A resurgence in UK Smaller Companies

Investors in UK Smaller Companies funds will not need reminding that it has been a torrid time for the asset class. Those who have clung on in the hope of a turnaround may be wondering what it will take to shift the fortunes of this beleaguered sector: even cheaper valuations? A revival in the UK economy? Or corporate activity such as M&A and buybacks?

Investors have grown so accustomed to the UK market being awful that they have missed a small turnaround in its fortunes already. The FTSE 100 has captured the headlines, hitting new highs at the end of April, but UK smaller companies have quietly outpaced their larger peers over the past six months.

Equally, while the mega deal between mining groups BHP and Anglo American has raised hopes that M&A activity will galvanise UK shares, there has been plenty of activity at the small and mid-cap end of the market as well, including deals for Virgin Money, Redrow, and Wincanton.

This has extended right down to micro-caps. The IFSL Marlborough UK Micro-Cap Growth fund has seen bids for its holdings Sopheon and City Pub Group. It has also held Mattioli Woods, which was recently acquired by Pollen Capital. Liontrust UK Micro Cap has just seen a merger of Belvoir Group. Another holding, Kitwave Group, rose as it announced the purchase of Total Foodservice Solutions.

While markets have been impressed by the billion-pound buybacks from groups such as Barclays, Shell, BP and Unilever, there are also buybacks among small-cap stocks. This is helping to absorb some of the outflows from the sector. Last year, around one in eight smaller companies bought back shares* and this appears to be accelerating.

Where employed, this strategy has had a significant effect. Simon Moon, manager of the Unicorn UK Smaller Companies fund, says: “One of our weakest performers in the first quarter was Severfield, despite it updating the market with outstanding operational performance. Since the quarter end, it has announced a buyback, which materially moved its share price. The share price was up more than 15% on the day. This just shows the impact of this ‘small scale’, run-of-the-mill, corporate activity can have.”

Simon believes there has been a notable change in sentiment since the last few months of 2023, adding: “It felt significant. There was a realisation of how extreme valuations had become.” This has been a catalyst for the M&A activity.

It is not just corporate activity. Dividends at the smaller end of the market have also started to look appealing. The FTSE Small Cap index now has an aggregate dividend yield of 4.1%**. That’s higher than the FTSE 100 (3.7%) and higher than the FTSE 250 (3.4%)**. This is both a function of weaker share prices, and a recognition from management teams that they need to find ways to return capital to shareholders. In many cases, UK smaller companies are still operationally sound, producing cash and doing well. This gives them plenty of firepower to pay dividends.

In March, Goldman Sachs analysts said they expected smaller and mid-cap UK firms to outperform larger companies this year. They were optimistic that an appreciation in the pound would benefit domestically-focused smaller companies, and a recovery in the services sector would improve both operational performance and sentiment in this part of the market.

For investors this sounds encouraging. For those waiting for a moment to get back into the market, this could be an opportune moment to look again at the sector. In the short term there is no danger that investors have missed the boat. Smaller companies have got a long way to catch up. The FTSE Small Cap is flat over three years and has trailed the FTSE 100 by over 30%***.

That said, there are concerns about the long-term health of the sector. The number of companies in the FTSE Small Cap index has fallen from 160 in 2018 to 114 at the end of last year****. A recent study from small-cap broker Peel Hunt pointed out that FTSE Small Cap would cease to exist by 2028 if the ‘relentless’ pace of merger and acquisition activity continued with no IPO activity to replace it. It said that the total value of FTSE Small Cap constituents had fallen from close to £60 billion in 2018 to around £30 billion today****. This doesn’t necessarily matter for investors in the sector today, but in the long term it will diminish choice and affect the proper functioning of UK capital markets.

Another issue for investors to wrestle with is how small they should go. Micro-cap has been more out of favour than the broader smaller companies market and, in particular, the FTSE AIM All-Share index has struggled. It is down 6% over one year, and is down over 37% over three years***. Aim stocks have had an additional layer of problems from the uncertainty over the future of inheritance tax (IHT). IHT planning provides a significant chunk of the flows into the AIM market (possibly up to a quarter^) and investors have been concerned about plans to scrap it.

However, valuations at the micro-cap end of the market look even cheaper than for small-caps, and therefore the sector may bounce back more quickly if there is a rally. History suggests small caps can move quite fast when sentiment turns, and micro-caps in particular. This last happened in the year to March 2021, when the FTSE AIM All-Share was up 77%, around 10% ahead of the broader UK Smaller Companies sector average^^.

Guy Feld, manager of IFSL Marlborough UK Micro-Cap Growth sounds an optimistic note: “While uncertainty remains, many portfolio companies across a range of industries have issued positive trading updates since the start of 2024 and share prices have risen in response: we are hopeful that strong fundamentals will be rewarded once again.” He believes that looser financial conditions, plus a soft landing, could bode well for equities, particularly small and mid-sized companies.

Recent performance from UK smaller companies suggests momentum could re-emerge in the sector. Corporate activity, such as M&A and buybacks, appear to be helping push share prices higher. The question is whether this momentum will become self-sustaining, as investors are persuaded to take another look. With valuations so depressed, the bounce back could be significant if it comes.

Research Elite Rated UK Smaller Companies

*Source: Artemis, 15 March 2024

**Source: Morningstar, 26 April 2024

***Source: FE Analytics, 29 April 2024

****Source: Peel Hunt, March 2024

^Source: Professional Paraplanner, 20 November 2023

^^Source: Liontrust, 15 April 2024