Top UK funds and shares the pros are backing as the market rebounds

British stocks are among the top-performing globally this year, with the FTSE All-Share index returning 7% so far (to 14 June), including dividends.

This is ahead of Japanese and European shares, measured in pounds, but behind the 14% gain of the S&P 500 index.

Over three years, the UK market is also ahead of European and Japanese rivals, driven in part by strong dividend yields and cheap valuations beginning to tempt back buyers.

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But just looking at index returns hides a number of interesting investment stories currently playing out.

Smaller companies lead the way

The first is that smaller companies are performing best. In fact, the Investment Association’s UK Smaller Companies sector has risen 9.4% this year, compared with a 6.5% gain for both the UK All Companies and UK Equity Incomes sectors.

Smaller companies are cheap by historic standards and actually trade at a discount to larger companies. This is unusual as investors normally have to pay a premium for smaller firms as their growth potential is greater.

For example, the MSCI United Kingdom Small Cap Index has a price-to-earnings (p/e) ratio of 13.69 times, which compares with a p/e of 14.13 time for the FTSE 100, according to BlackRock’s iShares passive investment arm.

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So far in 2024, to 14 June 2024, the top smaller companies funds are Schroder UK Smaller Companies (16.9% return), Marlborough Nano-Cap Growth(12.75% return), Unicorn UK Smaller Companies (12.2% return) and Marlborough UK Micro-Cap Growth (12.1% return).

But Abby Glennie, manager of abrdn UK Smaller Companies fund (up 7% this year), says that over the long term, smaller companies have a well-established track record of outperforming their larger-cap peers.

“While it is impossible to pin down the exact reasons behind this ‘small cap effect’, there are a number of likely explanations. Smaller companies tend to be more adaptable and less bureaucratic and are therefore able to react faster to changes in the business environment. They can exploit emerging opportunities quickly, unencumbered by legacy systems and processes,” she said.

Specific to the UK, Glennie says there could be a significant relief rally ahead if there are signs of life in the UK economy.

She says: “We see signs of data tentatively improving, with the UK economy returning to growth after a short-lived recession and Purchasing Managers’ Index (PMI) data – a forward-looking measure of economic confidence – improving. Sentiment may benefit from a range of government initiatives announced in the recent Budget to improve participation in UK equity markets.”

The top fund invests more broadly

However, the top UK fund overall this year is JOHCM UK Growth, a £200 million strategy that invests in companies of all sizes.

It has risen 20%, spurred higher by bets on AstraZeneca, Rolls-Royce and Funding Circle Holdings. The latter, an online lending platform, has more than doubled this year.

Other funds doing well and not investing only in smaller companies are Unicorn UK Growth (up 15.8%), Ninety One UK Special Situations (15.6%) and Chelverton UK Equity Growth (14.2% up).

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Shares they strongly back include Natwest, Associated British Foods, British American Tobacco, Gamma Communications and Premier Foods.

Investors are broadly optimistic about the future of UK shares. Mark Costar and Vishal Bhatia, fund managers of JOHCM UK Growth, say that while the narrative of economic troubles is becoming increasingly loud due to patches of slowing economic growth and persistently stubborn inflation readings, the outlook for UK companies is positive.

They say: “Notably, capital raisings have re-appeared with a vengeance with National Grid’s substantial rights issue, the biggest in the market since 2008, funding its monster £32 billion capital expenditure plan for the electricity backbone.

“Meanwhile, on a smaller scale but no less interesting, there was a similarly proactive deal from Great Portland Estates (LSE:GPE) to fund asset purchases at what they believe is the bottom of the cycle.”

Their view is that given the above and the still-large valuation gap with international firms, UK shares will keep going higher.

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The fund managers add: “This was further bolstered by tentative early evidence of things broadening out, with the first month of meaningful outperformance of small and mid-cap assets for a considerable period, alongside volumes and block placings picking up, the IPO market beginning to stir and international enquiries continuing to build. These are all classic bull-market indicators and should hopefully portend a strong period of returns ahead.”

Costar and Bhatia are very excited about top 10 stock BT, which recently jumped 17% in one day due to strong results and is up 10% in total this year.

They say that while BT’s results were in line with expectations, the increased confidence in the high-speed fibre roll-out and next-generation network potential was underpinned with a huge cash-flow upgrade.

“Our confidence has increased as a result and our position size has done likewise,” Costar and Bhatia concluded.