Brexit has profound inferences across all financial markets, but no more importantly than to those within the UK’s own borders. The trade and currency implications of Brexit are especially important in a market where the largest 100 publicly-listed firms export 72% of goods or services offshore, whereas mid-caps only export 41%.
All things considered, this would lead an investor to expect large companies to outperform under the influence of a lower sterling currency. Yet we find ourselves in a position where small companies are outperforming in a post-Brexit world, with performance numbers of 7.1%, 10.7% and 12.1% for large, mid and small companies respectively in the three months to September 30.
The question to ponder is: how does this make sense? While it would be foolish to ascribe short term price changes to any single fundamental cause, it is worth highlighting some of the factors that are likely to contribute to out-performance of smaller companies.
Economic data has generally exceeded expectations domestically post-Brexit. This is leading some investors to see merit in on-shore earnings.
The largest companies, especially those in the financial sector, carry some of the bigger risks regarding passporting rights and immigration-induced turnover if the E.U. blocks access to the single market. This is leading some investors to prefer exposures with less perceived ‘Brexit’ risk.
There is greater potential for merger and acquisition activity in smaller companies. The lower sterling is likely to boost the appeal of U.K. companies to overseas buyers. As private and trade buyers can typically justify higher valuations, it is somewhat logical that prices rise in anticipation of an increase in takeover activity.
Earnings growth has been significantly stronger for smaller companies in recent times, with 9.4% growth outstripping large companies which have fallen -28.6% due to higher materials, energy and financials exposure.
Large companies will see a relative increase in their foreign cost-base as they are far more likely to employ personnel in offshore countries. This offsets part of the export advantage and demonstrates the importance of deep research; including analysis of the differing hedging strategies that were in place prior to Brexit.
The shorter-term fundamentals appear to be generally more attractive for small companies. For instance, the return-on-equity numbers of the respective size categories shows a distinct advantage for small companies in recent times.
The Large versus Small Cap Divide
Some of the risk is deservedly getting priced in to large companies, however we fear the optimism is too strong in smaller companies at the current time. Underlying this statement, we are beginning to recognise an increasing valuation gap between large companies and small companies on almost all fundamental measures. Return on equity figures for example lead us to be more inclined to think large caps have upside potential whereas mid- and small-caps are already quite high in a post-Brexit world.
This is also evident in price-earnings ratios. While the traditional price to earnings ratio appears to suggest that smaller companies offer better value, we would regard this as a misleading indicator as it favours companies with lower exposure to cyclical assets; i.e. punishes companies that saw profits fall in the commodity crash. We would instead suggest that earnings are viewed on a cyclically adjusted basis and using this measure, it shows that valuations are much lower in large companies.
Therefore, whilst we had been relatively agnostic on size exposures leading into Brexit, we are beginning to see large companies as a relative opportunity within the U.K.
