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Smaller companies are showing signs of recovery as investors rotate away from big tech and search for better value sectors of the market. Analysts and fund managers say that UK smaller companies, in particular, could offer exceptional value in an environment of falling rates and a more stable political regime.
The AIC UK Smaller Companies sector has returned 25% over the past 12 months (to 22 July), making it one of the best performing sectors over this period. It has returned 38% over the past five years and 118% over the past ten years1.
We asked a range of fund managers for their views about the prospects for the UK smaller companies sector, and whether now is a good time to invest.
Richard Staveley, Lead Fund Manager of Rockwood Strategic, said: “For any sensible investing time horizon, it’s always been a good time to invest in UK small companies. The long-term record is hands down compelling versus mid or large company share performance. Given we have had a recent difficult period of small cap performance, it’s likely that the mean reversion process to the long-term average returns means an exciting period of returns is ahead of us. This constructive outlook is supported by cheap stock valuations, which is critical to the likelihood of future positive returns.”
Georgina Brittain, Portfolio Manager of JPMorgan UK Small Cap Growth & Income, said: “Small cap companies are typically associated with growth, but current valuations in the UK mean there are many high quality stocks also offering good value. Even within the undervalued UK market, small caps are cheap relative to large caps, despite frequently being able to maintain their growth potential regardless of the economic backdrop.
“We believe interest rates have peaked and will soon gradually decline. With consumer confidence and business confidence on the up, small caps offer an attractive opportunity for investors to generate higher returns over the long term. Small caps are much more domestically focused than large cap companies, providing exposure to the more positive economic signals that are now starting to come to the fore.”
Ken Wotton, Lead Manager of Strategic Equity Capital, said: “We believe now is an excellent time to invest in UK smaller companies. Valuations are compelling as evidenced by the steady stream of takeover offers for UK-listed companies at elevated premia coming from a range of domestic and international private equity and corporate buyers. Economic conditions appear to be improving with inflation lower, confidence recovering and the prospect of rates falling later in the year. There are a large number of high quality UK smaller companies trading at discounted ratings which bodes well for future returns.”
Roland Arnold, Manager of BlackRock Smaller Companies Trust, said: “Valuations in the UK, and in particular the UK small and mid cap sectors, are about as attractive as we have ever seen. Meanwhile, the economic backdrop is certainly improving. The UK economy has returned to growth, unemployment remains low, balance sheets are strong, inflation is falling, and consumer confidence and PMIs are improving. This backdrop gives us confidence that the outlook for the businesses we invest in is broadly supportive for an earnings recovery.
“Corporate confidence is also improving, which is seen in growing merger and acquisition activity. Companies increasingly have the confidence to buy their peers and build market share. Strong balance sheets also mean companies have the cash to invest. This is putting a floor under share prices for smaller companies.”
Stuart Widdowson, Portfolio Manager of Odyssean Investment Trust, said: “For long-term investors now is an interesting time to invest in UK smaller companies. Recently they have been weighted by negative sentiment due to mixed economic conditions, which has led to earnings downgrades. We believe that in many cases earnings are close to, or at a base level. Markets are forward-looking and will anticipate an earnings recovery before it happens.
“The only significant buyers of quoted UK smaller companies over the past two years have been corporate and private equity bidders – capitalising on the low valuations in the sector. Historically there was always a public market premium (or private market discount). From this point, we believe that public equities will perform well against private equity over the medium term and the private market valuation discount will reappear.
“Any slowing in the outflows from open-ended smaller company funds could also see a material re-rating and re-appraisal of the sector – we think it is well overdue and, when it happens, it will be sharp – a bit like pulling a brick across the table with a piece of elastic.”
Does the new Labour government make you more optimistic?
Roland Arnold, Manager of BlackRock Smaller Companies Trust, said: “We have begun to see early signs of a recovery in the huge potential of UK equities, with small and mid caps in particular outpacing large caps more recently, driven by takeover activity, a brighter macroeconomic outlook, and expectations of more buybacks and IPOs. A period of relative political stability following the recent general election could help brighten sentiment for UK assets and stem the outflows from UK small and mid caps.”
