While UK equity funds have generally been out of favour in recent years, the past nine months has seen a rally in UK mid and smaller company stocks.
Since October 2023, which Jonathan Brown, smaller companies fund manager at Invesco, says he regards as the “bottom” of the market, the UK mid-cap index has risen by 30 per cent and the small-cap index by 26 per cent.
Since the start of 2024, the FTSE All Share is up 7 per cent, but Victoria Stevens of the Liontrust Economic Advantage team, which runs both small and all-company mandates, says the data indicates small caps still “stand out” in terms of being cheap, and trade at a 31 per cent discount to the intrinsic value of the companies.
This compares with an 18 per cent discount for the FTSE 100, while US smaller companies trade at a 20 per cent premium.
Brown says he is in no doubt that a change in “sentiment” is responsible. “Last October we started to get better inflation data and that started the market thinking about rate cuts and that set the market off. We initially got exposure to this by increasing the level of gearing on our investment trust and running a very low cash level within our open-ended fund.”
Peter Dalgliesh is chief investment officer at Parmenion, and he began adding to UK and US smaller company funds at the end of the first quarter of this year, a move he says he made on “the back of historically cheap valuations, light ownership with investors herded into mega caps, and a belief that lower rates would lead to a narrowing of the underperformance as any softening of global growth would be modest and short lived.
“Arguably we were a little early, but the arguments remain valid in our opinion, and having come through a reasonable period of elevated rates, those small caps that have demonstrated resilient earnings growth are well placed to capture the recovery as and when global growth improves”.
Simon King, chief investment officer at Vermeer Partners, says: “We increased our exposure to UK small cap about six months ago when valuations had reached another new low. General UK pickup and new government have improved backdrop since then so despite the rally we think there is still further to go.”
Darius McDermott, managing director at Chelsea Financial Services, says: “We are firm believers in the long-term outperformance of small caps.
“As we all know that has not been the right call in developed markets over the past three or so years. The valuation opportunity is clear, they are cheap on a PE basis versus their long-term history and they are also cheap versus large cap.
“I am pleased to see the beginning of recovery and interest in the asset class. We have been adding to small cap via funds like Chelverton UK Equity Growth and Montanaro UK Smaller Companies Investment Trust (when the discount widens).”
What is next?
In terms of where the next stage of the rally could come from, Gervais Williams, a veteran UK smaller companies fund manager at Premier Miton, says the market rally in the UK and US has been driven by investors’ preference for mega caps, “but it is noticeable that more recently as the US big tech stocks have fallen in value, US smaller companies have performed better, implying those are inversely correlated”.
And as those companies produce profit warnings, he says investors will focus more on businesses that are profitable today, rather than businesses that will be profitable in the future.
Stuart Widdowson, who runs the Odyssean Investment Trust, which focuses on smaller companies, says the movements of the small-cap markets in recent years has largely been driven by outflows, with the assets in open-ended small cap funds dropping by about a third in three years, creating “forced sellers” in the market.
He says is also of the view that the tide may be turning in this regard, with some family office-type investors increasing their allocations.
Widdowson says institutional buyers have yet to increase their allocation to UK smaller companies and this is where he feels the next leg of growth can come from.
One area where he is finding particular value is industrials. He says many companies have had very low earnings in recent years and seen their share prices suffer accordingly, but he says earnings are starting to recover, even from a very low level, and so the market will start to push up the share prices of companies in that sector.
Widdowson added that while money has started to return to the smaller-companies sector, the market for initial public offerings has remained in the doldrums, meaning any flows will largely come into the companies already listed.
Invesco’s Brown is also keen on this part of the market. His rationale is that demand for industrial goods crashed after the pandemic, as many businesses had built up excess inventory during or immediately thereafter, particularly as a feature of economies since the pandemic has been consumers focusing on services, rather than goods.
But Brown says this is changing, with inventories having returned to more normal levels, implying that restocking, and therefore a pick up in demand for industrial goods, is imminent.
Ben Yearsley is an investment consultant at Fairview. He says he has been “structurally” overweight smaller companies as he believes those have the capacity to grow faster. He tends to have UK, global and US allocations.
Yearsley says he focuses on growth, rather than value funds, in the smaller companies space.
Georgina Brittain, who runs the JPMorgan UK Smaller Companies Growth and Income Investment Trust, says smaller company investing is typically associated with growth companies, namely businesses that would be expected to generate the bulk of their revenue in the future, rather than in the present.
But Brittain says valuations of smaller companies have been so low in recent times that many have started to screen well as value stocks – that is the earnings they are achieving today are not being reflected in the share prices.