Partner Content by Royal London Asset Management

UK smaller companies – what’s next?

Henry Lowson, Head of UK Alpha Equities at Royal London Asset Management and Lead Fund Manager for the UK Smaller Companies and Mid Cap Growth Funds, reflects on 2021 and discusses the opportunities that lie ahead.

2021 saw UK Smaller Companies once again come out on top, ahead of their larger cap peers, with a return of over 30% - a stellar year by any standards and the second year in a row that this asset class has outperformed the larger FTSE All share. It is a shame many asset allocators have missed out on these returns, as UK Equities continue to experience outflows.

However, it was a year that despite the positive headline result was fraught with danger. The first quarter saw a violent style rotation and a lurch towards cyclical and value-oriented stocks (those with cheaper headline Price Earnings (PE) multiples) and away from more highly valued growth stocks. Domestic companies, recovering from the travails of Covid-19 induced lock downs also performed strongly as consumers started to spend some of their increased savings on home improvements and other big-ticket items. The following three quarters of the year saw another market style rotation as growth stocks started to reassert themselves again; earnings upgrades were delivered, capital investment was cranked up and monetary policy remained expansionary. Significant hurdles of cost inflation and supply chain disruption (respectively compressing margins and restricting revenue growth) had to be overcome, as companies struggled to cope with an acceleration in demand at a time when many economies were still flipping in and out of lockdown.

2022 has experienced a similar start so far but rather than chase style rotations or attempt to predict future macroeconomic events, we continue to believe that our time is best spent analysing the fundamentals of companies and it is these that assert themselves over our long-term investment horizon (3-5 years). This year, we are faced with the prospect of further elevated cost inflation, supply disruption (although improving) and higher discount rates, so the ability of companies to pass on higher costs and innovate will be critical to maintaining profit margins and growth. Companies that exhibit these fundamental attributes will be best placed to do this.

As we stare into the crystal ball that is 2022, ‘bears’ will point to higher discount rates as being the barrier to equity market performance (particularly for growth stocks) but there are plenty of examples of strong equity returns made in years when interest rates have risen (e.g 2017 and 2003-2006). All else being equal, rising interest rates often signal stronger economic growth, and UK GDP growth in 2022 is still expected to remain robust at over 4.5%. In fact, as we have alluded to previously, it is our belief that many small and mid-sized companies have, post pandemic, an opportunity to accelerate their growth.

Some commentators believe that valuations are currently elevated. However, the differential between the earnings yield, that can be achieved through investing in equities, and the yield on corporate debt, is almost as high as it has ever been (a bullish signal). Furthermore, profits growth could well surprise on the upside, as management teams have erred on the side of caution regarding guidance for 2022, despite a strong finish to 2021. We have lost count of the number of companies that in Q4 upgraded earnings guidance for 2021 but did not roll this higher base forward into 2022 earnings.