The UK’s small-cap stocks might just be poised to come back into favour. There is no doubting they should have the scope to do so. In the past two years, small caps – as measured by the FTSE All-Small index – have markedly underperformed the FTSE 100 index. While the large-cap index has crept upwards, the All-Small index has dropped 20 per cent, for a 25 per cent relative underperformance.
As to why small caps may be on the cusp of something better, let’s begin with a diversion to the subject of Pareto distributions, just the mention of which can give many investors the heebie-jeebies. Sure the maths of a Pareto distribution is a bit forbidding. However, call the distribution by its common-or-garden name, the 80-20 rule, and suddenly the world seems calmer. Intuitively, we can grasp that, say, 80 per cent of Tesco’s profits may be made by only 20 per cent of its stores, or that 80 per cent of London’s traffic clogs just 20 per cent of its roads.
In the world of money, Pareto distributions abound. We keep being told, for instance, that 20 per cent of the people possess 80 per cent of the wealth. The distribution of stock market value among the components of the FTSE 100 index doesn’t quite match 80-20 – the 20 biggest currently account for 66 per cent of the index’s £1.9tn value – but it’s heading in that direction. More to the point, a portfolio’s returns are likely to follow an 80-20 rule – in any given year, an outsized proportion of its overall gains will come from a smallish fraction of its holding.