UK Small and Mid Cap Stocks: 'Boring' But Outperforming

VIDEO: Michael Born, research analyst at Morningstar, says falling inflation and lower valuation may be turning in favour of UK smaller companies

Christopher Johnson 18 April, 2024 | 11:07AM
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Christopher Johnson: Welcome to Morningstar. Today I'm joined in the studio by our own Michael Born, research analyst at Morningstar.

Michael, thank you so much for being here with me.

Michael Born: Thanks, Chris.

Johnson: So today we're here to talk about UK equities. So, I wanted to get your perspective on why you're so excited about them, by them at the moment.

Born: Yeah, sure. So, I mean, I think – and specifically I think I'm talking really about mid and small caps – but the first thing I'd point to really is the valuation. If you compare these industries versus their global comparators like the MSCI World, you're seeing like 20-year lows. Now, I mean, at least when we're talking about the large cap FTSE 100 stocks, this is maybe a comparison that's of limited use because the sector composition is so different. But we'll say that when you look down into the mid and small caps, there's much more comparable sector dynamics.

I mean, valuation in and of itself is rarely kind of a performance driver, particularly over the short term. So, the three things which I guess I'd really point to as being this time it's different would be firstly bids. So, you see some kind of excitement and activity into those mid cap names. Particularly for just UK, you saw Direct Line and Currys, they both got bids last month and then DS Smith, we've just seen the kind of conclusion of bidding war there. So, if you can't get – realize that value in the public markets, then we might see private markets step in.

The second thing I would point to is the economics. So, inflation is really coming down and then, life for the consumer is getting better. Particularly, when we look at UK mid-caps, they're very consumer focused. So, it should be maybe a real performance driver. And then the third thing I'd point to was earnings. So, we've started seeing, particularly into U.K. mid-caps, they've actually been outperforming their large cap peers in terms of their earnings, which just hasn't been reflected in the valuation.

Johnson: Are there any specific sectors that you're finding most interesting within the UK small cap space?

Born: Looking at where managers are really allocating to, it's maybe in "more boring" kind of industries. So, I think, you're seeing like airlines, pub chains, retailers like Dunelm and DFS, they're well represented amongst that peer group. And the message there that I think managers are really finding is like they're good businesses, but the valuation is great. So, with those kind of catalysts in mind to see a re-rating, you could see some dynamic performance over the coming period.

Johnson: So, which Morningstar rated funds do you like the most that are taking advantage of cheap UK stocks?

Born: We rate both two Scottish funds, Abrdn and Martin Currie, who both run UK small and UK mid cap funds, run by the same team. They're both kind of quality growth style funds and really got smashed when you had that turn in the narrative over 2022. I would also highlight Artemis UK Smaller which is more of like a core valuation-centric approach and yeah, I guess offers more exposure to value in UK small caps.

Johnson: UK fund managers always talk up the cheapness of UK stocks with the expectation that valuations and market sentiment will catch up to one another. But this is still yet to be seen. So, is this a likelihood in the near future or is it just a distant dream?

Born: Pointing to those factors that I mentioned right at the beginning, so economics, the earnings and so forth, are definitely a real upside. Well, it may have been pushed back a bit, but when the Fed starts to cut, the way that I guess developed markets' central banks have really just been following the Fed over this cycle, we would expect that to continue. So, when they do start to cut rates over this year, which is really I guess consensus, that could be a real catalyst. I would also say seeing some sort of reversal in the flow situation because it's been a horrible time to be UK equity manager. If you look at large caps, it's been monthly outflows since Brexit, and even the last few years for being a mid or a small cap manager, you're just seeing continuous outflows. And then also there's a bit of a chicken and egg story there with benchmark allocations because, well, looking 20 years ago at MSCI World, it was 11% into the UK; now that number is less than 4%.

Johnson: You mentioned boring industries. And I was reading an interesting story about how the FTSE 100's glamorous members, so companies like Compass and Bunzl way outperformed household names like Barclays and Tesco over the last two decades. So, is this more reason for investors to focus on UK small caps and do you think the key to maybe boosting listings on the London Stock Exchange is in smaller companies in the more boring industries rather than in sexier stocks like Arm, for instance?

Born: Sure. Well, I think the first thing I'd say is that the key there is to stop companies leaving. It's not to get more to come and list. But certainly, as I mentioned, if you look at those takeover bids that we saw, they're not for your Silicon Valley high-growth style startup sort of businesses. It really is those lower-growth businesses, but the value is undeniable. So, yeah, I think we might be seeing some of the boring stocks doing the heavy lifting.

Johnson: Michael, thank you so much for being here with me.

Born: Thanks, Chris.

Johnson: This is Christopher Johnson for Morningstar UK.


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Christopher Johnson  is data journalist at Morningstar

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