Can small-cap stocks offer better returns in a recession?

• Why are AIM-listed stocks outperforming their FTSE 100 counterparts?
• What are small-cap stocks and what are the risks?
• What are the best performing small-caps in 2020?

In a recent blog post by Invesco, the investment management company highlighted how small-cap stocks have historically outperformed their larger counterparts in economic downturns, with that trend visible again after the coronavirus pandemic plunged financial markets to March lows.

The FTSE 100 fell 35% from its peak in mid-January to dip below 5000 points in March, while the FTSE AIM All-Share index fell 40% over the same period, with small and large-caps alike succumbing to the economic fallout and uncertainty of the Covid-19 crisis.

But while blue-chip companies’ recovery has spluttered along and continues to look shaky, with the FTSE 100 still down 21% year-to-date, small-caps have bounced back. In fact, the FTSE AIM All-Share index is currently trading a whisker below its pre-crisis levels.

‘Looking ahead, we don’t claim to know exactly how the recovery will unfold, and we expect elevated volatility to continue,’ Invesco said in the blog post.

‘That said, we believe this is an exciting time for active stock pickers in the small-cap space who can identify companies with financial strength and management teams that have shown an ability to navigate through challenging environments.’

It is evident that during economic downturns, small-cap stocks can offer better returns for investors than blue-chips, but why? And more importantly, which stocks should traders watch in these opportunistic times?

Why are small-cap stocks outperforming large-caps?

One of the main reasons small-cap stocks are outperforming their larger counterparts is exposure.

Small companies, by nature, are domestically-focused and often simpler to run, while FTSE 100 companies like British American Tobacco, drinks maker Diageo and pharmaceutical heavyweight GlaxoSmithKline are more internationally exposed and, therefore, more prone to external shocks.

In the current climate, where interest rates are low, FX volatility is high and demand for goods and services is weak, large-cap stocks face a myriad of headwinds that can negatively impact their share price.

By contrast, smaller companies have fewer risks to monitor and are simpler and more agile, allowing them to pivot accordingly to during downturns and economic shocks.

Another reason small-caps are outperforming larger listed companies is growth potential. For example, a penny stock valued at 1p per share only needs to increase in value by a penny to give a 100% return on investment (ROI). Meanwhile, a blue-chip valued at £10 will find it far harder to offer anywhere near the same ROI.

It is worth noting that the same is true in reverse, however; with small-cap companies often coming with higher risks, including less capital and lower trading volumes (liquidity).

What are small-cap stocks?

Small cap stands for small capitalisation and is a term used to group stocks and shares. Sitting below large- and mid-cap stocks, small-cap stocks generally have a valuation, or market capitalisation, of more than £300 million, but less than £2 billion.

Small-cap stocks can include young and potentially fast-growing companies, and these stocks can generate large returns over time. However, there’s a greater level of uncertainty about these businesses compared with a long-established, already profitable companies, and hence small-cap stock prices can be more volatile and risky than mid- or large-cap stocks.

Some stock index providers have small-cap indices. For example, the FTSE 100 is a large-cap index, while the FTSE 250 is a mid-cap index and the FTSE Small Cap is, as the name suggests, a small-cap index.

Small-cap stocks can turn into a huge success or an utter failure overnight: winning or losing one contract or the level of success of a new product, for example, can decide their future. Many penny stocks have no track record and it is not uncommon for them to have no assets, operations or revenue.

Best performing small-cap stocks to watch

Avacta Group (£403.5 million, up 770% YTD)

The biotech company has had a busy 2020, with the business working closely with various partners to clinically validate a saliva-based coronavirus antigen test, which if successful could help governments with their track and trace efforts to limit the spread of Covid-19.

Its involvement in preventing the spread of Covid-19 has helped it attract a lot of investor interest, which in turn has helped its share price skyrocket over the last eight months, with the stock capable of pushing to new all-time highs if its rapid antigen test strip is developed successfully.

Greatland Gold (£537 million, up 676% YTD)

The economic fallout from the coronavirus pandemic has weighed heavily on global currencies and made investors far more risk averse, leading to increased interest in ‘safe haven’ assets like gold, with the price of the precious metal surging in value.

Unsurprisingly, shares in gold miner Greatland Gold have been on a tear over the last eight months, with the company boasting an upbeat outlook after its latest drilling campaign at its Havieron deposit, in the Paterson region of Western Australia, showing some ‘exceptional’ results.

‘These latest results, some of which are truly spectacular, sharpen our collective focus on the near-term objective of a maiden resource at Havieron, and further reinforce the potential to accelerate the timetable for commercial production,’ Greatland Gold CEO Gervaise Heddle.

ITM Power (£1.31 billion, up 240% YTD)

The energy storage and renewables company may have seen its income for the year ending on 30 April fall by as much as 60% year-on-year as a result of the Covid-19 crisis, but its share price has gone from strength to strength in 2020.

The reason being that weakening demand for fossil fuels like oil and gas amid the coronavirus pandemic have accelerated the shift towards renewables. As such, global energy markets are increasingly recognising the need for green hydrogen equipment - which ITM Power manufacturers - as an energy storage medium and as a transport fuel, chemical fuel and for renewable heat.

And with the Netherlands, Denmark, Germany, Australia, Korea, Japan, China, and the UK all developing green hydrogen roadmaps, the growth potential of ITM Power is significant over the long-term.

Naked Wines (£436.5 million, up 102% YTD)

The online wine retailer has cashed in on lockdown life, with the company seeing a surge in new customers that has contributed to signifcant rise in sales.

Naked Wines reported sales growth of around 76% for the first four months of its trading year, driven by a 185% uptick in new customer sales and a 115% lift in the number of new clients.

‘The evidence we are seeing across our markets is consistent with our view that Covid-19 has served as an inflexion point for the online wine market, with Naked uniquely placed to benefit from that,’ Naked Wines CEO Nick Devlin said.

‘We have the balance sheet strength and operational agility to enable Naked to continue to focus on ways to accelerate growth and take advantage of the opportunities presented by the new and evolving consumer landscape.’

Pan African Resources (£516 million, up 90% YTD)

The gold miner was initially hit hard by the coronavirus pandemic, with its South African operations almost grinding to a halt amid government-imposed lockdowns.

However, as restrictions eased and gold prices surged, the company has delivered strong cashflows, driving up the value of its share price in the process.

Analysts are predicting that gold’s bullish trend gold will continue, with Citigroup believing the precious metal could top $2500 an ounce.

Based on this outlook and the fact that Pan African Resources’ new gold production is on track to hit 190,000 ounces this year, the stock is well-positioned for further gains in 2020 and beyond.

How to trade small-cap stocks with IG

Looking to trade Avacta, Greatland Gold or other small-cap stocks? Open a live or demo account with IG and buy (long) or sell (short) shares using derivatives like CFDs in a few easy steps:

1. Create an IG trading account or log in to your existing account
2. Enter ‘Greatland Gold’ in the search bar and select it
3. Choose your position size
4. Click on ‘buy’ or ‘sell’ in the deal ticket
5. Confirm the trade