Britain’s army of small, listed businesses are facing a litany of headwinds that have hit valuations. But while some have come crashing down, others have weathered the storm and are preparing to stage a comeback.
From poor investor liquidity over the past two years, to present profits under pressure from rising interest rates, weakening consumer demand and UK political instability, British small caps have suffered a lot of late.
Cyclicals hardest hit
More cyclical sectors with the highest exposure to the UK economy have been hit hardest during this period, especially those where sharp increases in interest rates have had an immediate impact.
Scott McKenzie, co-manager of the TB Amati UK Listed Smaller Companies fund, invests in companies with low debt and high and sustainable profit margins – businesses that have weathered these storms well.
But in certain sectors earnings have been particularly affected, “include housebuilding, construction, and real estate, while other consumer-led sectors such as travel, leisure and retail have also seen pressures to varying degrees," notes McKenzie.
Investor sentiment towards the UK tech sector, where valuations have fallen materially from elevated levels, has also changed.
“Many of the more speculative or early-stage tech businesses have come crashing down to earth dramatically, with profit disappointments leading to a material fall in share prices,” McKenzie says.
Have we reached a turning point?
According to the latest data from the British Chambers of Commerce, the higher cost of borrowing is hurting almost half of small firms in the country, after 14 consecutive rate rises by the Bank of England.
However, on September 21 the BoE decided to hold interest rates at 5.25 per cent. This could mark an important turning point for sentiment in UK equities in general, as investors and businesses should now have some clarity on future funding costs.
From this point on, Alex Game, co-manager of the Unicorn UK Smaller Companies fund, says, on an operating basis, many companies appear in good health, delivering growth in revenues and profits, with forward earnings growth for the Numis Smaller Companies Index currently at around 10 per cent.
“Clearly there is a degree of short-term economic uncertainty, but what is seemingly being overlooked are the structural growth drivers that many smaller companies are aligned with that will continue to support long-term investment returns,” Game says.
Drivers like sitting on cash in the bank. Liontrust has two funds exposed to smaller British companies, its UK Micro Cap and UK Smaller Companies funds.
Natalie Bell, manager on the Liontrust Economic Advantage team, says 72 per cent of companies in the UK Smaller Companies fund are in a position of net cash.
This is “not only a safety net for these companies, but now an asset earning a return in its own right”, because of higher interest rates, she points out. Examples of companies that have particularly benefited from this, she says, are financial firms like Alpha Group.
Even weakness in the consumer discretionary sector is not total, Bell points out. In the wake of the pandemic, the UK consumer may shun discretionary purchases on products, but appear more willing to spend on ‘experiences’ like holidays and leisure activities.
"What is really clear is, overall, the aggressive de-rating of UK listed smaller companies has been far in excess of any reported weakness in trading," says Bell.
"This has been painful for market participants to endure since the beginning of 2022 but has undoubtedly meant there is currently a wealth of opportunities for investors in the asset class."
Taking advantage of low valuations
The fund manager has been active at topping up existing holdings “beaten up” from a valuation perspective and has taken the opportunity to add new holdings at attractive long-term entry points.
Eustace Santa Barbara, co-manager of the IFSL Marlborough UK Micro-Cap Growth fund, has also been deploying cash to add to existing positions in companies he says look significantly undervalued – and strongly positioned to bounce back when the economic backdrop and investor sentiment improve.
“What the sell-off has done is create what we believe is a very attractive valuation opportunity,” Santa Barbara says. “We believe the case for well-managed, high-quality UK small caps, and their ability to outperform slower moving corporate giants over the long term, remains as strong as ever.”
There is currently a wealth of opportunities for investors in the asset class.Natalie Bell, LiontrustFor example, he has been increasing his investment in Volex, which supplies specialist cabling used in charging points for electric vehicles, healthcare facilities and data centres, in addition to providing power cords for consumer electronics.
Volex recently reported solid full-year results, with strong revenue growth and higher profit margins, and Santa Barbara says it has “outstanding” long-term growth prospects.
And even currently stressed companies could be coming out through the other side, and bringing with them attractive opportunities for UK small-cap investors.
Unicorn’s Game certainly sees it that way: “As inflation continues to moderate and the hiking cycle comes to an end, the sectors that have been hit especially hard, like construction and building materials, which are close to trough earnings and valuations, should perform particularly well in the early stages of a market recovery,” he says.
With the recent easing in headline and core inflation, the decision by the BoE to pause the rate hiking cycle at the September committee meeting, and upwards revisions to GDP that suggests the economy is performing better than expected, we could finally have a near-term catalyst for improved investor returns for UK small caps.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre
