Interactive Investor

History tells us it’s almost time to buy UK small-cap shares

7th February 2023 13:28

Graeme Evans from interactive investor

Research by this team of City analysts shows that small-cap stocks typically outperform the FTSE 100 by miles during a certain point in the cycle. Here are the dates they expect it to happen this time.

Analysis of recessions going back to 1986 has highlighted how mid- and small-cap stocks are more likely to outperform FTSE 100-listed companies towards the end of a downturn.

The chart published by strategists at Liberum shows blue-chips up by 3% in the period covering the last two quarters of a recession and the first two quarters after a recession. That compares with increases of 11.2% for the FTSE 250 index and 14.1% for the FTSE Small-Cap.

The findings reinforce the City broker’s expectations for similar market behaviour between the second quarter of 2023 until the equivalent three-month period in 2024.

It said earnings are just one part of the reason for the outperformance by small- and mid-cap (SMID) stocks, with a bigger factor being moves in discount rates (long-term bond yields).

Liberum explained: “Share price reactions are some 10 times more sensitive to changes in discount rates than to changes in earnings. Thus, especially towards the end of a recession, SMID stocks typically outperform large caps as bond yields decline.”

The FTSE 100 index recently touched a record high and the FTSE 250 traded above 20,000, having been as low as 16,661 in the autumn.

However, Liberum points out that its investor sentiment indicator shows that the UK market has gone above what can be justified by fundamentals.

It added: “While pessimistic investors and consumers might support a rally for a little bit longer as they become more optimistic, fundamentals have to improve or the market rally will falter.”

Liberum believes the UK market entered another overbought position in mid-January, indicating “that we need to work off recent advances in the coming months”.

It said: “We have not seen a volatility spike in the US or Europe, indicating that investors remain relatively complacent about the coming recession even though earnings are now downgraded rapidly.”

The broker’s list of most overbought stocks in the FTSE All-Share is topped by LED lighting and electric vehicle charging firm Luceco (LSE:LUCE) after its recent upgrade to profits guidance.

There are nine blue-chip stocks on the 20-strong list published on Friday, including NatWest Group (LSE:NWG), Lloyds Banking Group (LSE:LLOY), International Consolidated Airlines Group SA (LSE:IAG), Burberry Group (LSE:BRBY) and Smiths Group (LSE:SMIN).

The most oversold stock is Spirent Communications (LSE:SPT) after reporting that its performance is now likely to have a heavier than usual second-half weighting as customers take longer to reach investment decisions.

FTSE 100-listed stocks on this list include Diageo (LSE:DGE), Reckitt Benckiser Group (LSE:RKT), Unilever (LSE:ULVR), AstraZeneca (LSE:AZN) and British American Tobacco (LSE:BATS).

The largest upgrades to earnings guidance across a two-year horizon have been for IAG and Whitbread (LSE:WTB), with the biggest downgrades for the builders Persimmon (LSE:PSN) and Taylor Wimpey (LSE:TW.)

Since 2000, Liberum notes that buying the highest-yielding stocks each month has generated significant outperformance over the lowest-yielding stocks.

However, it finds that January was a month for stocks with low dividends or no dividends after they outperformed income stocks by 2.1%.

Last month’s cheapest FTSE 350 stocks by forward dividend yields across a two-year horizon are Energean (LSE:ENOG) at 8.6% and Glencore (LSE:GLEN) at 8.3%, followed by the traditional income stocks British American Tobacco, Aviva (LSE:AV.), Legal & General (LSE:LGEN)and Imperial Brands (LSE:IMB) near to 8%.

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