Why now is the time to stock up on UK small caps

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Why now is the time to stock up on UK small caps
(Leungchopan/Envato Elements)
ByKen Wotton and Tom Makey

Few years have posed so many challenges to UK equity investors as 2022.

An onslaught of headwinds – including elevated inflation, rising interest rates, political uncertainty, the surging cost of living, and a looming recession – has left British businesses badly out of favour in recent months.

With the UK economy not forecast to grow materially over the next year, the outlook for British companies remains murky as we enter 2023.

However, we believe there is strong cause for optimism.

The ongoing turbulence is offering up a number of compelling opportunities for entrepreneurial British businesses.

Companies displaying strong growth momentum in the public and private equity arenas are now trading at highly attractive valuations.

Many smaller companies possess the agility and resilience to excel amid an extended economic downturn.

Similar to 2009-10, we believe with the benefit of hindsight investors will look back and see the present period as optimal for capturing long-term shareholder value growth. 

Given their focus on early-stage innovators, venture capital trusts are in prime position to capitalise on this.

We are confident the investments we are making now will prove to be prescient in five years’ time.

As an illustration of what could occur, earlier this year we exited our stake in Nottingham-based compliance software leader Ideagen, in which we had invested in 2012.

Over this time, the business grew its revenue from £4mn to more than £90mn, while earnings before interest, taxes, depreciation, and amortisation (Ebitda) grew from breakeven to more than £30mn. As a result, we were able to generate an exceptional 13.5x return.

Bargain British innovation

The economic and fiscal uncertainty currently playing out in Britain has resulted in de-ratings of UK companies across the size range, with a pronounced impact at the smaller end.

However, the early-stage enterprises targeted by VCTs are often naturally better equipped to weather market turbulence, and we believe this poses an attractive entry point for investors.

Many smaller companies possess the agility and resilience to excel amid an extended economic downturn, relative to their larger peers, which are slower moving and often financially leveraged.

In addition, larger firms commonly operate across several market sectors, which leaves them more exposed to macroeconomic risk.

The threat posed by cyber attacks has increased dramatically, and implementing robust defences has risen to the top of the agenda.

Meanwhile, companies operating in structurally growing sectors are more inclined to display enduring growth fundamentals.

One business we recently invested in is London-based IT security specialist Crossword Cybersecurity.