Why are UK small-caps getting crushed right now?

A stock price graph showing declines

It’s been an extraordinary few weeks for UK small-cap investors, and not in a good way. The star category of the last few years, small-cap growth stocks have been absolutely smashed in recent trading sessions, with the FTSE AIM 100 index falling around 14% since the start of October (versus -6% for the FTSE 100).

Looking at my own portfolio of small-cap growth stocks, it’s pretty ugly. For example, identity specialist GB Group is down 15% this month. And email marketing group dotDigital is down 16% in that time. It’s no doubt frustrating seeing share prices plummet so quickly.

So, why are small-caps falling so sharply?

Indiscriminate selling

Well for starters, investors all over the world are indiscriminately dumping equities – both large and small – right now, because they’re panicking over rising US Treasury yields. The logic is, that with 10-year Treasury yields rising above 3.2%, investors can now get a return on their money without having to take on the risk of the stock market.

When global stock markets experience big sell-offs, it’s often smaller companies that suffer the most damage. Investors gravitate towards safe-haven assets and dump small-caps as they are seen as higher risk. This is an important thing to understand about smaller companies – while they can offer faster growth than larger companies, they also tend to be much more volatile.

Tech sell-off

Another issue is that US technology stocks are being sold off heavily right now. For example, Amazon is down 13% this month, as is Netflix. To be honest, this doesn’t surprise me, as valuations across the US tech sector have been extraordinarily high in recent years. This is something I warned investors about at the start of the year. With valuations so elevated (Amazon had a P/E ratio of 300 at one stage), there was always the potential for a correction.

Now, while the UK stock market generally isn’t known for its technology prowess, there are plenty of exciting UK technology companies in the small-cap space, like the two stocks I mentioned above. So a US tech sell-off is probably having a negative impact on many tech-focused UK smaller companies.

High valuations

Lastly, it’s worth noting that many small-cap growth companies in the UK have been trading at high valuations over the last few years. In this recent bull market, investors have been willing to pay higher multiples for exciting growth companies, and higher valuations (P/E ratios of 25+) became the new normal, to a degree. Investors forgot about risk. However, when stocks are trading at high valuations, it does leave them vulnerable to sharp corrections, and that’s what we’re seeing now.

What to do

Is it game over for small-caps? No, in my view. While we’re seeing some pretty extreme selling activity right now (which could last for a while), over the long term, smaller companies are likely to continue generating strong returns for investors, because they tend to grow quickly. The key, as always, is to not be overexposed to this section of the market. 

With many small-cap stocks being crushed in recent sessions, plenty of exciting companies are starting to look interesting, valuation wise. As such, it could be a good idea to draw up a wishlist of companies you’d like to own, with a view to drip-feeding money into the market… while other investors are panicking.

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Edward Sheldon owns shares in GB Group and dotDigital Group. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. The Motley Fool UK owns shares of and has recommended Amazon and Netflix. The Motley Fool UK has recommended dotDigital Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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