The myths and misconceptions surrounding the UK’s smallest companies

At the risk of sounding like a broken record, Brexit negotiations are causing rather a lot of uncertainty. It’s therefore not surprising that some UK investors are opting to invest overseas instead, with emerging market and European equities comfortably returning more than double the FTSE All Share index over the last year*.

Where investors are sticking to the home market, they are tending to be favour funds with significant exposure to our much larger global-facing companies: some 75% of the FTSE 100’s revenues come from overseas.

This has meant that funds which invest further down the market spectrum have become somewhat unloved. This is despite the fact that, over the last year, the FTSE small and mid-cap indices have actually outperformed the FTSE 100 index**.

So will investors continue to miss out by tarring all UK small and mid-cap equity funds with the ‘Brexit fear’ brush?

Dispelling the myths

One of the biggest misconceptions about investing in smaller UK companies is that they’re domestic-facing, but this isn’t necessarily the case. For instance, 50% of our medium sized companies’ revenue exposure (those in the FTSE 250 index) comes from overseas. And it isn’t just mid-caps that are global-facing. Some of our smallest companies are too.

For example, Richard Hallett, who heads up the Elite Rated Marlborough UK Multi-Cap Growth fund, has a significant overweight to small and medium-sized companies in his fund. But this hasn’t meant the fund has been reliant on the UK economic growth cycle over the last five years. One global-facing smaller company he owns is gaming technology company Quixant, which is headquartered in Cambridge but has operations in Australia, Germany, Italy, Japan, the USA and Taiwan.

Another factor which can deter investors from investing in UK smaller companies funds is the fear that they are higher risk and illiquid. This can indeed be the case but, for investors with genuinely long-term time horizons, this shouldn’t present itself as much of an issue.

Investors should also look at their investments from a valuation risk perspective, as well as how well-known the company is. There are often more attractively-valued opportunities further down the cap spectrum because the companies remain undiscovered by the broader market.

Funds to consider

Funds such as the Elite Rated F&C UK Mid Cap, which is headed up by Thomas Wilson, combine finding both ‘sensible’ stocks with low debt levels and consistent track records with a focus on valuation, which means the portfolio should be less susceptible to unforeseen market shocks.

Other funds, such as the Elite Rated Neptune UK Mid Cap and LF Livingbridge UK Microcap funds, actually boast lower maximum drawdowns (which measures how much money a fund could have lost if bought and sold at the worst possible times) than the FTSE All Share index over the last five years***.

For investors who would like some exposure to UK smaller companies but aren’t willing to take the plunge into a small or micro-cap fund, offerings such as the Elite Rated AXA Framlington UK Select Opportunities fund will invest in large-caps but will use some small and mid-caps to generate returns above the benchmark.

Generally speaking, I think it would be a shame not to include UK smaller companies within a wider portfolio, regardless of ongoing Brexit negotiations. After all, UK small and mid-caps notoriously outperform their large-cap counterparts over the long term.

It is simply a case of remaining diversified, picking the right managers, and maintaining a long-term time horizon.

*Source: FE Analytics. Total returns in sterling for the MSCI Europe ex UK, MSCI Emerging Markets and FTSE All Share indices over one year, as at 1 March 2018.

**Source: FE Analytics. Total returns in sterling for the FTSE Small Cap, FTSE 250 and FTSE 100 indices over one year, as at 1 March 2018.

***Source: FE Analytics, five year numbers to 1 March 2018