While UK small caps re considered a riskier investment, paraplanners can take advantage of volatility in the sector, says Darius McDermott, managing director, FundCalibre
It’s been a case of feast or famine for UK small caps in recent years. The left-right combination of Brexit and a global pandemic could justifiably floor any small company in that time – as ongoing concerns impacted both sentiment and cashflow (liquidity). But to me, small caps have shown incredible resiliency to survive and, in many cases, flourish.
The past 20 months or so really have encapsulated the sector’s fortunes. A stellar return of 23 per cent in 2021* has been followed by an exceptionally challenging year-to-date as inflation and the threat of recession has seen the average fund fall over 25 per cent in that time**.
The challenge for us is at what point does the hammering these stocks have taken become too big an opportunity to ignore? As investment managers we’ve always backed the view that mid and small-caps outperform long-term – they also historically lead markets out of a recession.
The Numis UK Smaller Companies Index has now fallen by 22 per cent from its September 2021 peak, while trailing seven-year returns from UK smaller companies are now approaching the lowest level since the benchmark was created in 1955 – with historical figures showing returns from small caps have never been negative on a seven-year view***.
However, the pessimist in me questions just how close to the bottom we are. Whenever I hear the words “a lot of bad news is now in the price” I’m tempted to think the exact opposite. It was only in early August that the Bank of England predicted a 15-month recession, which will no doubt bring liquidity issues into play if the BoE is less willing to underpin the market. There’s a reason why active management is particularly important in this sector.
TM Tellworth UK Smaller Companies manager Paul Marriage says the current focus must be on the companies that have survived well in the past six months – having shown some pricing power. He highlights two specific issues. The first is that the market has been prone to ignoring good news for small companies in recent times – unless there has been a bid made on a specific business. This brings him to his second point – the uptick in M&A in the sector, something which he says has historically resulted in UK small-caps outperforming****.
Artemis UK Smaller Companies fund manager Mark Niznik says although small caps have significantly underperformed the wider UK market recently, prolonged periods of underperformance have been rare, with UK small caps having historically outperformed two in every three years. As a result, he sees the current sell-off as a great buying opportunity, particularly as valuations now seem to be discounting a recession that is by no means certain in his view***.
A recent research update from Franklin Templeton says UK small-caps are currently pricing in a lot of downgrades, with investor sentiment swinging to pessimism – as a result the team are finding opportunities in four specific market areas: digital economy, decarbonisation, consumer brands and content and IP creation^.
Much will end up depending on a company’s balance sheet strength. These firms have the flexibility to invest and grow in these uncertain periods in markets. It’s effectively consolidation as the strong get stronger.
The final point I would like to make is the catch-up trade – which makes UK small-caps particularly attractive versus their global peers. Essentially, the discrepancy in performance between UK mid and small caps versus large in the past 12 months is even more pronounced because of the strong performance of the FTSE 100 due to its value tilt. In a nutshell, it could give UK small caps an even greater tailwind in the recovery phase.
Waiting for markets to bottom-out is a foolhardy strategy. Despite being battered, UK small caps have historically shown a great ability to bounce back quickly. They’ve also been incredible performers in the long-term. In my opinion, investors who shun them completely at these valuations do so at their own peril.
Funds to choose from:
Liontrust UK Micro-Cap fund looks to tap into early-stage companies with the potential for significant growth. To do this, the team only invests in profitable companies, which also have at least one intangible asset – these include a strong distribution network, high recurring revenues, or a strong brand.
Unicorn UK Smaller Companies is a high conviction fund with around 40 holdings. The manager focuses on company fundamentals and aims to make long-term investments, while avoiding low quality, cash-burning businesses. All companies must be profitable at the point of investment.
TB Amati UK Listed Smaller 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. Valuation is important, and the managers love to buy cheap businesses when they can, but they think it is much more important to find the right companies first.
*Source: FE fundinfo, total returns in sterling, Investment Association UK Smaller Companies sector, 31 December 2020 to 31 December 2021
**Source: FE fundinfo, total returns in sterling, Investment Association UK Smaller Companies sector, 31 December 2021 to 1 September 2022
***Source: Artemis – UK Smaller Companies update, 4 August 2022
****Source: Tellworth UK Smaller Companies fund update, 4 March 2022
^Source: Franklin Templeton – Opportunities in UK-small and mid-cap equities, June 2022
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.
