The “Woodford effect” has been a factor in the poorer than expected performance of the smallest of the small-cap companies listed on the UK market in 2019, according to an influential investment study of the sector.
Illiquid stakes in small-cap companies led to the suspension of Neil Woodford’s flagship fund last summer when it could not meet investor redemption requests.
The wider fallout has caused investors to “reprice liquidity”, according to the compilers of the annual Numis Smaller Companies Index, with growing investor nervousness firmly reflected in the valuations of the smallest listed companies, known as “minnows”.
Numis defines a “minnow” company as one that swims in the bottom 2 per cent of the UK stock market in valuation terms — although historically, these kinds of companies have produced outsized investment returns.
The Numis “minnows index” of the smallest 1,000 companies has outperformed the FTSE All-share by 4.7 per cent over the past 65 years.
The minnows appeared to have a good year in 2019, generating an annualised return of just over 15 per cent. However, small-cap companies — defined as the smallest 10 per cent of the market by value — outperformed the minnows with annual returns of just over 25 per cent. This is the biggest gap between the two indices for five years, according to Numis.
“Investors were repricing liquidity,” said Professor Paul Marsh from the London Business School, who co-authored the Numis report with researcher Scott Evans, noting how the Woodford scandal and rising liquidity concerns are being reflected in the performance of smaller companies.
“During 2019, investors and regulators got much more worried about illiquidity and started to be concerned about unquoted stocks, but also about smaller listed stocks,” said Prof Marsh.
While this was less of an issue for private investors with a long horizon, open-ended funds needed to be able to sell their units at any point in time, he said.
“The problem Woodford faced is that he had unquoted stocks that were hard to sell at a realistic price — there wasn’t a market for them,” said Prof Marsh.
“It may be because of these liquidity concerns that these smaller small companies did rather less well than larger small companies [as] people were marking down the prices of illiquid stocks.”
Investors looking to sell investments quickly might struggle to offload large holdings in smaller listings. “And they may have to take a price discount to get out,” said Prof Marsh.
Liquidity management was dragged to the fore in 2019 as a result of the Woodford scandal, problems at H2O Asset Management funds that held significant investments in illiquid bonds and the suspension of M&G’s property fund late last year.
Numerous small-cap managers have reported reviewing their liquidity management process in light of these events. Yet Prof Marsh stressed any valuation discount could prove tempting for long-term investors.
“This is an opportunity for those funds most able to bear illiquidity [as] it holds the promise of higher than expected returns from the smaller smalls,” he said.
Mr Evans noted that 2019 was nevertheless an “excellent year” for small-cap companies overall. “The long-term record favours small-caps — and the smaller, the better”.
However, it was mid-cap companies — with market caps between £787m and £4.1bn — that delivered the greatest outperformance in 2019, showing a return of almost 30 per cent.
This was partly due to valuations of UK mid-caps being pushed up by high-profile takeovers, Mr Evans said, referencing the £6bn acquisition of Merlin Entertainments by Lego and Blackstone, the £3.3bn takeover of Boston Scientific by rattlesnake bite drug producer BTG and the sale of pub group Greene King to Hong Kong billionaire Victor Li for £4.6bn.
The Numis index tracking London’s Alternative Investment Market (Aim) produced an annual return of just under 15 per cent overall.
This year marks the 65th anniversary of the Numis index, which has analysed the investment performance of smaller companies since 1955.
Over the decades, some small-cap sectors have performed much more strongly than others.
For example, if an investor had put £1 into the leisure sector in 1955 and reinvested their dividends, they would have enjoyed a 17.9 per cent annual growth rate and be sitting on a portfolio worth £46,000.
“Compound interest is a wonderful thing,” said Prof Marsh, adding that the small-cap mining companies had been the weakest overall sector.
Numis said a significant vulnerability for both small and large UK companies in 2019 was exposure to currency risk. For much of the year, companies with the greatest exposure to the UK economy were hit by the weak pound, but this reversed when sterling rallied in the final quarter, hitting companies with a high percentage of overseas sales.
Investors have coined the term the “Boris bounce” to describe this reversal of fortunes, but the academics declined to use it in their report. “We just call it the Q4 rally in sterling,” said Mr Evans.