How cheap is too cheap to ignore? To answer that question we have to look at what history tells us, says Darius McDermott, managing director, FundCalibre
For most of this year there have been two standout equity markets which have looked incredibly cheap from a valuation perspective.
The first is China, a market still recovering from Covid and beset by both regulatory and geopolitical uncertainty. While there are clear valuation opportunities, the recent news that the Biden Administration issued an executive order, aimed at restricting certain investments in advanced technologies in China, has led to us having to step back and take stock of investing in the region in the short-term.
The second opportunity is one we arguably know best of all – the UK – an area which has been largely out of favour since interest rates were cut to record lows in the wake of the Global Financial Crisis in 2008. Brexit has also hung over the economy, with some £30bn of assets pulled between 2016 and 2022*.
Within this is the challenge facing UK smaller companies which, for one reason or another, are always in the eye of the storm. The past 18 months have been particularly challenging for this innovative part of the market. Rising interest rates made it more expensive for smaller companies to borrow to finance their growth, while higher volatility raised liquidity concerns.
Since the beginning of last year, the average loss for a fund in the Investment Association’s UK Smaller Companies sector is almost 30 per cent, compared with a rise of 3.4 per cent for the more internationally focused FTSE 100**.
Niche products, smaller customer bases and the challenge of raising capital in difficult conditions is never the best mix – but UK small-caps have shown themselves to be the ultimate survivor in recent years, which means now could well be the best time to invest.
Artemis UK smaller companies manager Mark Niznik says the UK economy is proving far more resilient than had been widely expected. Six months ago, the Bank of England was forecasting one of the deepest and the longest recessions in history. It is now forecasting that there will in fact, be no recession at all in 2023. Instead, it now sees real GDP growing from here***.
He says: “Despite this improving economic backdrop, UK equities – including smaller companies – remain unusually cheap relative to companies in other regions. This reinforces our view that this is a great buying opportunity as small caps continue to price in a recession that we increasingly feel is unlikely***.
LF Montanaro UK Income manager Guido Dacie Lombardo says you have to consider the small-cap effect from a global perspective as well. He says: “Basically, smaller companies in most countries around the world have outperformed large cap, that small cap effect remains in place in the UK. If you go back to 1954, since then, small caps have outperformed large caps by 3.1 per cent per annum. So, if you compound that over time, actually going back to 1954, small caps have given a return almost seven times greater than large caps.”
Merger and acquisition activity is typically the great signal for valuing UK equities, and we have seen a consistent flow of it throughout 2023. There has also been signs the initial public offering drought could be coming to an end, with a growing number of companies making enquiries in the past couple of months. This can be a double-edged sword, the positive is UK companies are seen to be attractive by both private equity companies and overseas investor.; However, some are being bought – and taken off the market – at such cheap levels, that many fund managers do not feel they are being fairly valued.
VT Downing Unique Opportunities fund manager Rosemary Banyard says: “At times like this, when the market is down and the UK is cheap versus overseas, it is particularly painful when you get directors recommending a bid at around a 30 per cent premium to the price. You then get the directors recommending it because it’s a premium. The advisors are saying it’s going to be a year or two before you get this price any other way. So, they feel under pressure to recommend it. And these deals get done and dusted and it is very painful.”
Valuations and timing also need to be considered. Figures show the UK smaller companies benchmark began the year on just 8x earnings, down from 17x at the start of 2022. This is one of the lowest starting multiples in over forty years****.
But waiting for a catalyst to turn these fortunes around could arguably be the biggest mistake of all, as you can miss the first bounce of the recovery. Research shows that if you had stayed fully invested in the Numis Smaller Companies ex-IT index since 1991, you would’ve made a 600 per cent returns from the sector, this falls to 435 per cent if you exclude the five best discrete monthly returns^.
In summary, history is telling us UK small caps are cheap and that you ignore them for the long-term at your own peril.
Funds to consider
TM Tellworth UK Smaller Companies
Managers Paul Marriage and John Warren have an exceptional track record of investing in UK smaller companies. They predominantly look for companies with a differentiated product, high sustainable margins, management aligned with shareholders and a market leading position. A smaller portion of the portfolio will be made up of ‘self-help’ recovery stories.
TB Amati UK Listed Smaller Companies
This fund is managed by a highly experienced quintet of small-cap specialists. The portfolio of 65 to 70 companies focuses on structural growth businesses, which the managers believe can add value in the under-researched small and mid-cap part of the market.
ISFL Marlborough UK Micro-Cap Growth
Management of the IFSL Marlborough UK Micro-Cap Growth fund is outsourced to Hargreave Hale, one of the best small-cap boutiques in the country. This portfolio typically holds around 250 companies to reduce stock-specific risk. Relatively small positions are taken initially, and the managers will add to the stocks as their stories unfold.
*Source: Investment Association
**Source: FE fundinfo, total returns in sterling, 31 December 2021 to 8 September 2023
***Source: Artemis Fund Managers – Artemis UK Smaller Companies – reviewing the first half of 2023
****Source: R&M – Will UK Smaller Companies bounce back in 2023?
^Source: Tellworth – figures to 9 January 2023
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