Stuart Widdowson, Portfolio Manager of Odyssean Investment Trust, said: “Despite the perception of UK smaller companies having a lot of domestic exposure, our portfolio is much more international – deriving more of its revenue from outside the UK than the FTSE 100 basket of companies. From a micro level, governmental change has little impact on our portfolio.
“On a macro level, the large majority provides the new government with a stable base. This is in direct contrast to larger countries in the EU, and the UK may be perceived to be an inexpensive ‘safe haven’ for public equity investors. Provided the new government’s tax and spending plans are appropriately received by the bond markets, and they can continue to keep inflation in check, falling interest rates seem likely – which would be positive for all UK equities, particularly UK smaller companies, and especially those with some gearing.
“It would be great to see the incoming government address the long-running cost disclosure anomaly for investment companies. Positive change here could see improved demand for investment companies and with that a narrowing of discounts.”
Ken Wotton, Lead Manager of Strategic Equity Capital, said: “The decisive change of government should herald a period of stability which is welcome after a protracted spell of political and economic volatility and uncertainty. Specific policies may benefit or hinder individual companies, but clarity allows planning and reduces risk which should be good for UK smaller companies and markets in general.”
Richard Staveley, Lead Fund Manager of Rockwood Strategic, said: “Certainty is always rewarded in markets, despite them forgetting nothing is certain and uncertainty always remains. Politicians tend to change their tune more often than others, so we cannot be assured the supportive market narrative from Labour will be followed through in the long term. I don’t think we can be truly optimistic until risk-taking is properly rewarded by society and the public sector fully embraces the benefits of a ‘profit motive’. The public sector itself cannot drive the economic future for the country and clearly needs to be reformed: its commitments are moving out of balance with what’s affordable from the private sector. If Labour can make the hard decisions regarding this for the benefit of all then I would be optimistic.”
What are the main risks facing the sector?
Georgina Brittain, Portfolio Manager of JPMorgan UK Small Cap Growth & Income, said:“Given the UK’s economy leans heavily on services, consumer confidence is crucial to underpinning growth here in the UK. But, despite the financial headwinds of the last few years, the UK consumer has demonstrated astonishing resilience, and we have every confidence they will continue to withstand future challenges. In addition, data suggests consumers and companies are adapting to the reality of higher interest rates, allowing consumer spending to settle into a new normal. We are also quietly confident that falling inflation, rising wages and easing pressures on consumers will provide a further boost to overall consumer confidence.”
Richard Staveley, Lead Fund Manager of Rockwood Strategic, said: “Rising interest rates would be a disaster for the sector, as would the removal of tax incentives to invest in British AIM and LSE Main Market businesses whether via ISAs, SIPPS or via inheritance tax reliefs. I look forward to the opposite – falling interest rates and new incentives such as the British ISA.”
Ken Wotton, Lead Manager of Strategic Equity Capital, said: “The main risks facing the UK smaller companies sector are geopolitical and macroeconomic. A resumption of inflation and ‘higher for longer’ interest rates could provide a headwind for growth. Despite this, the sector offers a wealth of opportunities to uncover attractive growth businesses benefitting from structural tailwinds, and with high quality management teams with the agility to navigate an uncertain background and deliver value growth over the medium and long term.”
Stuart Widdowson, Portfolio Manager at Odyssean Investment Trust, said: “There are the perennial black swan risks that few think of, and an escalation of the Ukraine conflict. Inflation could prove to be higher for longer, which will limit both the speed and scope of interest rate cuts.
“Over the medium to long term, the UK smaller company sector needs to attract and retain public companies – the recently announced changes to the Listing Rules is a start. But in general, there needs to be a mindset change of long-term investors away from risk and more towards returns.
“Business relief has been a positive driver for long term investment into AIM companies – we believe that AIM managed portfolio services alone are of an equivalent size to the whole UK Smaller Companies investment company sector. Scrapping the inheritance tax relief entirely is a major risk and would create market turmoil.”
Roland Arnold, Manager of BlackRock Smaller Companies Trust, said: “There is still fragility in certain sectors of the market, and it remains important to be selective. However, we believe that many of the factors that have held back UK smaller companies in recent years appear to be stabilising or reversing. Therefore, as ever, we remain focused on the micro: industry level change, company fundamentals and the current opportunities in our universe are as exciting as ever. Historically, periods of heightened volatility have been followed by strong returns and have presented excellent investment opportunities.”
