Farewell 2016 – a challenging year for UK small caps

Whether it’s Brexit, Trump, OPEC or the celebrity death-toll, it feels like we have lurched from one drama to the next in 2016. Stock markets have taken all this excitement and chosen to run with it – the FTSE 100, for example, looks set to end the year close to all-time highs around the symbolic 7,000 level. Not many people would have called that in mid-February when it languished at 5,600, especially if you had told them that we would vote to leave the EU and appoint Mr Trump leader of the free world.

But here we are, so with the tree up and the stock market heading for the holiday wind-down, it’s time to reflect on what we can learn from it all in small-cap land.

A quick glance at the share-price leader board gives us our first clue: it has undoubtedly been the year of the recovering commodity stock. Top of the pops in the Numis Smaller Companies Index (NSCI) is Ferrexpo, up an eye-watering 533% at the time of writing. It is joined in the top ten by six other miners and an oil company, all of which are up over 150% this year. All but one of these are decent sized businesses, ranging from Kenmare at £275m market cap to Evraz, which at £3.7bn has, by some margin, the largest weighting in the NSCI today.

small-cap-chart

For all these stocks, this year’s fireworks have followed a long period of underperformance going back to the early 2010s. The details vary, but Ferrexpo is typical, having hit a high of 450p in 2011 and a low of around 20p in late 2015, the shares now trade on c.135p. Another common feature is high debt levels – Ferrexpo had $870m of debt at the end of 2015 against a market cap at the time of less than $200m.

Perhaps unsurprisingly these stocks are not core holdings for UK small-cap funds – either through aversion to the scary balance sheets or simple unfamiliarity. As a consequence, the sector has badly underperformed its benchmark this year – as at 9 December the median fund had returned 4.16% against 8.42% for the NSCI. Whether investors would have wanted a portfolio of bombed-out miners is a moot point – it has been a tough year to be a small-cap fund manager!

The other end of the performance spectrum is perhaps a little less homogenous than one might expect. Stocks exposed to the UK domestic economy took a spectacular bath in the days following the referendum result, but in many cases have recovered really quite strongly. Others are certainly still in the proverbial doghouse, but these generally have more specific problems that are not necessarily related to Brexit.

Among the stocks propping up the NSCI are plenty of non-UK focussed businesses, many of which are very much the architects of their own downfall. It seems a little unfair to single anyone out in this group, but as it is now being taken over, and caught us out along with many of our peers, I will mention Sepura. As a case study in management failure I suspect it will be cited for years to come, drawing in classic mistakes like acquiring outside areas of expertise and failing to properly manage cash. As fund managers there are plenty of lessons to learn too, although a very experienced colleague of mine would simply point out the folly of combining high operational and financial gearing.

Overall then, it has been a year of significant challenges in small-cap. What is perhaps reassuring for the future is how the market has reacted to some of the economic shocks that have come its way. In particular the optimism in the US following Trump’s election and subsequent increases in bond yields, as well as inflation expectations, should be positive for equities. Stock picking will remain key, but hopefully we will start 2017 with a more balanced universe and can leave some of the more esoteric resource stocks to our mid-cap colleagues.