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Brexit Undermining Small Caps? Baloney!

I don’t get why the prospect of a possible EU referendum this year should be hammering UK smaller companies, but it’s having a visible impact on share prices at the moment. The volatility in the markets has been affecting small and mid-caps stocks more than larger companies. The FTSE 100 is down 5.48% since the start of this year and has outperformed the FTSE 250 (down 7.47%) and AIM (down 6.98%) between 4 January and last night’s closing.

The Chinese slowdown and record low oil prices have left their imprint all over the indices. In addition to this mess, smaller UK-focused companies could suffer from more pronounced volatility should a referendum be held as early as June, which news reports suggest is David Cameron’s preference.

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Analysts at Credit Suisse are pointing at the three UK companies with the largest risk due to European exposure  — Berendsen Plc, Thomas Cook Group Plc and Shanks Group Plc. They generate more than 60% of their income on the Continent and all three happen to be in the FTSE 250.

Volatility indicators show too that the swings in UK markets have been more pronounced this year than movements in European markets.

Small IS better

Over the past few years there has been sense in fleeing into small and mid-caps when the Footsie let you down. The FTSE 100 comprises companies that generate 70% of their income outside the UK. Escaping its global risks by targeting companies with more UK-focused operations might no longer make such sense if you look at the performance of indices this month.

But is that really the case? Let’s look at what’s going on and how stocks are really affected.

The hype factor?

Firs, there might be more hype than fact to the idea that the indices are down due to Brexit fears. In my view, the FTSE 250 is at its lowest premium over the Footsie since May because investors have taken out money while it was still there in the wake of the global carnage caused by oil and a weakening China. Valuations, which had been driven up last year by investors eager to buy into UK companies dealing with the strong UK economy, have fallen 18% this year. Incidentally, the index hit a decade high at the end of 2015. The FTSE 250 average multiple is now 15.8 times projected earnings compared with 14.8 for the FTSE 100. And both indices are said to still be overvalued.

Second, the forecast earnings of smaller companies still outstretch those of the FTSE 100 generously, something investors never ignore for long. Last year’s returns on the AIM All-Share Index were robust. It was up 6.6% despite also being dragged down by energy stocks. And the FTSE Small Cap index, which was up 4% last year and has shed less than 1% so far this month, has an average growth prognosis of 25%.

Finally, Britons won’t stop consuming should the Brexit happen. They might consume differently. But that won’t immediately wipe out the earnings potential of sound UK businesses operating in a still-expanding economy.

There’s plenty of scope for small and selective mid-cap companies to continue performing well, despite Brexit fears. Brexit is a concept at the moment and not a reality, which is important to bear in mind as the EU recovery starts to pick up and potentially offer good opportunities, especially in cyclical stocks.

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Angelique van Engelen has no position in any shares mentioned. The Motley Fool UK has recommended Berendsen. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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