With many investors concerned about valuations of certain sectors and the Mag7 in particular, other sectors remain undervalued and overlooked.
In the following analysis for IFA Magazine, Eustace Santa Barbara, co-manager of the IFSL Marlborough Special Situations, UK Micro-Cap Growth and Nano-Cap Growth funds, reminds us why it can prove lucrative to look beyond the big high profile names and look for value elsewhere when it comes to investing in UK equities.
The term “picks-and-shovels investing” can be traced back to the gold rushes of the 19th century. While thousands of prospectors dreamed of unearthing a fortune, the people most likely to make money were those who sold the equipment needed for mining.
Today, long after the last nugget was chiselled out of the Yukon rock, this philosophy still applies. A useful way of framing the idea is to divide businesses into “architects” and “enablers”.
We might say, for example, that Apple was the principal architect of the smartphone revolution. We might also say the manufacturers of components such as semiconductors and LEDs were among the enablers.
Apple generated cumulative total returns of nearly 6,000% between 2007, when it launched the iPhone, and the end of 2021. Such performance is not to be sneezed at, to say the least. Yet some of the tech titan’s suppliers delivered almost 10,000% during the same period.
A key lesson for investors, then, is that it can pay to look beyond the big-name, high-profile stocks at the heart of a boom industry of sector. These may not represent the brightest opportunities over the long term.
Superior outcomes might instead stem from backing lesser-known businesses that are out of the limelight yet absolutely central to what is taking place. This possibility is worth bearing in mind as investors reassess the appeal of UK equities and UK smaller companies in particular.
Smaller companies and the bigger picture
The election of a new government invariably represents something of a “reset”. For UK equities, which have been unloved for several years, the chance to be seen in a more encouraging light is not only welcome but overdue.
Crucially, though, this is also a chance for investors to factor in a little context. Consider, for instance, the question of how Labour’s spending plans will square with the pledges in the party’s manifesto.
It seems reasonable to suppose housing, infrastructure, defence and healthcare will be among the principal beneficiaries. But does this mean investors should simply aim to snap up the major players in each arena?
The picks-and-shovels school of thought suggests not. Cast the net more widely and you realise many of the enablers in these settings are at the lower end of the market-capitalisation spectrum.
Housing perhaps provides the ultimate illustration. It is difficult to build a house without bricks, so why not invest in a brickmaker?
Marshalls fits this bill. It also produces masonry, paving, roofing, kerbs and drainage for housing developments. Labour’s pledge to build 1.5 million new homes by 2029 should help fuel the company’s continued growth.
Beneficiaries of positive change
Infrastructure offers a similar story. Many small-cap and mid-cap businesses could experience an upturn amid promises to rejuvenate hospitals, schools and transport systems.
Take Breedon, which supplies asphalt, ready-mixed concrete and surfacing products. Like Marshalls, it has seen its share price creep up during the past year and may enjoy a further boost if the government’s plans come to fruition.
The ever-strengthening argument for defence, meanwhile, is clearly underlined by the ongoing instability of international relations. Although the timeline is uncertain, Labour has vowed to increase spending to 2.5% of GDP as soon as resources allow.
Some extremely large and successful businesses operate in this space, but their small-cap and mid-cap counterparts may also merit consideration. They include Chemring, which specialises in countermeasures such as threat-detecting sensors and already has clients in more than 50 countries.
Finally, more spending on the NHS could be good news for drug companies, medical device makers and even private healthcare providers. Importantly, much of the innovation in this sphere now comes from smaller and more agile companies that are inherently geared towards the cutting edge.
One of them is Advanced Medical Solutions. A manufacturer of tissue-healing and wound-dressing technologies that help treat chronic and acute wounds, it can already lay claim to being one of the global leaders in its field.
From perfect storm to renewed appeal
There is no denying that UK smaller companies have endured something of a perfect storm during the past few years. They have been pounded by the pandemic, assailed by inflation and ravaged by rising costs.
It would be an exaggeration to say more recent events – not just the General Election but the Bank of England’s cutting and subsequent freezing of interest rates – could herald a long-awaited “big bang” moment. But sentiment may be gradually shifting at last.
Although they can be disproportionately impacted by market downturns, we already know small-caps and mid-caps tend to outperform large-caps over time. While the past is not an infallible guide, this is what history shows[1] – and there is nothing to indicate this trend has been permanently derailed.
This is an also asset class that is still notably cheap. Even though they have demonstrated resilience in a challenging environment and shown faith in themselves by initiating share buy-backs, many of these stocks remain undervalued.
These attractions might themselves warrant investors’ renewed attention. A capacity to enable and underpin positive change on a significant scale could be regarded as the icing on the cake.
Armed with their picks and shovels, the prospectors of yesteryear were driven by a frenzied belief that there was “gold in them thar hills”. Many ended up empty-handed. The most sparkling opportunities in the landscape of UK equities may also demand some digging – but in this case the effort could prove worthwhile.
Eustace Santa Barbara is co-manager of the IFSL Marlborough Special Situations, UK Micro-Cap Growth and Nano-Cap Growth funds.
[1] See, for example, Deutsche Numis: “Smaller Companies Index” – https://dbnumis.com/equities/deutsche-numis-indices#:~:text=Over%201955%2D2023%20the%20Deutsche,larger%20companies%20by%202.9%25%20p.a.
