At first sight, it is difficult to make a compelling case for UK smaller companies. Sentiment is in the doldrums and there are few apparent catalysts for a change: there is no imminent revival in the UK economy, for example, or change in investor attitudes. However, should the sector now be attracting the attention of a hawk-eyed contrarian?
Make no mistake, sentiment is bad. While outflows from the IA UK Smaller Companies sector have narrowed slightly from last year, July and August saw outflows of £93m and £95m, respectively. The sector is now £10.1bn, compared to £20.2bn in August 2021. For investment trusts, discounts remain well above long-term averages. By almost any measure, the sector is unloved.
But an experienced investor knows this will not last. They recognise that the best time to buy smaller companies is in exactly this type of market – when the sector is utterly out of favour and risk aversion is at its highest.
Past examples include March 2009, the height of the global financial crisis, from which point the FTSE Small Cap index subsequently returned 340% to investors over the next nine years. We saw something similar during the pandemic-induced market crash in February and March 2020, when the index bounced back some 41% over the next six months.
They also understand that over the long-run, small caps have outpaced other parts of the market. The Numis Small Companies index shows that a typical investment in smaller companies in 1955, with dividends reinvested, would have been worth around 368x its original investment at the end of 2022, adjusted for inflation. For contrast, larger companies have grown 55x over the same period.
Dr. Gareth Blades, an analyst on Amati UK Listed Smaller Companies fund, says: “Historically, investing in UK smaller companies as an asset class and holding for the long term has been a recipe for outperformance. However, as is the case currently, this outperformance is punctuated with periods of higher volatility and risk. These episodes can cloud the long-term attractiveness of the asset class.
“As a consequence of the current cycle, and longer-term factors such as Brexit, the UK market has reached a historically low discount to its global peers, and within this, UK small caps have become even cheaper relative to UK large caps – a double discount.”
Are we seeing catalysts for change?
But investors want a sign. It is too uncomfortable to invest at these levels for all but the hardiest investors. They need some signal that sentiment could be about to turn. If the operational performance of smaller companies had been weak, that might be the catalyst, but for the most part, smaller companies have continued to deliver on earnings and profitability.
Could it be merger and acquisition activity? Certainly, the lack of activity has exerted a drag on the sector. M&A has traditionally provided an option to realise value in smaller companies where the market hasn’t done so.
There are signs that M&A is coming back. A recent report found that companies were looking at smaller, more ‘digestible’ deals. Although deal volumes are still relatively low, it suggests they might come back to the small-cap end of the market first.
There is also interest in specific sectors – in life sciences, for example, which have long-term, structural growth characteristics. Liontrust UK Smaller Companies fund, for example, was given a boost by the private equity bid for research group Ergomed. It also holds Alfa Financial Software, which recently announced that it was in discussions with Thomas H Lee Partners.
Blades adds: “While most companies have de-rated, their longer term growth prospects have not diminished uniformly – there will be some babies thrown out with this bath water. This is being recognised by external players to the UK equity market in the form of bid activity from private equity and corporates, and the fund has seen its fair share of take-outs over the last couple of years.”
Is price the only catalyst we need?
However, ultimately, it may simply be that valuations get too cheap. Given the selling pressure, it would only take a handful of brave investors to shift sentiment.
Many fund managers report a growing interest in small caps and that investors recognise that they should cover underweight positioning in anticipation of a recovery. History and intuition tells us that eventually some will bite.
Paul Marriage, manager on the Tellworth UK Smaller Companies fund, sums up the situation nicely: “We are by no means a value led strategy, yet we keep tripping up on very low multiples and high dividend yields on the most solid, well invested and well managed businesses. As non-macro wonks this all looks a little topsy turvy.”
Blades agrees: “We are active in finding top-quality, growing businesses with sustainable margins and cashflows, which have been substantially de-rated in the current environment.”
The UK Smaller Companies sector remains in the doldrums, but may be close to the bottom. Historically, when it has moved, it has moved extremely fast. It may be worth investors starting a tentative re-examination of the sector, just in case they get left behind. While the ride is not always a smooth one, history tells us these are the growth stories to back long-term.
Investors wanting exposure to small-caps through a multi-cap approach may want to consider the likes of the WS Montanaro UK Income fund, which has 29% of its assets in companies worth £1bn or less, or the ISFL Marlborough Special Situations fund, which has around two-thirds of its holdings in companies at or below the £1bn threshold.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre. The views expressed above should not be taken as investment advice.