Is it (finally) time for UK smaller companies?

Predicting a turnaround in small-caps has become like predicting a victory for the UK in a major football tournament. Tantalisingly close, but no cigar. However, with a rate cut from the Bank of England, improved sentiment towards the UK and greater strength in the UK economy, it seems like the UK small-cap market may finally be on the cusp of a revival.

The challenges and realities

It’s been a tough period for the sector. Sentiment has been hit hard by rising interest rates and smaller companies have been the fall guy for a general disillusionment with the UK market. The sector is almost half the size it was in May 2021*, performance has been poor, and investors have found little reason to reinvest. Earlier this year, broker Peel Hunt issued a dire warning that the UK small-cap market was on track to extinction.

The reality for many smaller-cap companies was never as bad as this grim picture suggested. In reality, many smaller companies were only lightly affected by rate rises, operating in strong niches little affected by the broader economic environment. Equally, there are around 1,300 listed companies below £1 billion on the UK market**. If a fund manager didn’t like what they saw, they could simply avoid them.

The long-term arguments for smaller company investment have not changed. Since 1955, smaller companies have outperformed their larger peers by 2.9% per year, and delivered around 400x their initial investment after inflation***. They are also an important part of the UK economy, creating skilled jobs, tax revenues and economic growth.

Eustace Santa Barbara, manager of the IFSL Marlborough UK Micro Cap Growth fund, says: “The UK’s smaller companies are often at the forefront of long-term structural growth trends, where technology and other forms of innovation are at the heart of powerful waves of change. We believe that well-managed companies benefitting from these trends have the potential for strong growth over the long term. In our top-ten holdings, we have a number of companies in the vanguard of rapidly evolving new industries underpinned by structural growth trends.”

The Marlborough fund includes an international data business that helps leading global brands understand consumer trends likely to shape their markets over the next 10 or 20 years. It also holds a global cybersecurity business that is playing an increasingly important role in helping companies such as banks and power grid operators protect their services against cyber threats, plus a mobile payments processor helping tech giants including Amazon, Netflix and Spotify grow their businesses by enabling customers to pay for services via their mobile phones****.

Improving market conditions

However, these companies had been largely overlooked by investors. Yet the tide finally seems to be turning. Performance has picked up since the start of the year. The FTSE Small Cap index is up 5.9% for the year to date^.

This is encouraging, but there is still a sense that this performance has been shallow, driven mostly by merger and acquisition activity and buybacks, rather than mounting enthusiasm for the asset class. The real challenge for UK small-caps is to build some self-sustaining momentum, led by improving inflows.

Natalie Bell, a member of the Liontrust Economic Advantage team, which runs the Liontrust UK Micro Cap and UK Smaller Companies funds, believes a number of stars are aligning: “A stable government, interest rates falling, inflation stabilising and growth returning. This, coupled with likely policy intervention, should help turn the tide following decades of outflows. We hope the next government recognises the opportunity to promote economic growth and domestic prosperity via a thriving stock market sooner rather than later.”

The macroeconomic backdrop is improving. Sentiment around smaller companies should benefit from the cut in interest rates. Equally, there should be some boost to economic growth, as mortgage costs fall and consumer confidence improves. UK consumer confidence hit a two-year high in May as wage increases and a stable employment market provided support.

There are tentative signs that outflows are easing. This is particularly evident in the mid-cap sector, which has started to see positive inflows over the past three months^^. Where the FTSE 250 leads, the small-cap market will usually follow.

Natalie says valuations remain compelling: “Valuations of UK-listed companies remain substantially lower than their long-run average and their global peers.” This is echoed by Eustace: “In our view, there is a significant disconnect between valuations and company fundamentals. Many high-quality smaller companies are trading strongly and expect to continue to increase their profits during the year ahead. Earnings per share for the AIM All-Share index are forecast to grow by more than 12% over 12 months, according to data from broker Peel Hunt. Despite this robust trading performance, valuations are languishing at lows seen only once in the past decade, which was in the depths of the COVID-19 pandemic.”

Opportunities and risks

When smaller companies bounce, they bounce quickly. Thin trading volumes tend to exaggerate moves in both directions. When the market begins to rise, share prices can increase sharply as buyers chase a limited amount of shares. As such, this could be a moment to re-examine the sector.

It is worth noting that there are shades of small-cap investment. There are funds that target the smallest, highest-growth business, including IFSL Marlborough UK Micro Cap Growth and Liontrust UK Micro Cap. These have been the most beaten-up in the recent rout, and therefore may benefit most from the recovery, but are higher risk. More conventional options would include Unicorn UK Smaller Companies and WS Amati UK Listed Smaller Companies.

The Amati fund has a more technology flavour, and includes Gamma Communications, Qinetiq and Accesso Technology group^^^. Unicorn is well-balanced across sectors, and its top holdings include engineering group Goodwin, and construction group Severfield^^^.

It’s not the first time the bell has been rung on a small-company revival. However, the rate cut, the improvement in the economy and a revival in sentiment are helping build momentum for the sector. It could be a moment to give it another look.

*Source: The Investment Association, May 2021

**Source: Investors’ Chronicle, 10 June 2024

***Source: Deutsche Numis, 2024

****Source: Marlborough Group, 20 June 2024

^Source: FE Analytics, 29 December 2023 to 5 August 2024

^^Source: Bloomberg, 21 June 2024

^^^Source: fund factsheet, July 2024