Small-cap investors can find opportunities in the current difficulty

English theologian Thomas Fuller was the first to coin the phrase “it’s always darkest before dawn”, while German philosopher, poet and composer Friedrich Nietzsche is associated with the phrase “that which does not kill us makes us stronger”.

Then there is Winston Churchill, one of the greatest leaders and orators Great Britain has ever produced. One of his more tongue-in-cheek maxims was “KBO” or “keep buggering on” – a rallying cry he used at the start of each day and at the end of every telephone conversation.

It seemed to do the trick in the end, with Churchill being voted the greatest Briton, principally for his efforts and leadership during the second world war.

“Keep buggering on” seems a particularly apt instruction for all investors today, as rising rates to meet stubbornly high inflation have fuelled the threat of recession. But spare a thought for those investors in UK smaller companies, they have had Brexit, Covid-19, political turmoil and war to contend with over the past seven years, and have always seemed to be in the eye of the storm.

Showing resilience

Resilience is the word that comes to mind when I think of UK smaller companies. Battered, bruised, beaten – they always seem to pass the test with flying colours, but the past 18 months have been particularly unkind.

Rising interest rates made it more expensive for smaller companies to borrow to finance their growth, while higher volatility raised liquidity concerns. This has been compounded by slowing forecasts and the threat of recession damaging investor sentiment, as did a weaker pound, which hits domestically focused companies extremely hard.

In that time, the average loss for a fund in the Investment Association’s UK Smaller Companies sector is almost 30 per cent, compared with a rise of 8 per cent for the more internationally focused FTSE 100. Meanwhile, figures from the IA show the UK small-cap sector has seen almost £1.3bn of outflows from retail investors.

Resilience is the word that comes to mind when I think of UK smaller companies. Battered, bruised, beaten – they always seem to pass the test with flying colours, but the past 18 months have been particularly unkind

In times of trouble and uncertainty, people continue to look to the words of Churchill for inspiration and guidance – so I have nicked a couple that indicate why investors should not rule out UK small caps in the current climate.

The first is: “The pessimist sees difficulty in every opportunity. The optimist sees opportunity in every difficulty.” Simply put, the outlook for UK small caps is brightening.

This is highlighted by a recent report by Marlborough Fund Managers, which shows the FTSE SmallCap Index (ex Investment Trusts) has begun to outperform the FTSE 100 and the FTSE 250 over the past six months, returning 4.5 per cent – versus 3 per cent and 1.1 per cent for the FTSE 100 and 250, respectively.

Marlborough chief investment officer Sheldon MacDonald says his team believes interest rates are approaching their peak and, with market volatility falling to pre-pandemic levels, the UK has so far managed to avoid recession and the pound has been strengthening against the dollar.

Liontrust UK Micro Cap co-manager Matt Tonge says if there is evidence that inflation is being tamed faster than anticipated, it is likely that investor sentiment towards smaller companies will improve.

He says: “We had a taste of this effect when the consumer price index data released on 19 July showed an unexpected slowdown to 7.9 per cent inflation. UK equities rallied sharply, with mid and small caps outperforming large caps.”

Merger and acquisition activity is typically the great signal for valuing UK equities, and we have seen a consistent flow of it throughout 2023 – not least the recent acquisition of Gresham House. There has also been signs the initial public offering drought could be coming to an end, with a growing number of companies making enquiries in the past month or so.

TM Tellworth UK Smaller Companies co-manager Paul Marriage also says companies coming out with stronger results are starting to be rewarded, rather than being held back by poor sentiment.

Valuations offer compelling opportunity

The final point is valuations, which look incredibly attractive at these levels. Price-to-earnings multiples for the Numis Smaller Companies Index (ex investment companies) more than halved between 2022 and the start of 2023 – from 17 to eight. This is a level last seen on the back of the global financial crisis in 2009.

Marriage says: “We’ve seen companies trade through interest rate rises, wage increases and supply chain discomfort, and are now on the other side of that. Most people are facing an end market which is challenging, but not a disaster, whereas the valuations suggest that it is terminal for a lot companies.”

As Churchill once said: “The farther backward you look, the farther forward you can see”, and figures from Marlborough show that when the FTSE SmallCap (ex IT) Index has fallen substantially further (more than 22 per cent from a two-year high point) than the FTSE 100 – which it has on four occasions since 1988 – it has usually outperformed the blue-chip index over the next 24 months, returning 42 per cent (versus 27 per cent for the FTSE 100).

Most people are facing an end market which is challenging, but not a disaster, whereas the valuations suggest that it is terminal for a lot companies Paul Marriage, Tellworth Investments

This happened twice in the 1990s, in 2009 and most recently in November 2022.

Clearly, there are still dangers, with further volatility and liquidity both a concern. But there are a number of tailwinds favouring the small-cap sector – not to mention the potential for Mansion House plans to reinvigorate the UK as a destination for growth company investment.

Investors should be mindful of missing the first phase of the recovery, which can be damaging longer term. Figures from the Numis Smaller Companies ex IT Index show that if you had stayed fully invested since 1991, you would have garnered a 600 per cent returns from the sector, this falls to 435 per cent if you exclude the five best discrete monthly returns.

Could the stars be aligning for those willing to be patient with the UK’s burgeoning businesses?

Funds to consider

Liontrust UK Smaller Companies

This fund has a very clearly defined investment process, based on intangible strengths. Every stock in the portfolio must have intellectual property, a strong distribution network or recurring revenues. Managers Anthony Cross and Julian Fosh also prefer to invest in stocks where management has a significant personal equity stake. The fund is multi-cap and has an overweight to mid and small-cap stocks. 

TB Amati UK Listed Smaller Companies

This fund is managed by a highly experienced quintet of small-cap specialists. The portfolio of 65 to 70 companies focuses on structural growth businesses, which the managers believe can add value in the under-researched small and mid-cap part of the market.

IFSL Marlborough Special Situations

Manager Eustace Santa Barbara looks to build a well-diversified portfolio of 150 stocks to minimise risk. Relatively small positions are taken initially, with winners run aggressively as their story unfolds. The fund has evolved as it has grown over the years, and now invests in small and medium-sized companies. Long-term performance has been exceptional.

Darius McDermott is managing director at Chelsea Financial Services and FundCalibre