What next for UK smaller companies?

That statistic is put into context by the fact that over the past 10 years the UK Smaller Companies sector has comfortably outperformed relative to its multi-cap equivalent.

In normal times, small-cap companies should have a stronger growth trajectory than large-cap equivalents, and so the small-cap index should beat the large-cap index, even if the former is more volatile as it is more sensitive to the wider economic climate.

Specifically in the UK context, smaller companies are more likely to be exposed to the UK domestic economy, whereas companies in the FTSE 100 derive about 80 per cent of their earnings from overseas. 

Darius McDermott, managing director at Chelsea Financial Services, says the present underperformance is quite unusual. 

He says: “We like small caps because over any meaningful time period, except for right now, they outperform relative to large caps. And that is true for most parts of the world, the one exception being the US where the big tech companies ensure large caps outperform over longer time periods."

The valuations at which companies are trading, relative to the valuations at which they are being acquired, is quite a compelling opportunity.James Sullivan, Tyndall

In addition, the decline in the value of sterling relative to the dollar also means US private equity funds can buy the UK companies for fewer dollars than before, effectively providing what McDermott calls a “double discount” for buyers. 

The counter to that is higher interest rates may restrict the capacity of private equity firms to borrow to fund purchases. Also, as interest rates rise, investing in companies that pay no or little dividend becomes relatively less attractive as investors can access a ready yield from bonds or other equities. 

Additionally, smaller companies are more likely to need to access cash to expand and the cost of that cash, if borrowed, has risen sharply in recent weeks and months as interest rates have risen. This may hinder the growth potential of those companies, if they are unable to access the capital they need to grow. 

Remaining popular

With economic uncertainty rife in the UK right now, that should imply advisers and their clients stay away from small and mid-cap funds in the UK. 

Yet amid all of that discord no one seems to have told private equity firms and other global investors, who have been lining up to bid for and buy UK-listed mid and small-cap companies. 

History tells us this is exactly the time to be brave, but it may be a little early since we have not yet seen real earnings downgrades.Simon King, Vermeer Partners

Pendragon and Aveva, listed companies in very different sectors (car sales versus computer software) have attracted bids over the past 10 days, at stoutly higher prices than they were at on the stock market.

James Sullivan, head of partnerships at Tyndall, says: “What we are seeing is UK mid and small-caps trading at multiples of seven of eight times earnings on the stock market, which is very cheap by historical standards, but then being bought and taken private by private equity or other buyers at multiples that can sometimes be twice that level.

"Although mid and small caps are more exposed to the UK economy, the fact good companies are being bought like this shows there are opportunities in the mid and small-cap area.

"Of course the economic outlook is uncertain, so it is important that investors are very selective. But the valuations at which companies are trading, relative to the valuations at which they are being acquired, is quite a compelling opportunity right now.” 

Despite his keenness on the sector as a whole, McDermott is not looking to increase his exposure to UK smaller companies right now, as a result of the prevailing economic climate.

But it may be a question of timing, according to Simon King, chief investment officer at Vermeer Partners, a wealth management firm.

He says that while the sector looks cheap, it may be that the easiest money has already been made.

King says: “The main issues are that international investors have no interest since they think UK economy is going to hell in a handbasket and the record outflows from unit trusts are making the specialist funds forced sellers to meet redemptions with private clients not interested in taking up the slack.

"History tells us this is exactly the time to be brave, but it may be a little early since we have not yet seen real earnings downgrades. Once they get into full flow then there will be some seriously attractive opportunities. Every small-cap broker in town is running their takeover screens, but a lot of the obvious targets have already gone.”

UK mid caps tend to be more sensitive to the domestic economy than large caps.Ben Seager-Scott, Evelyn Partners

This could have the long-term impact of meaning the better quality UK small and mid-cap shares leave the UK market and only poorer quality assets remain, making investing in small and mid-cap funds relatively less attractive in future. 

Another investor cautious on the outlook for UK smaller companies is Ben Seager-Scott, head of multi-asset funds at Evelyn Partners, who takes the view that, given the prevailing level of economic uncertainty, it may be too early to decide that the market is cheap.

Seager Scott says: “In aggregate, UK mid caps tend to be more sensitive to the domestic economy than large caps, which are generally more globally exposed, and with the deteriorating outlook for the UK economy they have understandably been coming under pressure.

"Of course there is a clearing price for everything and at some point there will likely be attractive entry points – I’m not sure we’re quite there yet, but as always broad sell-offs can create specific opportunities for discerning investors.”

McDermott says one advantage of investing in UK mid or small-cap funds is that they generally tend to outperform relative to the index, “meaning an investor can find genuine alpha in the sector”.

David Thorpe is special projects editor of FTAdviser