Small-cap ‘haves’ and ‘have nots’

Most investors are aware that the post-referendum UK equity market rally has not treated all stocks or sectors equally. Since 23 June, for example, the mining sector is up (+38.6%) to date, while retail stocks are down (-8.4%).

In the small-cap space, much of the recent focus post-Brexit has been on the disparity in performance between sectors. What has attracted less comment has been an acceleration of the already widening gap in valuation between the most expensive and the cheapest stocks.

What this means is that the investment ‘haves’ have become increasingly expensive (as measured by the Price/Earnings ratio) while the ‘have nots’ have lagged behind. This is a classic momentum market where investors crowd into the perceived safety of winning stocks, paying little attention to valuation. This in turn drives the price and valuation of these stocks higher still. My colleague Ritu Vohora discussed this phenomenon in more depth in her recent blog on herd behaviour.

To illustrate the point, I looked at the interquartile range1 of P/E ratios for current constituents of the FTSE small-cap index each month over the last two years. This analysis comes with some caveats – for example I have only included stocks in the index at both the start and end of the period – but I think the scale of the move justifies the short cut. It is shown in the chart below:


A market like this is good for those investors whose focus is principally on owning the ‘best possible’ companies. It is less rewarding for those who care more about valuation and are willing to look at a wider range of businesses. The challenge for all investors is that momentum never lasts forever and at some point the ‘gravity’ of valuation tends to reassert itself. It can be a painful wait, but for those of us who think that way, it can offer significant rewards.

1. The interquartile range is the difference in P/E of the stocks at the 75th and 25th percentiles when ranked from cheapest to most expensive.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.