. In straight arithmetical terms, the Magnificent Seven have outperformed the S&P 500 by 18x over the ten-year period. Meanwhile, the Russell 2000 has underperformed the S&P 500 by 132% and the S&P SmallCap 600 Index by 111%.
Globalisation has favoured bigness.
Megacap stocks have outperformed, with their return further enhanced by extra global growth, the lowering of debt costs, margin expansion, and ultimately valuation enhancement over recent years as ETF flows have accelerated.
The bottom line is that the overall returns of mega caps in the largest global market—the US—have generated exceptional returns.
Passive investing might face challenges as well
I would argue that investor behaviour in terms of indexation investing is bottle-like.
Under normal market circumstances, institutions would be wary of putting clients into positions with high stock-specific risks.
Under normal circumstances, they would be wary of putting a large percentage of their clients’ assets in holdings where such large percentages were correlated.
Under normal circumstances, they would be wary of putting such a large percentage of their clients’ assets in strategies where the source of return was solely investment Beta.
The only reason they have is that they have mostly been underweighted, as US megacap technology stocks have outperformed. They felt they were at career risk if they didn’t reduce their index underweighting position. They also comforted themselves that the strategies were invested in very liquid stocks, so they could still retain the option of liquidating at will in the future when they wanted to return to prior portfolio norms.
Even before Trump, the pattern of globalisation was already slowing, and with Covid it has moved into full headlong retreat. Clearly, with Trump, that pattern has greatly accelerated over recent weeks. As mentioned above, our view is that the current market position is highly unstable.
What might drive change now?
We always need to be a little cautious about predicting the future. Still, the current position is that client stock-specific risk within their portfolios is massively out of line with the usual metrics. Furthermore, most Mag 7 share prices are relatively closely correlated, representing an unusually concentrated correlation risk. In other words, the current asset allocation is highly fragile. That doesn’t mean it will change in the next few months or quarters. But over time, there will be something that leads to this excess risk becoming recognised, and something of a stampede as nearly all asset allocators move back to past norms together.
What will that be? Whilst we can't be absolutely certain, in my view, the extra instability injected by Trump's proposals is more than enough. This is not just because of the radical nature of Trump’s proposals, which might well be watered down in the future, but also because of the unintended consequences of Trump’s policies. He is acting with great purpose and believes he can unwind the impacts if countries change their behaviour. Whilst this might work to some degree, he completely overlooks how becoming an unreliable partner means some countries will not return to the prior relationships. Once trust is broken, it is no use just going back to the prior norms, as distrust will persist.
So, how can we be so confident that asset allocators will change enough to trigger the small-cap effect again?
In my view, the nature of the instability is more than sufficient. Furthermore, we only need the smallest scale of change to initiate a new cascade in market trends. Specifically, when there is a change, the impact is amplified. Small caps are inherently somewhat illiquid. Continuous selling pressure has significantly depressed valuations. We believe a steady influx of additional investors will be more than enough to kickstart the small/micro-cap recovery.
Once it begins, all the momentum investors will converge. Hopefully, the sector's outperformance will exceed expectations, partly because current valuations are so low. Additionally, as various corporations vacate markets, companies with strong balance sheets can expand at a low cost, leading to extra earnings growth. Even better, public limited companies can acquire overleveraged but otherwise viable firms from receivers, often debt-free for just £1, generating upgrades. The scale of these upgrades favours small caps since the low cost of acquisition enhances a smaller company more than one with a large market capitalisation. Some microcap acquisitions might lead to transformational upgrades.
Corporate Implications?
If the global outcome is more unsettled, those businesses with little net debt or a degree of cash surplus could not only have an advantage but a disproportionate advantage. I worry that many resilient companies will find excess balance sheet strength degraded by a series of bad debts.
So, when it comes to expanding into markets vacated by the zombies failing or others pulling in their horns, some may have developed into those areas who are forced to change their plans due to the balance sheets being a bit tighter than anticipated. Of course, when acquiring the indebted but otherwise viable companies’ debt-free from the receiver, where the upside can be transformational, again those with stretched balance sheets might feel unable to take the risk.
Insolvent acquisitions may only cost £1, but they all need their working capital to be replenished, and in decent sized companies this can extend to £10ms of cash. PLCs with strong balance sheets have the advantage. Whilst their share prices and valuations might not be as high as they might want, the ultra-low cost of the acquisition would still justify issuing new shares at a low rating, because of the transformational scale of the upside. PLCs with weak balance sheets would probably struggle to raise the additional working capital needed for the deals, while those with inefficient and excess cash would find it easier. In sum, I recommend that all the PLCs we invest in refrain from buybacks and run the most inefficient balance sheets they can. In addition, while earnings growth will be from small caps, I expect earnings growth to accelerate in the best-placed ones. This will be via expansion into vacated markets, but potentially to a much greater extent by the transformational upgrades via the insolvent but otherwise viable acquisitions for £1, etc.
Portfolio implications?
In short, move your portfolio into assets with the opposite characteristics compared to globalisation.
· Scale back those with all-out cashflow-draining growth to invest in those with more persistent expansion potential while generating bountiful cashflow.
· Scale back crowded equity markets such as the US, and invest in those which are very overlooked, such as those dominated by low-beta equity income stocks (UK, etc).
· Most importantly, in my view, scale back your holdings in megacaps, and step up your holdings in small and microcaps. This can be done by stepping up holdings in global small caps, with the small-cap effect returning, it will greatly pay to scale up holdings in genuinely small and microcaps. Due to the unintended consequences of BPR (business property relief) during the years of globalisation, the UK exchange has retained a viable small and microcap market.
For this reason, the UK stock market is superbly positioned to be the globally leading small and microcap market from here. So, not just providing extra capital for UK national small and microcaps, but alongside those operating in many other developed nations.
Overall, during globalisation, I would argue that public equity markets lost sight of their purpose. In essence, they aren’t just there so that savers can generate a higher rate of return. I argue they are there because they are socially beneficial for the electorate. When a national stock exchange thrives, private savings are funnelled into the most productive companies, boosting skilled employment, enhancing local productivity and hence the ability of wages to rise faster than inflation, and ultimately for the successful companies to increase the tax take for the government. During globalisation, particularly since the GFC, QE has distorted market prices and, in the process, led to sub-optimal capital allocation. With nationalism, we must stop exporting our private savings overseas and bring much of it back home. We need UK savings to generate UK employment, boost UK productivity, and add to the Exchequer’s tax take.
To summarise, the reason for my high conviction is that, a bit like the cartoon character, most investors have already run over the cliff. At this stage, they haven’t noticed. I think they will before long. And this will lead to a correlated withdrawal of capital from the megacaps. How can I be sure they will go for small caps? I accept that many/most will not reach for small caps in the first instance, bonds and other assets may be preferred, but at least some will scale up small caps, and we only need the tiniest amount to get the recovery cycle going.