Interest Rates and Small Caps

For now, the Bank Of England is keeping the rates steady at 0.5%. The question is, what should you do as an investor in small cap equities if there is a rise in interest rates?

A rise in interest rates generally is a rare event but in the past, markets stalled for a little while and small caps did slightly worse than large caps. We may have had a taste of what is to come with the taper tantrum episode in May 2013 where risk assets such as EM stocks sold off most heavily. This time, this may extend to growth-oriented small caps and you might want to consider de-risking your positions. However, if the small cap names involved are those of ‘undiscovered’ or deep value, then it might be the best time to add to the positions. Deep value is a long term game and it is best to have a strategy of how to deal with the many cycles and scenarios (including interest rate changes) that will occur throughout the period. Deep value is often more cyclical; rising rates are related to rising nominal GDP, which benefits cyclical firms more.

Another consideration is leverage. Small caps often have higher debt levels than large caps. A hike in interest rates means greater interest payments, unless the company in question has renegotiated their terms for several years before the interest rate rise. Higher nominal GDP does not flow to all companies equally, some will be left behind and these levered firms face increased risk of bankruptcy.

In terms of projected future cashflow, the new scenario should take into account that the first rise in interest rate may be a signal for further hikes, and therefore, resulting in a lower PV, unless higher growth in nominal GDP offsets this effect.

With the UK as one of the first countries that is considering raising rates, currencies are another important consideration. Small caps that deal mainly with the local market would be insulated from the effect of a stronger currency, whereas firms that rely heavily on foreign market sales will be at a significant disadvantage.

What remains relatively undiminished though is the attraction of small caps as M&A targets. While financing the riskiest deals may become a little harder for an acquirer, we still have a situation where companies are facing low growth and more cash than they know what to do with. The UK in particular is very takeover friendly and we are seeing increased interest from emerging market and US companies that want to buy expertise, credibility or a strong niche market position via the acquisition of smaller companies, Aga being a very recent example.


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