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Resilient UK small-caps cannot be ignored

6 August 2019

Data shows that investor exodus from small cap equities in the post Financial Crisis has been a mistake, says Darius McDermott, managing director, FundCalibre.

UK equities have been unloved for almost a decade: the IA UK All Companies sector has been the worst selling asset class among retail investors in eight of the past ten years*.  Digging a little deeper, UK Smaller Companies have been even more unpopular, with more than £2 billion* of net outflows since the global financial crisis.

So when the UK voted in favour of leaving the EU in 2016, and international investors shied away from British businesses, a bad situation became worse. What little exposure there was to UK companies was in the larger, overseas earners, while our smallest companies are now significantly under-owned in portfolios.

However, hindsight shows that this has been a mistake. Three years on from the referendum and UK smaller companies have defied the odds, demonstrating strong resilience through significant bouts of volatility: the average fund in the IA UK Smaller Companies’ sector has returned 46.6%**, compared with 32.7%** for the UK All Companies sector.

And, if we were to put Brexit aside for just a moment, the indicators for UK smaller companies actually still look very attractive, regardless of whether we are late in the market cycle or not.

Reasons to invest in UK small-caps

Firstly, a number of fund managers I have spoken to recently, including Will MacIntocsh-Whyte, deputy manager of Rathbone Strategic Growth Portfolio, believe there is now more risk of missing a rally in the pound, than there is that sterling will fall further. Should this happen, we could see a reversal of fortunes: the FTSE 100 could slump while UK small caps get a boost.

But it’s also important to note that not all UK small caps are as domestically focused as many may think. Paul Marriage, manager of LF Tellworth UK Smaller Companies fund, said recently that there is an unfortunate perception that UK smaller companies are domestic, backward and generally not as good as everywhere else in the world. In his view this is simply not the case. He cited AB Dynamics as a good example. Based in Bradford-on-Avon, it is a “world leader for testing autonomous cars” and the technology behind it. He added that the UK has 1.5x as many listed smaller companies (worth less than $1bn) per capita than the US and 2.5x more than Germany or France – so secondly, there are plenty of opportunities for active managers.

Thirdly, UK companies are trading at relatively attractive valuations and small-caps even more so, despite the fact that consensus earnings expectations for UK small-caps are significantly higher and the move away from rising interest rates has created a strong tailwind for smaller businesses.

Finally, over the long-term, UK smaller companies have historically rewarded more than their larger peers. The Numis Smaller Companies Index reflects this point. Covering the bottom 10% of the market, the index has produced a compound return of 13.9%*** per annum – with dividends re-invested – some 3.5%*** ahead of what the FTSE All-Share has returned.

For now, there is an element of wait and see, but I would encourage those without any allocation to UK small-caps to add to their portfolio.

For those looking to invest the Liontrust UK Smaller Companies fund is a good place to start, having developed a strong following among financial advisers by delivering stellar long-term results. The team’s decision to place an emphasis on quality and avoiding cyclical stocks has worked particularly well with smaller companies. And if you want the UK’s minnows, the fund’s smaller brother, Liontrust UK Micro Cap – which has just marked its third anniversary – is worth a look too.

Marlborough Special Situations is another good alternative, with Giles Hargreave and his team having developed a strong reputation as stock pickers. Giles typically holds around 200 companies to reduce stock-specific risk. Relatively small positions are taken initially, and Giles will then run his winners aggressively, adding to them as their story unfolds. Again, if you want to stick to very small companies, Marlborough has another equally-good offering, Marlborough UK Micro-Cap Growth.

The Tellworth UK Smaller Companies fund was only launched in November 2018, but is run by two experienced managers in Paul Marriage and John Warren, both of whom are well-known for the strong performance achieved in their time at Schroders.

*Source: Investment Associaction, statistics by sector, best and worst selling investment association sectors by year.

**Source: FE Analytics, total returns in sterling, 24 June 2016 to 28 June 2019

***Source: FE Analytics, total returns in sterling,10 years to 28 June 2019

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.

Professional Paraplanner