A vicious circle for the UK

Small caps are struggling globally, but London has good reason to fret about the fate of the FTSE 250

The past few years have been a weak spell for small-cap stocks almost everywhere, but the UK has suffered more than most. The MSCI UK Small Cap index has lost about 2.75% per year over three years, including reinvested dividends. The only major markets with a worse record are Hong Kong (for obvious reasons) and Germany, where mid-sized industry has been hard hit by energy prices – in contrast to the DAX large-cap benchmark that is setting new records.

In fairness, a few others are not much better (France has lost 2.12% per year), but the UK stands out for the angst this is generating. Nowhere else is the chancellor trying to make a flagship policy out of underwhelming ideas for encouraging taxpayers to buy domestic stocks.

The shrinking mid-market

So what’s the problem in the UK? There is clearly a vicious circle of lack of interest, low valuations and poor returns, and it is notable how much the market has shrunk. The number of listed companies has tumbled in the UK in recent years. After being broadly steady for more than two decades, there was a brief boom in listings just before the financial crisis (mostly on Aim and with a strong skew towards resources stocks) and then a continual decline after that.

The underlying trend here is something that we can see elsewhere – even in the US, the number of listed companies has declined over the same period. Reasons include corporate consolidation (fewer, larger companies) and listed companies being bought out by private equity funds. But in the US and some other markets, listings have at least remained reasonably stable since the latter part of the 2010s. The worsening decline in the

UK stands out, especially given the extent to which London has always been seen as a global financial centre that attracts listings not just from Britain but the rest of the world. In contrast, the US has even seen a uptick in listings, helped by non-US companies choosing to lost there instead of their home markets or the UK.

Quality concerns

So the UK mid-cap market has a real problem with stocks being delisted and not being replaced. I am sceptical that it can be turned around by a “British Isa”, an end to stamp duty, or even by easing listing rules (Aim, which has looser rules than the main market, has seen listings decline as much). In the absence of stronger plans, we have to wonder what it means for an index investor.

If the better companies are being bought out and not being replaced by comparable ones, the quality of the index will decline. So even if the market looks cheap now, is it rightly cheap because it is deteriorating? You may get a one-off gain when a company is taken over at a premium, but if the proceeds are effectively reinvested in something worse, you may lose on the deal. Hence the case that UK small caps are a useful growth asset in our exchange traded fund (ETF) portfolio gets weaker, while the apparent cheapness could be a value trap. We’ll consider some alternatives that might replace them next time.