UK's best small-cap shares

The superior returns of small cap stocks versus large caps have been well documented on these pages over recent years, supported by evidence going back over two decades.

But can this outperformance continue in the face of rising interest rates, particularly given there's been such a long run in which monetary policy has been so accommodating?

UBS analysts have just asked this question and come up with findings that challenge the conventional wisdom that policy tightening will inevitably have a disproportionate impact on less liquid assets, such as small caps.

Their research - Do higher rates threaten the small caps cycle? - suggests there's little evidence that they suffer more during periods of tightening. However, they recommend a selective approach and pick out 35 global stocks to consider in the event of much higher interest rates.

They include three from the UK in the shape of Lancashire Holdings, Rotork, and Vesuvius. The trio are favoured because they generally have low leverage or net cash, which should provide some comfort in the event of a sustained squeeze on monetary policy.

Experience of previous periods of rising rates studied by UBS shows that small caps have continued to outperform large caps in most key regions, including Europe. The main exception is Japan, where small caps have tended to be highly rate-sensitive.

The future could become trickier, however, as average small cap debt/EBITDA has increased in the past cycle for small caps to 2x, versus just 1.2x for large caps. Leverage among US small caps is higher, and caution is warranted.

UBS said: "Some of our findings challenge the conventional wisdom on small caps. Historically, we see little evidence that small caps have suffered more from rate tightening, but increased leverage and valuations (e.g. in the US and Japan) could be an issue in the future."

The three UK-based picks are familiar to readers from UBS's European small caps Top 20, which is based on the bank's coverage of 400 pan-European small and mid-cap stocks.

Bath-based Rotork, which operates in markets where the flow of gases or liquids needs to be controlled, continues to impress with its recovery after shares fell as low as 156p in February 2016.

They are now at 292.3p, with UBS holding a price target of 315p based on a projected 2019 PE ratio of 21.1. UBS is confident that management will be able to restore margins back to the 25% level over the next five years.

Bermuda insurance company Lancashire Holdings has a UBS price target of 710p, having been as high as 759.5p in early November. The stock has fallen back to 550p in recent weeks.

And despite having risen 35% in the past year, UBS has a price target of 660p on engineering firm Vesuvius, which principally serves the steel and foundry industries. The business has a slender projected debt to earnings ratio of 1, which is why it makes the UBS list small-cap list.

Small caps have globally outperformed large caps for most of the past 25 years or so, a trend that UBS believes has been driven by stronger earnings growth, more active M&A and solid corporate governance.

"While these key aspects remain, we also acknowledge that the past decade has seen an unprecedented period of loose monetary policy, which could have distorted returns."