Funds and trusts to play a smaller companies’ comeback

Those with exposure to UK smaller companies have lately seen their patience sorely tested. While they know that small is often beautiful, the experience of the past two years has been painfully ugly.

The figures speak for themselves. Over the past 12 months, the FTSE 100 is flat, including dividends, while the FTSE Small Cap has dropped 6%. Looking only at 2023, small-cap stocks are down almost 2% while large-caps are just about positive.  

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This isn’t the way it is supposed to work. The allure of smaller companies is that they have the agility to exploit opportunities more quickly than their larger counterparts – and, simply, more headroom to grow. Investors are getting in at the start of the growth story, rather than once the good times have passed. Outsized returns should, in theory, follow.

Such arguments have often paid off in the past. Going back to 1955, smaller companies have outperformed in two out of every three years – and never lost money on a seven-year time frame. Small-cap shares in the UK have outperformed large-caps by an average of around four percentage points a year.

However, that potential comes with a downside. “Smaller companies will see greater volatility of returns and a higher level of risk,” warns Alex Watts, an investment data analyst at interactive investor.

Indeed. Since 2000, UK smaller companies have delivered annual gains of more than 10% on no fewer than 12 occasions. But they’ve also lost more than 10% in six separate years.

The current malaise in the small-cap sector is largely about confidence. When the economic backdrop is challenging, investors naturally become more cautious; they pull money out of assets perceived as riskier. They are particularly likely to steer clear of smaller companies – these are businesses that tend to be more consumer-focused and domestically biased, leaving them more exposed to a downturn or outright recession in the UK.

What could spark a rebound?

So far, so bad, but are there reasons to be optimistic? The short answer is yes, says Robin West, who runs the Invesco Perpetual UK Smaller Companies (LSE:IPU) Investment Trust, who points to at least three potential catalysts for sentiment to quickly turn.

The first is economic. There’s no doubt that the recent underperformance of small-caps reflects the widespread expectation that the UK is headed for recession – not least as the Bank of England tightens monetary policy to deal with runaway inflation. But it’s possible that investors have overdone the gloom.

For one thing, the relative underperformance of small-caps versus large-caps was larger last year than in the first year of every previous recession in the past 50 years. according to analysis from fund manager Artemis. For another, there is a growing feeling that expectations of recession are too pessimistic – corporate earnings and consumer spending have proved remarkably resilient so far this year.

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In that case, July’s 6.8% inflation print could be a turning point, down from 7.9% in June. As a result, economists now expect the Bank of England to slow its trajectory of interest rate increases. Bond markets are now pricing in a peak of 6% for the UK base rate – above today’s level of 5.25% but down on the previously anticipated high of 6.25%.

The second potential driver of a return to favour for smaller companies is a surge in mergers and acquisitions (M&A) activity.

Mark Niznik, co-manager of the Artemis UK Smaller Companies fund, says since the start of last year “we’ve had nine formal takeover offers for stocks in our portfolio and typically at a premium of between 30% and 50% to the listed valuation”.

He says this is a “clear signal that UK small-caps are at bargain basement prices and there are genuine bargains to be found”.  

Indeed, that idea is reflected in the third argument for taking an interest in UK smaller companies right now – the fact that valuations in this part of the market look unusually cheap by historical comparisons.

Recent research by the investment trust team at analyst Quoted Data points out: “The MSCI UK Small Cap Growth Index is trading on a price to book ratio of 2.5 times’ currently, more than one standard deviation below that of its post-global financial crisis average, and a valuation opportunity seen once in a decade.

“Even more striking is the earnings potential of the UK small-cap sector, as its forward price-to-earnings ratio recently went two standard deviations below its long-term average; even though the index has begun to recover, the valuation opportunity is still one that we have only seen during the most aggressive sell-offs of the past two decades, during Covid-19 and the financial crisis.”

Smaller companies shares and funds to look at

None of this is to call the absolute bottom of the market – catalysts and turning points are far easier to identify in hindsight. But Niznik, for one, is confident a turnaround is on the way. “When sentiment is sufficiently negative – as we believe is the case now – a catalyst is not required for a substantial recovery to take hold,” he says.

In which case, investors need to think carefully about how to exploit the opportunity. One important point to make is that small-cap investment requires a more active approach – this is one part of the market where a rising tide doesn’t necessarily float all boats. “It is an area that many investors may wish to access through a skilled and experienced active manager with time-tested processes,” says interactive investor’s Watts.

Watts’ own picks for funds offering exposure to UK smaller companies include Diverse Income Trust (LSE:DIVI) – currently overweight to smaller companies but with the freedom to invest more widely – run by seasoned small-cap investors Gervais Williams and Martin Turner.  “A valuation-conscious approach leaves the portfolio looking relatively inexpensive compared with the already inexpensive index,” Watts argues.

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He also likes Henderson Smaller Companies (LSE:HSL) investment trust. “A high sector concentration towards industrials and consumer discretionary stocks, with a notable level of gearing, make this trust an option for investors with sufficient risk appetite and a long-term investment horizon,” Watts explains.

As for fund managers themselves, they see a variety of opportunities in the current environment. “Regardless of where in the world you live, if you look at your options on equity markets, you’d look at the Alternative Investment Market [the junior market of the London Stock Exchange] and say that’s where some of the best opportunities lie today,” argues James Henderson, co-manager of the multi-cap Henderson Opportunities (LSE:HOT) Trust and Lowland (LSE:LWI) Investment Company.

On a sector basis, Henderson picks out two areas of interest. “One growth sector we like is alternative energy – the heatwave in Europe is a sign that climate change is at a critical point, and we look at hydrogen-based technology businesses ITM Power (LSE:ITM) and Ceres Power (LSE:CWR) and see they are making real progress in an area of serious growth,” he explains.

“We also like fintech – a company such as mobile payments business Boku (LSE:BOKU) is not affected by interest rates, but when rates fall risk appetite rises and at that point I think investors will revisit its share price,” Henderson adds.

At Artemis UK Smaller Companies, Niznik points to valuation opportunities in consumer discretionary stocks. “Examples include Moonpig (LSE:MOON), the market leader in online greeting cards, DFS Furniture (LSE:DFS), the market leader in sofas, Dunelm Group (LSE:DNLM), the market leader in soft furnishings, and Halfords (LSE:HFD), the market leader in car servicing,” he says. “We believe all these businesses have the balance sheets to withstand a tougher backdrop in the short term should it materialise.”

Other portfolio holdings include H&T Group (LSE:HAT), the UK’s largest pawnbroker. “It’s providing an important service at a time when competitors like payday and home-collected credit lenders have fallen away,” Niznik says. He also singles out the telecoms business Gamma Communications (LSE:GAMA).

“It’s got a strong customer ethos and innovation, which has driven strong organic growth,” Niznik says. “The business is a clear market leader in the niches in which it operates and that has generated strong double-digit increases in earnings per share over all but one year in the past decade.”