Fund Spotlight: are UK smaller companies back on road to riches?

It has been a difficult few years for investors in UK smaller companies. Returns from this sector have lagged their global counterparts, prolonging the poor sentiment around UK equities. A recent uptick in performance suggests the tide may be turning for this unloved area of the market.

For those who are bullish on the outlook for the UK, WS Amati UK Listed Smaller Companies,one of ii's Super 60 funds, is one which you may wish to consider. The fund aims to achieve long-term capital growth through investing in a well-diversified portfolio of UK smaller companies.

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The fund is managed by Paul Jourdan, a highly experienced and long-tenured manager, with an excellent track record who co-founded Amati Global Investors in 2010. He is supported by co-managers David Stevenson and Scott McKenzie, with all significant investment decisions taken as a team. The portfolio managers are supported by analyst Gareth Blades, whose background in life sciences further strengthens the overall level of resource.

In addition to this strategy, the team manages an AIM Venture Capital Trust. The Alternative Investment Market (AIM)is a sub-market of the London Stock Exchange that is designed to help smaller companies access capital from the public market. Management’s knowledge of this part of the market provides a valuable source of added knowledge for this smaller companies strategy.

After a long period of underperformance from UK smaller companies there are now a combination of factors pointing to a recovery in the UK market, which can benefit this fund.

First, from a valuation perspective, UK assets appear undervalued globally. The FTSE All-Share index currently trades on a price/earnings (PE) ratio of 12.2 times, with the MSCI World Index trading at 19 times. In addition, small-caps are on a material discount to mid and large-caps. This is reflected in the valuation of the Amati fund, which has a PE ratio of 13.5 times down from a peak of 25.4 times in September 2021. This offers a highly attractive entry point for investors.

In recent times there has been a significant pick-up in takeover activity in the UK market. In 2024 so far, five companies in the fund have received takeover approaches. This is more takeover activity than any of the five previous years and we are only halfway through the year.

Share buybacks have also been a key feature in the UK market this year. The fund’s top two holdings - QinetiQ Group (LSE:QQ.)(3.8%) and Alpha Group International (LSE:ALPH) (3.4%) - both announced share buyback programmes in January of £100 million and £20 million respectively. The demand for UK stocks from corporates and private equity companies proves the attractive valuations on offer in the UK, and this is a trend likely to continue and boost returns for shareholders.

In the UK, consumer confidence is improving and inflation is moderating, reaching the Bank of England’s 2% target for the first time in three years in May. With rate cuts now on the horizon this year, this is likely to give smaller companies a boost, as this part of the market tends to outperform in this environment.

A final catalyst to drive the recovery further would be a return of domestic investor demand, a lack of which remains a headwind for UK equity funds.

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What does the fund invest in?

The managers employ a predominantly fundamental, bottom-up approach (analysing individual companies) and seeks businesses that can grow faster than the broader economy over the longer term. These are typically companies demonstrating strong barriers to entry, competitive advantage, strong pricing power and sustainable growth. The trio also take account of the underlying macro-economic conditions and industry trends.

The fund currently holds 59 stocks, down from 80 in 2021 as management have actively tightened the focus of the fund. The resulting portfolio now has an increased exposure to financials (25.1%), consumer discretionary (15.3%) and industrials (18.9%). These are all cyclical sectors whose share prices tend to be correlated with the wider market and could benefit from an economic recovery in the UK. The fund retains a bias to growth and quality companies and is geared towards a positive market environment.

Liquidity is treated as a distinct category of risk and the managers seek to diversify the portfolio by market cap to maintain sufficient liquidity in the event of a market downturn. The illiquid part of the portfolio, which is defined as companies with a market cap of sub £250 million, remains small at 12.5%, and current exposure to the AIM market is 45% which has remained constant over the past year. All new investment ideas for the fund sit in the sweet spot identified by management of between £250 million and £1 billion in market cap.The portfolio currently has a weighted average market cap of £793 million.

With UK equities trading at low valuations relative to history, management has been busy adding quality businesses to the portfolio. One example is Keywords Studios (LSE:KWS) a British technology company which was initially invested in via the Amati VCT. The holding was purchased after a significant derating on artificial intelligence (AI) gaming concerns, and management believe the stock has strong recovery potential. Another recent addition to the portfolio is Brooks Macdonald (LSE:BRK). The investment management firm has made solid progress in a challenging market for wealth managers and has the potential to be involved in industry consolidation.

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How has the fund performed?

Jourdan and the team have built a very strong long-term track record. Over a 10-year period the annualised return of the fund is 8.5%, comfortably outperforming both its benchmark and category average which returned 4.6% and 6.3% respectively. Over the past few years, however, UK smaller companies have been out of favour and, as a result, this strategy has suffered. 2022 was a particularly bad year for the fund during which it underperformed its sector peers.

Management have addressed the underperformance by reducing the number of holdings in the fund, and took a decision at the end of 2023 to increase the funds beta (a measure of sensitivity relative to the market) to capture the upside in this sector. These changes have contributed to the turnaround in performance. Year-to-date the fund is up 12.4%, outpacing its Numis Smaller Companies plus AIM ex IT benchmark which is up 7.6%, and there is still ground to be made up.

Source: Morningstar Direct Total Return (GBP) as at 31 March 2024.  Past performance is not a guide to future performance.

Why do we recommend this fund?

The Amati UK Smaller Companies Fund is included in the ii Super 60 list of high-conviction investment ideas as a UK Equities, small companies recommendation. The fund provides exposure to quality growth opportunities from the UK market selected by Amati's highly experienced team of managers. Due to the fund's unconstrained, concentrated nature and heavy exposure to AIM stocks, its return profile is likely to be more volatile, making it a riskier, more adventurous option and better suited as a satellite holding in a well-diversified portfolio.

Overall, Jourdan’s lengthy tenure provides stability and continuity for investors, and he is well-supported. The key differentiator and potential source of added value of this process over small-cap peers is the focus and expertise in the smaller end of the AIM market.

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