A beginner’s guide to investing in small-caps in 2024

Investing in the stock market can be a rewarding yet challenging endeavour. For those looking to explore opportunities beyond large-cap stocks, small-cap stocks can offer an exciting avenue. Over the past two years, smaller companies in the UK, Europe, and the US have faced challenges, trailing their larger counterparts. However, this scenario may present a unique opportunity for investors. 

In this guide, we will delve into the why, what, and how of investing in small-cap stocks, providing insights, strategies, and considerations for any investor looking to diversify their portfolio.

Why invest in small-caps?

Despite recent underperformance, small-cap stocks have historically demonstrated long-term outperformance. The MSCI World Small Cap index, for instance, has delivered an average annual return of 8.78% since 2000, outpacing the 6.87% return of the MSCI All Companies World Index*. It is worth noting that the latter includes the performance of technology giants such as Meta, Alphabet, Apple and Microsoft.

While small-cap stock performance can be volatile, these stocks can offer significant growth potential during market upswings.

Several factors are aligning that may indicate a potential upswing in small-cap performance in 2024. Stabilisation of interest rates, increased merger and acquisition activity, and attractive valuations are some of the key factors contributing to this optimistic outlook. The recent rally following hints of interest rate cuts from the Federal Reserve underscores the importance of interest rates in influencing many small-cap stocks.

Discover the pros and cons of small versus large-cap equities in our ISA Guide

Understanding small-cap stocks

Small-cap stocks represent shares of companies with smaller market capitalisation, typically ranging from a few hundred million to a few billion dollars — depending on their region. These companies, while often overlooked, can provide investors with opportunities for substantial capital appreciation. However, they also come with higher volatility and risks compared with larger, more established companies.

It’s crucial to understand that small-caps vary across regions. UK small-caps, for example, have faced unique challenges, including the aftermath of the Brexit vote and domestic economic weaknesses. On the other hand, North American smaller companies have benefited from the strong US market and robust GDP growth. Investors should be aware of these regional nuances when considering small-cap investments.

Strategies for successful small-cap investing

– Diversification with small-caps

Diversification is a fundamental principle in investing, and it holds true for small-caps as well. Rather than putting all your eggs in one basket, consider spreading your investments across companies of different sizes, regions and sectors. This approach helps mitigate the risks associated with individual companies or industries.

Global smaller companies funds, such as abrdn Global Smaller Companies or The Global Smaller Companies Trust, provide a straightforward way to diversify across regions and industries. These funds aim to provide a well-diversified portfolio, reducing the impact of individual market fluctuations.

Read more: Why diversification is a necessity, not a buzzword

– Building a small-cap portfolio

Building a small-cap portfolio requires careful consideration of your risk tolerance, investment goals, and time horizon. Begin by identifying your investment objectives – whether it’s long-term growth, income, or a combination of both. Allocate your portfolio strategically based on these goals.

Consider adding specific small-cap funds that align with your investment strategy. For instance, the Unicorn UK Smaller Companies and TM Tellworth UK Smaller Companies funds may be suitable for those seeking exposure to the potentially undervalued UK small-cap market.

While those considering the US market might look towards the T. Rowe Price US Smaller Companies fund for exposure to both growth and value opportunities in the small and mid-cap space. Closer to home, Europe is another excellent source of growing smaller companies with Janus Henderson European Smaller Companies holding roughly half of the portfolio in stocks with a market cap of less than €1bn.

Factors to consider when investing in small-caps

– Valuations

One of the key attractions of small-cap stocks, particularly in the UK, is their compelling valuations. Despite recent rallies, many smaller companies still trade at discounts to their long-term averages. This presents an investable opportunity as these companies return to their historical valuation norms.

Investors should analyse the valuation metrics of potential small-cap investments, comparing them to historical averages and industry peers. This analysis can provide insight into the potential for share price re-rating as these companies move toward their historical norms.

– Merger and Acquisition Activity

Rising merger and acquisition (M&A) activity can be a positive signal for small-cap stocks. Private equity groups in the UK, Europe, and the US are capitalising on low valuations to acquire high-quality, small-cap businesses. Additionally, corporate rivals are seizing opportunities to buy their peers.

