Can UK Smaller Companies Get Back on Track?

Smaller companies are some of the most dynamic and high-growth of all UK stocks, but are currently out of favour with investors - along with the rest of the domestic market

James Gard 28 October, 2020 | 1:36PM
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Russian dolls, large to small

UK equities have been buffeted by the coronavirus crisis and Brexit this year, with fund flows suggesting that investors are shunning domestic funds in favour of bonds and other regions such as the US and Japan.

Dividend cuts have harmed the prospects of the large-caps – the FTSE 100 is off nearly 20% this year – but there has been no hiding place for faster-growing smaller companies either, with the Morningstar UK Small Cap index down more than 17%. Indeed, sentiment towards UK small-caps is so poor that the launch of the Buffettology Smaller Companies investment trust, which had been slated for this month, has been scrapped after it failed to attract enough money. 

Still, UK small-cap managers remain upbeat that the long-term outperformance of small-caps will prevail, and hope that a Covid-19 vaccine and/or Brexit breakthrough could draw investors back to the UK.

We spoke to two UK smaller companies’ managers, one running an investment trust and one running an open-ended fund, about how they are navigating the current hostile terrain and how they are positioning for an eventual recovery in the UK economy.

Growth vs Value

Building a small-cap portfolio is a delicate balancing act between sticking with tried-and-tested growth stocks and picking value and/or recovery plays, according to Dan Nickols, manager of the Gold-rated Merian UK Smaller Companies Fund. In the former category is Gamma Communications (GAMA); the third largest holding in the portfolio, it provides telecoms services to SMEs and its share price is up 50% in a year, reflecting the growing demand for remote working communications.

Other examples of higher growth holdings in the fund include specialist translation firm RWS (RWS) and technical software provider Aptitude (APTD). Nickols puts tool hire firm Speedy (SDY) in the value/recovery basket as it has benefited from the increasing spending on home maintenance and the swift resumption of homebuilding and other construction projects this year. 

One of the fund’s largest holdings is recently floated e-commerce firm The Hut Group (THG), which is the biggest IPO on the London market so far this year. Nickols thinks the company, which is also owned by Merian Chrysalis Investment Trust (MERI), is in the vanguard of UK e-commerce firm and its successful IPO (it floated at 500p and is now over 600p) lays down a marker for future floats in the sector. But investors need to be realistic about UK tech, he adds; perhaps we won’t have the next Amazon or Google but “we do have a whole raft of winners” in specific niches.

Sold-Off Stocks

Jonathan Brown, who manages the three-star rated Invesco Perpetual Smaller Companies Trust (IPU), is optimistic that the UK economy can bounce back next year assuming a working vaccine is introduced. He has a number of recovery plays in the portfolio, including pubs group Youngs (YNGN) and Mitchells & Butlers (MAB), with the view that the hospitality sector will eventually get back on its feet - and that the best capitalised firms in the sector can survive this crisis.

Brown also says that this year’s sell-off in the most affected sectors has thrown up opportunities for patient investors. One example of a cyclical company that has hit the buffers this year is gym operator Gym Group (GYM), whose shares are off 52% in 2020 (at the depth of the crisis they had fallen 75%). Brown likes the fact Gym Group is technology-led, keeps overheads as low as possible, and has managed to hold on to members in this crisis year.

Biden, Brexit and a Vaccine

Both managers are cautiously optimistic about the UK’s recovery prospects, while acknowledging that the current situation is very challenging. "If you look at the current moment in time, things look pretty grisly,” says Nickols, "[But] the stars are aligned for quite a nice story to develop from here”. He thinks a Biden US election victory in early November could kickstart global growth and help trigger a broader-based recovery in assets, bringing value stocks such as those found in the UK smaller cap space back into favour - or at least narrow the gap with soaraway growth stocks.

And AJ Bell analyst Laith Khalaf points out that the long-term performance of UK smaller companies is a compelling argument for sticking with them through this tough period: "Given the economic damage caused by Covid restrictions, it’s a time when investors might think big is better. But if you take a long term view and are willing to ride out turbulence, smaller companies can still deliver strong returns, given time."

And as our recent article shows, sticking with the FTSE 100 over 20 years would have be much less rewarding than focusing your attention on companies in the FTSE 250, which range from a tiny £19 million capitalisation to a more chunky £4 billion size.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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James Gard  is content editor for Morningstar.co.uk