UK smaller companies are often seen as a play on the domestic UK economy but, in reality, we always have the choice to invest in more internationally-focused companies if that is where we see investment opportunities. However, at the moment, we see the best prospects for long-term capital growth in the domestic market. Why?
UK small-caps – and domestic companies in particular – have been through their longest bear market in history. The reasons behind this weakness have been well-rehearsed: from the sluggish UK economy; to the instability of its politics; to higher interest rates.
Investors have turned away from investing in UK markets and small-caps have been notably out of favour. The share price weakness has been near-universal, affecting the majority of sectors and businesses.
This has left valuations looking low on every measure – relative to earnings, relative to international peers, and relative to their own history . For the majority of companies, the feared weakness from a more sluggish environment has not materialised, particularly among the type of low-debt, high-quality businesses in which we invest in.
These companies have, for the most part, continued to grow their earnings and pay dividends. It is worth noting that the yield on the FTSE Small Cap is now higher than that on the FTSE 100.
While operational performance and earnings hold up, sentiment has remained poor, it has meant that these companies continue to get cheaper. In particular, the premium for higher quality businesses has all but disappeared.
Small-cap catalysts
While we do not believe that valuation is, of itself, a catalyst for a reappraisal of the smaller companies sector, there are a number of factors coming together that appear to be prompting investors to look again at UK smaller companies.
The interest rate environment is shifting. Inflation may not be coming down as quickly as hoped, but it is past the peak and the most recent CPI reading was 2%, in line with the Bank of England’s target. This gives some flexibility for the central bank to cut later in the year.
Bond markets are now more realistic on interest rate cuts, which is giving businesses and households greater visibility and stability. Smaller companies have tended to fare better as rates fall.
M&A activity is picking up strongly, with international corporate and private equity buyers taking a growing interest in UK companies. A variety of buyers recognise that these companies are being mispriced by the market and are seizing the opportunity to snap them up at lower prices.
Companies are buying back equities and those buybacks are helping absorb some of the flow coming out of smaller companies. While the giant buybacks from larger companies have captured the headlines, it is very much a phenomenon in smaller companies as well.
The definitive result of the general election may usher in an era of greater stability in British politics. The incoming government recognises that action needs to be taken to improve how the UK’s capital markets function.
At the moment, action has been relatively piecemeal – the British ISA, for example – but it shows the direction of travel. Further plans are likely to emerge over the next few months, as the new government beds down.
The market is ripe for reappraisal. Even a small reversal in the outflows from the sector would make a significant difference. Equally, any revival in the IPO market would reinvigorate the market and bring a new opportunity set.
In the very short term, we have started to see investors recognise the opportunities in British smaller companies. We believe this is set to continue.
Dan Whitestone is the manager of Throgmorton Trust. The views expressed above should not be taken as investment advice.