Fund managers often monitor the M&A landscape within the small-cap space and consider how it may impact the companies in their portfolio. Companies subject to M&A activity may experience a meaningful uplift in their share prices, presenting opportunities for investors.

Rosemary Downing, manager of the VT Downing Unique Opportunities fund, a fund with a focus on small and mid-cap companies in the UK, tells us more about recent M&A activity and what it could mean for investors on the Investing on the go podcast. 

Potential pitfalls and how to mitigate them

– Risks of Rising Borrowing Costs

One of the challenges facing small-cap stocks is the impact of rising borrowing costs. As interest rates increase, smaller companies, often more leveraged than their larger counterparts, may face higher debt-servicing expenses. This can adversely affect their profitability and stock prices.

To mitigate this risk, managers often assess the debt levels of small-cap companies in their portfolio and favour companies with manageable debt loads and strong balance sheets. It’s important to stay apprised about macroeconomic conditions and central bank policies, as these factors can influence interest rates and, consequently, small-cap performance.

Paul Marriage, manager of the TM Tellworth UK Smaller Companies fund, gives more insights into the impact of falling interest rates on UK smaller companies in a recent interview. 

Watch the interview with Paul Marriage [9 minutes]

– Economic Volatility

In periods of economic uncertainty, these companies may face challenges such as slow growth, weak business models, or even bankruptcy. To navigate economic volatility, active managers conduct research on the operational performance and financial health of potential small-cap investments. It’s important to focus on companies with resilient business models, diverse revenue streams, and strong growth prospects.

– Liquidity Concerns

Liquidity is a critical factor and small-cap stocks may pose challenges in this regard. Due to their smaller market capitalisation, these stocks often have lower trading volumes than their larger counterparts. This lower liquidity can lead to increased difficulty in buying or selling shares at desired prices. Mitigating liquidity concerns involves careful consideration of the trading volumes and average daily liquidity of small-cap funds. Investors should be mindful of the potential for increased price volatility in less liquid stocks. While small caps can offer exciting growth prospects, understanding and navigating liquidity concerns is vital to ensure a smooth investment experience.

Opportunities in 2024

Despite recent challenges, there are several factors pointing towards potential opportunities for small-cap investors in 2024:

1. Stabilisation of Interest Rates: The recent stabilisation of interest rates is anticipated to benefit many smaller companies. As interest rates become more predictable, investor sentiment towards the small-cap sector is improving. This positive sentiment has contributed to the outperformance of small-caps compared with their large-cap counterparts.
2. Merger and Acquisition Activity: Rising M&A activity is driving markets higher, particularly in the UK, Europe, and the US. Private equity groups and corporate rivals are taking advantage of low valuations to acquire small-cap businesses. These deals often occur at a meaningful uplift to the current share prices, providing potential gains for investors.
3. Attractive Valuations: Despite recent rallies, valuations for smaller companies, especially in the UK, remain compelling. Many companies are trading at discounts to their long-term averages, presenting an investable opportunity. As these companies return to their historical valuation norms, there is potential for share price re-rating.

Best performing Elite Rated small-cap funds

Wrap-up

Investing in small-cap stocks can be a rewarding venture for those willing to navigate the associated risks and uncertainties. While recent challenges have impacted small-cap performance, there are signs pointing towards potential opportunities in 2024. Investors should carefully consider their investment goals, risk tolerance, and time horizon before venturing into the small-cap space.

Diversification and thorough research are crucial when building a small-cap portfolio. Consider the regional nuances, such as the unique challenges faced by UK small-caps or the growth potential of North American smaller companies. Keep an eye on factors like interest rates, M&A activity, and valuations, as these can significantly impact small-cap performance.

In conclusion, small-cap investing requires a proactive and informed approach. Stay abreast of market trends, economic conditions, and company-specific developments. With careful consideration and a well-constructed portfolio, small-cap stocks can play a valuable role in a diversified investment strategy.

Want more smaller companies? Darius McDermott and Juliet Schooling Latter, managing director and research director at FundCalibre respectfully, both give more long-term insights into UK smaller companies sector in our quarterly market update. Listen below. 

*Source: MSCI index factsheet, 31 January 2024

**Source: FE Analytics, total returns in sterling, 12 February 2014 to 12 February 2024