Why the stars are finally aligned for UK small caps

18 June 2021

Is it time for investors to invest in UK small caps? Alex Game, assistant fund manager, Unicorn UK Smaller Companies fund, explains why he believes it is.

Since the Brexit referendum vote in June 2016 UK equities have been unappealing to many investors, a view that was further enforced by the severe economic contraction dealt by the pandemic.  At this juncture, however, following the agreement of a Brexit deal and the successful domestic vaccine rollout, there is cause for optimism in the outlook for UK equities and smaller companies specifically.

The merits of investing in smaller companies are well known.  Over the long term, this area of the market has consistently delivered superior returns relative to larger peers, which can be attributed to the propensity for higher rates of growth and also the potential for valuation expansion.  The very low analyst coverage of smaller companies, typically with one to two research analysts covering a stock compared to twenty plus on some FTSE 100 companies, also provides a fertile hunting ground for stockpickers to capitalise on mispriced opportunities, which fall under the radar of the broader investment community.

The combination of disease and lockdowns had a devastating impact on the UK economy at the height of the pandemic when economic output suffered the worst fall in 300 years.  Whilst very few companies were fully immune from this exogenous shock, the advantage of being nimble and adaptable enabled smaller companies to protect their businesses and staff throughout this extremely challenging period.

This agility will be equally as important during the recovery phase.  A lasting impact of the pandemic will be the structural changes it has inflicted on society such as the instantaneous change to working habits. Another consequence has been the acceleration of trends already in train such as digitisation and e-commerce.  Smaller companies, which are typically younger and more exposed to structural growth areas such as technology, are particularly well placed to adapt to these changes.

The UK economic outlook is looking increasingly favourable.  The late agreement of a Brexit deal in December 2020 and the hugely successful vaccine rollout have removed the two most significant economic risks to the UK’s economic health, which have both been an understandable deterrent against UK equities over the past five years.

According to the OECD, the UK economy is forecast to grow by 7.2% in 2021, the fastest growth in 80 years, which compares to growth of 6.9% and 4.3% in the US and Eurozone respectively.

Smaller companies represent 99% of British businesses and account for over 60% of national employment.  Therefore, whilst individually these companies are by definition “small”, collectively they are crucial to the nation’s economic interests and are very much aligned to the economic rebound.

Not only do smaller companies tend to perform strongly in broad economic recoveries, they are much more sensitive to the fortunes of the domestic economy than their larger peers.  Smaller companies typically generate the majority of revenues from the UK, whilst in contrast the FTSE 100 is extremely international with roughly three-quarters of its revenues being earned in overseas markets.  UK smaller companies are therefore particularly sensitive to the strong outlook of our domestic economy.

Valuations are also looking attractive with UK equities trading at a significant discount to other developed market equity indices despite this positive outlook.  Whilst the valuation discount between UK large and small companies has corrected of late, versus other developed markets, namely the US, UK smaller companies are looking attractive valued, particularly in the context of a superior near term economic outlook.

Smaller companies also play a hugely important role in the UK’s ambition to be net zero by 2050. Business and industry contribute 25% of the UK’s emissions of which smaller companies account for nearly half.  Investing in these companies therefore not only provides opportunity for investors to earn attractive long-term returns, it offers exposure to the companies which are fundamental to driving forward the nation’s environmental agenda.

Taking all into consideration there is considerable cause for optimism.  The combination of a bright economic outlook, attractive valuations and improving underlying environmental trends provide the ingredients for a very positive backdrop for UK smaller company investing.

Professional Paraplanner