Jeff Prestridge: time to own UK stocks that are stars of the future

It’s been a tough time for investors in UK smaller companies, but our columnist believes the good times will roll again. Here’s the argument in favour of buying this unloved sector while it’s cheap.

If I had another 30 years of my working life left, I would love to be a fund manager specialising in smaller companies. Probably a UK-focused investor, but I would be happy with a global remit. Although it’s never going to happen - I’m what people refer to as too long in the tooth these days to enjoy another profession (and yes, journalism IS a profession) - being a UK smaller companies expert seems to embody all that is good about active investment management. Identifying nuggets before anyone else.

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Of course, I’m not talking about those managers who trawl the unlisted universe (something that Neil Woodford attempted and failed somewhat spectacularly). That’s an altogether different skill set requiring great patience and big involvement in the companies you take a stake in. Few possess it (one of the best is Tim Levene at investment trust Augmentum Fintech).

I’m on about those investment managers who trawl the lower reaches of the UK stock market in search of companies that are going to be the stars of the future. Businesses off the radar of most investment analysts and fund managers. Under-researched, sometimes under-valued.

As a sector, UK smaller companies funds have had a wretched time as of late. While the FTSE 100 has raced to new Everest-like heights, smaller companies have been seriously off colour.

Why? It’s because many investors (both private and institutional) believe the risk-reward ratio has swung heavily towards risk. As a result, they’re shunning the sector. Why take a proverbial punt on UK smaller companies when you can invest in the FTSE 100 awash with financials (that love higher interest rates) and energy companies (that quite like an energy crisis).

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Investment trade association, the Investment Association, said net flows out of UK smaller company funds in 2022 reached a record level – higher than in both 2007 and 2008 when the global financial crisis raged.

Unlike the FTSE 100, UK smaller companies are also more domestically than internationally orientated. The threat of a recession this year and into 2024 doesn’t provide a great backdrop.

Nor do double-digit inflation and interest rates that have jumped from 0.1% in December 2021 to their present level of 4%.

The performance numbers are dreadful. The FTSE Small-Cap Index is down 7.3% over the past year, comparing unfavourably with both the FTSE 100 and FTSE All-Share, which are both in positive territory. The average UK smaller companies fund is down 15.1% over the same period, while the average stock market listed investment trust has registered losses of 11.6%.  

A rather awful backdrop. Yet speaking to a number of UK smaller companies managers over the past few weeks, I get the sense that the market has overreacted. The gloom has been overdone. Valuations across the UK smaller companies universe have fallen further than they should have. Good - as well as average - UK smaller companies have been marked down in price, even though their businesses remain robust.

Investment house Montanaro likes smaller companies. It says good years tend to follow bad years for the sector. So, for example, the Numis Smaller Companies Index fell by 40% in 2008. It then bounced back by 78% over the next three years. Similarly, the 23% fall in the index in 1990, triggered by recession, was followed by three good years, generating overall returns of 85%.

It believes a similar bounce is possible over the next three years, especially as company valuations look increasingly attractive. Dan Green, co-manager of FTF Martin Currie UK Smaller Companies fund, agrees. I had a long chat with him at the start of this month and his view (in his words) was as follows: “Yes, corporate earnings will come down as the economy toys with recession, but they won’t reduce by as much as some fear. As managers, we believe some company valuations are now so low that they represent attractive buying opportunities.” Bold words.

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Even bolder is asset manager Crux. Late last year, it launched the TM CRUX UK Smaller Companies fund with manager Richard Penny proclaiming that the best time to invest is when desperation - rather than optimism - holds forth. It was very much in line with one of Warren Buffett’s most famous savings: “The best chance to deploy capital is when things are going down.”

So far, so good. Although still very early days, Penny’s fund (a minnow at £5 million) is already up 25%.

Nothing is guaranteed when it comes to investing. But on a five-year view, I think UK smaller companies could well deliver in proverbial spades. But maybe, a drip-drip approach is the best way forward, investing on a monthly basis.

I’m off to find the elixir of life so that I can follow in Mr Penny’s footsteps!

Jeff Prestridge is a freelance contributor and not a direct employee of interactive investor.