There has been a lot of weakness in the UK stock market recently, particularly in the smaller companies space. Over the last two years, a lot of penny stocks and small-cap shares have fallen 50% or more from their highs.
For long-term investors like myself, I think this could be a major chance to build wealth. I think we could be looking at a once-in-a-multi-decade investment opportunity here.
Small-caps have been smashed
There are a few reasons UK small-cap stocks have tanked recently. The main one, in my view, is rising interest rates.
When interest rates rise sharply, small companies often feel more pain than larger businesses. That’s because small businesses tend to be more dependent on external finance for growth.
This jump in rates has led to huge outflows from the space since the start of last year.
According to the Investment Association, cumulative outflows from UK small-cap funds have amounted to around £2.1bn since January 2022. That’s roughly the same amount of outflows as during the Global Financial Crisis (GFC) of 2008/2009.
A rate cut could be a game-changer
The thing is, UK interest rates are most likely near their peak levels now. And while rates could stay higher for longer, I think it’s only a matter of time until we see a rate cut.
If we were to see that, I think there’s a good chance penny stocks and small-cap shares could shoot higher. And I reckon returns could be explosive.
Potential for blockbuster gains
For a start, we haven’t seen this kind of underperformance from small-caps for decades.
Believe it or not, the Numis Smaller Companies index has now lagged the broader UK market over the past one, three, five, and 10 years.
This is rare. The last time this happened was the late 1990s.
Secondly, stocks are dirt cheap. According to investment manager Montanaro, valuations for the asset class have returned to levels near those seen during the GFC (which marked the start of a big bull market).
“While the past is of course not guaranteed to repeat, history tells us that when valuations have previously reached current levels, returns over the subsequent five years for small caps were between 100% and 150%,” wrote Montanaro in a recent report.
A ‘coiled spring’
It’s worth noting that investment managers in this space say they’re seeing a lot of opportunities right now.
“The majority of our recent buys have been in the sub-£300m market-cap space. That’s where people have been exiting, leaving good companies on illogical ratings. We are investing where the crowd is running away, and when the market turns, it could come back like a coiled spring,” wrote fund manager Dan Green, who manages the FTF Martin Currie UK Smaller Companies Fund, recently.
A big opportunity to build wealth
Putting this all together, I’m sensing a huge opportunity in small-caps and penny stocks right now. Of course, smaller stocks are more volatile and generally riskier. I accept that.
But I reckon when rates start to fall, we are likely to see big gains. I don’t know exactly when rates will come down. It could be in three months. It could be in 12 months.
But I want to be ready for the action, so I’m positioning my portfolio now.
