14 Dec 2023 4 min read

They say good things come in small packages…

By Camilla Ayling , Karlson Lau

When we were children, the biggest presents generated the most excitement, but as we mature it's the smaller ones that have most allure - think fine jewellery versus the latest fad kitchen appliance! Ahead of the festive season, we assess whether parallels can be drawn with small-cap investing.


It has long been argued that smaller companies can provide a premium to investors. Famously, the Small Minus Big component of Fama-French’s three-factor model demonstrated that smaller companies typically have the potential to outperform their larger counterparts. 

Smaller companies are considered riskier investments than larger publicly listed companies. Therefore, investors should, in theory, be rewarded with a higher expected return for taking on this additional risk. 

Focusing on the UK, we chart the size premium as the difference between the total return (net dividends) from the MSCI UK Small Cap Index and the MSCI UK Index – the latter being a basket of the largest UK listed companies – over the past 25 calendar years.


Over this period the average premium was 2.2%. Although these premiums have largely been positive, we note that in recent years investing in small caps has not been rewarded. This was especially true in 2022, when we saw an extreme negative premium of over -30%.

This is not just a UK phenomenon. JP Morgan highlights that small and mid caps have underperformed large caps in most regions of the world since 2022, and have done so by a record margin in developed markets.1

The macro environment

Focusing on the UK, why have smaller companies underperformed in recent years? One reason is that UK smaller companies are more exposed to the domestic macro environment, whereas the largest UK companies are predominantly global in their operations and generate a significant proportion of their total revenues outside the UK. 

Furthermore, from late 2021, inflation crept up. Energy prices were already rising amid the post-COVID recovery, and rose rapidly following Russia’s invasion of Ukraine. This fuelled inflation, leading to interest rate hikes and increased volatility.

This had a greater effect on UK smaller companies, which have more limited access to capital and faced higher borrowing costs for existing debt. Many investors therefore gravitated to perceived safer havens in the form of larger companies that could potentially offer a steady income stream or dividend yield.

Another factor is the sector composition of the two different groups – the recent macro environment has benefited materials, energy and commodity-heavy businesses. These are the main constituents of the FTSE 100, while small-cap indices are underweight these areas.

Cheap, cheap and dirt cheap

The cumulative negative small-cap premium over the past three years highlights the widening gap between the price paid for a share of the largest companies versus the price paid for a share of the smallest companies. The former has become more expensive while the latter has become a lot cheaper. In fact, a third of companies in the MSCI UK Small Cap Index are now trading on a forward P/E ratio of less than 10x – approaching a record high.2

History has shown us that such a discount tends to narrow significantly at trough valuations. While past performance is not a guide to the future, the historic returns from investing in the FTSE 250 when valuations have been at these trough levels equated to high single digit percentage returns annualised over the next 10 years.


Given valuation is the price we pay for company's future earnings growth, these extreme levels of valuation discount mean the starting point is favourable, in our view – potentially offering what some investors refer to as a greater ‘margin of safety’.

Picking diamonds

There is no guarantee about when the small-cap premium will emerge again, but given how extreme recent trends have become, we believe it is plausible to expect movement towards normalisation at some point.

So, is it time to start hunting for diamonds?

Given how cheap valuations are on a relative basis, the critical point is sorting the diamonds from the rocks that could drag down returns.

The table below sorts the MSCI UK Small Cap universe into quintiles based on the company’s price-to-earnings multiple and the return for each bucket over the recent negative returns period of 2021 to date.


Source: Bloomberg as of 30 November 2022. Quintile 1 has the highest P/E multiple and Quintile 5 the lowest. Past performance is not a guide to the future.

The index was down over -9% over this period and most of this return was driven by loss-makers representing just under 20% of the index. By avoiding loss-makers and uncovering the gems we aim to achieve higher returns. 

For this reason, we argue that there are merits in both a systematic and an active approach to hunting for stocks that we believe to be potential beneficiaries of a moderating interest rate environment.


1. JP Morgan, ‘The SMid View — Dec 2023’, 5 December 2023, Eduardo Lecubarri

2. Source: Bloomberg, as of 7 December 2023

Camilla Ayling

Portfolio Manager – Active Equities

Camilla is a Portfolio Manager in Active Strategies in London at LGIM. Camilla joined LGIM in 2019 from Rathbones, and prior to that she worked at Barclays. Camilla was featured in Citywire’s 2019 ‘Top 30 under 30’ list and was awarded Investment Analyst of the Year at the 2020 Women in Investment Awards. Camilla graduated from the University of Bath with a BSc (Hons) degree in Economics. Camilla is a CFA charterholder and also holds the Investment Management Certificate, the PRI’s Foundations in Responsible Investments qualification and the CFA Certificate in ESG Investing.

Camilla Ayling

Karlson Lau

Active Equities Investment Specialist

Karlson joined LGIM in January 2022 as an active equities investment specialist within the active strategies team. Previously he was a client portfolio manager at AXA Investment Managers within their quant equity platform for their Asia clients and before that a portfolio management analyst at Dimensional Fund Advisors. Karlson graduated from Cass Business School in BSc Banking and International Finance. He is a CFA charterholder and holds the CFA Certificate in ESG Investing.

Karlson Lau