Transition to low-carbon economy could benefit small caps, says Investec

‘Small-cap stocks should outperform large caps. That’s what conventional wisdom tells us,’ Roger Lee, head of UK equity strategy at Investec, tells IR Magazine. ‘They’re exposed to growth industries, make for easy acquisition targets and are under-researched, making it possible to unearth a bargain.’

From 2016 to almost the start of the pandemic-led sell-off in February 2020, however, Lee notes that small-cap stocks performed ‘pretty much in line with their larger counterparts.’ But then things changed and the rally began. ‘On March 23, 2020, markets turned,’ he notes. ‘Small-cap stocks have significantly outperformed large caps, by around 80 percent to date.’

So what changed? ‘Well on one level, the reason for their underperformance in the recent past is now their advantage: exposure to the UK domestic economy as the country benefited from the vaccination roll-out and the subsequent dramatic economic bounce back following the reopening,’ Lee continues. ‘But it’s also what the small-cap indices aren’t significantly exposed to that’s having an impact: oil.’

The green economy

Lee says small caps should continue to outperform for the same historic reasons but adds that ‘as the world transitions from fossil fuels and pressure grows on the oil industry, there is now an additional driver for small-cap stocks to outperform.’

He also says companies should be doing more to talk up how they might benefit as we move to a greener economy. Instead, he notes that ‘companies generally focus more on the downsides of exposure.’

During periods of high input prices – ‘for example, when the oil price spikes and affects so much of the supply chain, from basic heating and fuel to plastics and broader raw materials’ – few companies are immune, Lee notes. This is the situation currently impacting companies across the UK and Europe. In such situations, Lee adds that ‘some companies see their margins severely impacted if they are unable to pass the price increases on and then potentially risk significant earnings downgrades.’

He singles out financials and tech stocks as generally faring better when energy costs rise. ‘But they tend to be more affected by the ‘second derivative’ of rising oil prices: higher interest rates and bond yields,’ he says. For financials, that’s a positive as it helps their interest margin. ‘For technology though, it tends to be a negative as rising bond yields can reduce their valuations,’ he explains. ‘This macro theme is broadly what we are seeing across markets at the moment.’

A time to shine

Of course, these volatile periods also provide opportunities for companies that are less affected by these macro themes to ‘shine through,’ says Lee.

‘Companies that can deliver on guidance will stand out, especially if their competitors are unable to manage the challenging oil price environment and see pressure on their margins,’ he says. ‘Maintaining and delivering guidance should be a key differentiator that will attract new investors and ultimately higher valuations through a higher multiple.’