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Fund Review: Small-cap sector bears brunt of Brexit vote

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Fund Review: UK Smaller Companies

Fund Review: Small-cap sector bears brunt of Brexit vote

The EU referendum in June shocked many, with the UK equity market, and in particular the smaller end of the spectrum, taking the brunt of the hit.

Data from FE Analytics shows that in the week following the Brexit vote – June 23-30 – while the FTSE 100 index bounced to show a modest rise of 2.7 per cent, the FTSE Small Cap (ex IT) index fell 5.8 per cent in sterling terms in the period and the FTSE 250 declined 6.1 per cent.

That said, all three indices have made gains year to date, though the gap between the FTSE 100’s increase of 11.1 per cent and the FTSE 250 index’s smaller rise of 1.5 per cent shows small caps have had more of a struggle. 

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With the triggering of Article 50 remaining uncertain thanks to the recent court judgment and consequent appeal by the government, this sector of the market looks set to continue to face strong headwinds. 

Financial author Jon Beckett points out both small-cap and Aim-listed UK companies face a difficult period ahead. He cites factors including “Brexit uncertainty, typically an over-reliance on UK consumers, the drying [up] of surplus capital for early cycle investment or predatory venture capitalists sniffing an Aim bargain or two on the back of a weakening pound”.

Mr Beckett says: “The valuation case remains attractive, so long as you perhaps avoid the more expensive [FTSE] 250 part of the market. For those still wanting to allocate into UK firms beneath the FTSE, then an active strategy at the right price makes sense. This is especially so among micro-cap names, which often trade in pennies, have longer return on capital horizons and carry the highest risk of failure. Open-ended funds therefore still have a role to play.”

The macroeconomic picture appears to be weighing on investors’ minds in this space, with the latest figures from the Investment Association showing September was the fourth consecutive month for net retail outflows from the UK Smaller Companies sector. 

Dan Harlow, manager on the Axa Framlington UK Smaller Companies fund, notes the UK is an economy that has “displayed anaemic growth for a number of years, and with the full consequences of the Brexit vote still unclear, there appears little chance that it will accelerate in the near to medium term”. 

But he suggests robust economic growth is not necessarily a prerequisite for small-cap investments to deliver positive returns. Instead he argues: “Identifying young firms with excellent product or service offerings and management gives good scope for them to grow through the economic cycle. The organic growth opportunities they have, whether it be from taking share from unfocused big companies, or from benefiting from taking their skill set or product to global markets, means that with solid execution they can still deliver growth. 

“With Brexit-related uncertainty mounting, there is a likelihood this thesis will be tested. We see economic headwinds growing. The collapse of sterling will present challenges for firms heavily exposed to importing products, whether those are components or resale products.”