This week’s interview from the FundCalibre team looks at the UK Smaller Companies sector with David Stevenson, co-manager of the WS Amati UK Listed Smaller Companies fund. He discusses current market dynamics and outlook for the sector, despite a challenging two-year period marked by receding investor appetite and outflows from small-cap funds.
Why you should listen to the interview: David argues now is a unique entry point for UK smaller companies, buoyed by recent improvements in relative performance and the potential benefits of lower interest rates. The interview also covers the surge in M&A activity and share buybacks, underscoring the attraction of UK companies for both domestic and international investors.
This interview was recorded on 8 May 2024. Please note, answers are edited and condensed for clarity. To gain a fuller understanding and clearer context, please listen to the full interview.
Interview highlights:
A tough period for smaller companies
“It’s fair to say that UK smaller companies peaked in late 2021. That coincided with a period of hyperactivity during the early stages of Covid when interest rates were cut to boost economic activity and lots of companies were raising money. Since then, investor appetite has receded for the earlier stage risk and illiquidity that’s usually associated with smaller companies which has caused outflows from small-cap funds which has exerted further pressure on share prices and company valuations. So, it’s been a tough time, really over the last two years, but the flip side of that is always about the opportunity that creates. And we see this as once in a very long time significant entry point for UK smaller company investing.
If interest rates fall, this would likely help UK smaller companies recover quickly and we’ve already seen some evidence of that. The relative performance of UK smaller companies – and global – has picked up since late 2023. And that coincided with a cooling-off of inflation concerns and also a lowering of expectations about where interest rates might peak. And that was sufficient really from October of last year to drive a relative outperformance of UK smaller companies.”
Waiting for the penny to drop
“UK smaller companies are at a material discount, 15%, to UK larger companies and the UK market as a whole is on a very significant discount to global equities. So this is a very attractive entry point, we see this as a once in a very long time opportunity.
The data overall for fund flows is suggesting that, certainly for the first time in two years, domestic investors are buying more equity funds. The problem at the moment is that is North American equity funds; they are not buying the UK market. We feel that that will come and it will probably come from fear of missing out. If M&A activity, if share buyback activity carries on, then eventually we feel that the penny will drop that there are outstanding bargains on offer.
More recently, we’re seeing signs that companies who are coming out with good announcements in terms of trading or contract wins et cetera are seeing their share prices pop up by 15-20%. That’s different from the last two years where, for the most part, share prices didn’t react particularly to good news but did react to bad news. This suggests to us that perhaps some of the selling pressure is now beginning to come off and there are fewer sellers now. As this momentum continues, then we feel retail investors will hopefully return to the UK market. They certainly are seeing headlines every day about how cheap the UK market is, so hopefully the penny will drop with them.”
Self-help for share prices
“A growing feature in the UK market has been the increase of M&A activity and even share buybacks and we’re seeing a definite acceleration of that activity. We’ve had three bids in the portfolio in the last two months. Two were for IT/tech-related companies and one was for a building materials supplier. That added to activity that we’ve seen over the last several years, so we’re well into double digit number of bid approaches for holdings that we have in the portfolio. Those bid approaches have come from the full range of acquirers: we’ve seen domestic corporates acquire, we’ve seen overseas corporates acquire, we’ve seen domestic and international private equity provide bids.
A good deal of that has come from the US where there’s a currency benefit as well to the valuation of UK companies. And we definitely see this activity carrying on. Those are the main investors in the UK market at the moment. Domestic investors, institutions and private investors are the ones who are holding back and as they hold back, that vacuum has been filled by corporates and private equity. And in terms of private equity, the valuations they see for publicly-listed companies relative to what they might have to pay to invest in private companies is very attractive.
Regarding share buybacks, we’re also seeing significant activity from corporates themselves. It’s a form of self-help for their share prices. Currently, nine of our top ten holdings in the portfolio are companies that have launched or are in the process of buying back significant material amounts of stock. We see this as wholly rational. If companies are finding that making acquisitions or investing in individual projects aren’t offering the same returns as buying back their own stock, then we have no issue with that. It underpins the share price. If the share price drifts back, then the company is there to step in and acquire more stock so we see that as a positive feature really.”
Conclusion: Investors in UK smaller companies funds will not need reminding that it has been a torrid time for the asset class. However, David makes a clear case for the sector in this interview and the attractive opportunities available to investors today.
