Investment Week considers - UK smaller companies remain an 'uncomfortable trade'
Author James Baxter-Derrington reported that Brexit, the pandemic and a looming recession have not helped the UK's smaller companies
UK smaller companies may be cheaper than they have been in two decades, but investors continue to be wary of a domestic market still suffering from Brexit and the pandemic, along with a recession on the horizon. While the FTSE 100 enjoyed escaping 2022 as one of the few indices in the green, returning 4.7% to investors, the mid-cap FTSE 250 lost 17.4% over the period and the AIM dropped 30.7%, according to data from FE fundinfo.
The combination of international firms, mega-cap companies and oil and gas giants pushed the UK's blue chip index somewhat skyward, but the overhang of the past decade did not benefit the UK's smaller companies. Investor forum warns of UK equities' 'diminished importance'
Fahad Hassan, CIO of Albemarle Street Partners, explained:
"The last decade has seen the UK economy buffeted by the aftershocks of Brexit, a global pandemic and severe labour shortages. Last year, domestically focused businesses, such as retailers and leisure companies saw a decline in consumer spending while energy and labour costs skyrocketed.
"UK smaller companies faced a perfect storm of challenges that pressured margins and caused a severe fall in share prices."
Hassan also noted that UK mid-caps trade on just 0.8 times their book values, the lowest multiple in 20 years, which may well offer "extraordinary value", but does not necessarily spell a goldmine. "I believe the real challenge to small-cap UK plc was caused by the unique combination of Brexit and the pandemic," he said. "Small businesses, unlike larger companies, cannot rely on oligopolistic pricing and must right-size their businesses."
Hassan also explained that there was some positive news, with "pricing, wage and input cost pressures" starting to subside. But a recession is still on the horizon, if not already with us, and while the survivors are likely to benefit on the other side, investors must be wary to avoid the losers.
Head of partnerships at Tyndall Investment Management James Sullivan also noted the UK Small Cap index ex-investment trusts currently trades at just over one times book value, representing a "very attractive valuation opportunity".
"It may not always be a comfortable trade, but the best ones often are not."
For investors eager to dip their toes into UK smaller companies, co-manager of Marlborough UK Micro-Cap Growth Eustace Santa Barbara recommended a player likely to benefit from the world's ever-growing population.
"We have been adding to our holding in Agronomics, which is an AIM-listed company that invests in businesses in the field of cellular agriculture," he said.
"This includes what is often known as 'lab-grown meat' - where scientists grow meat using cells taken from a sample of animal tissue."
He added that the process had "huge potential advantages", such as using half the energy of conventional food production methods, while using "a fraction" of the land and water and 95% less greenhouse gases.
Buy small caps for the recession? Yes, really
However, he has been reducing the fund's exposure to the industrial sector, as PMI data continue to fall across Western nations.
"While there are many high-quality UK companies in the industrial sector, we believe current valuations offer little scope for upside if the current environment persists," he said. Rob Morgan, chief investment analyst at Charles Stanley, recommended FTF Martin Currie UK Smaller Companies as a "strong option" for investors seeking a fund that pays attention to fundamentals and introduces proprietary research.
"It is pragmatically managed with an emphasis on quality, has a concentrated portfolio and is stylistically closer to neutral than many peers with a good balance of exposures from growth-orientated businesses to potentially under-appreciated value names."
For investors seeking a trust angle, his choice was BlackRock UK Smaller Companies, which is "built of companies with good management, strong market positions, sound balance sheets and a demonstrable ability to convert earnings into cash".
"In other words, it steers away from highly cyclical, excessively leveraged, or blue-sky companies.
"A diverse portfolio of around 100 holdings reduces stock-specific risk and the investment trust structure allows the managers to safely explore the relative minnows of the universe.
"Shares presently trade at a 13% discount to NAV, potentially offering additional value should this narrow as and when prevailing sentiment improves."