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

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.

The company is a managed services provider and software consultancy that supports clients in building robust cybersecurity systems spanning not only the core business but also its supply chains – a critical yet often overlooked area of vulnerability for many groups.

In the context of the Russia-Ukraine war and broader geopolitical tensions, the threat posed by cyber attacks has increased dramatically, and implementing robust defences has risen to the top of the agenda in many boardrooms.

As such, the space is underpinned by structural demand drivers, and Crossword Cybersecurity should achieve meaningful growth over the coming months and years.

Similar opportunities exist on the unquoted side of the UK equity market, where valuations have remained higher but still suffered over the past year.

In fact, investing across both public and private markets provides an added layer of diversification, with exposure to different cycles offering investors greater insulation against market volatility.

Sterling’s weakness relative to the US dollar during 2022 has exacerbated the discount for UK businesses on offer.

One unlisted business set for resilient long-term growth is Airfinity.

The company is a science information data analytics platform that connects and analyses disparate data sources to provide actionable insights on various therapeutic areas to the life science industry, governments and other corporations.

While there is an ongoing proliferation of vast datasets, these are being poorly accessed by the life sciences community.

Meanwhile, pharma companies increasingly require aggregated data to help predict commercial demand.

As such, the proposition Airfinity has developed is underpinned by long-term structural tailwinds, and the business can continue to expand across therapeutic areas while building defensibility through its proprietary data platform.

Deal flow due a bounce

Another key reason why now is particularly opportune to back earlier-stage British companies is the expected rebound in buyout activity set to occur in 2023.

While the heightened macroeconomic uncertainty and recent unrest in UK gilt markets resulted in some short-term discontinuity with regards to deal flow, with many companies seeing little reason to sell or raise external funds given depressed valuation levels, the tides may be turning.

If there is little change by the end of this first quarter, businesses will likely be forced to reconsider their need for liquidity and may be more open minded to considering a deal.

British businesses have perhaps never been as attractively priced to foreign investors as they are today.

In addition, sterling’s weakness relative to the US dollar during 2022 has exacerbated the discount for UK businesses on offer to overseas buyers and investors.

British businesses have perhaps never been as attractively priced to foreign investors as they are today. Unsurprisingly, we have already seen evidence of increased overseas investment in UK companies reflecting this.

The disconnect between public small-cap multiples and private equity transaction multiples should further drive deal flow, as private equity groups see the opportunity to take de-rated listed entities out and drive value creation.

Ken Wotton and Tom Makey are co-managers of the Baronsmead VCTs at Gresham House