Better times ahead for UK plc?

Amid all the noise about the Chancellor’s tax proposals following this week’s Budget, you may have overlooked some of the economic news in his statement. The headline figures were better than expected – the Office of Budget Responsibility now expects inflation to drop below the target rate of 2% before the end of the year and predicts 0.8% economic growth for the UK in 2024. Both forecasts represent improvements compared to what the OBR said in the autumn.

How might investors respond to this more positive news? If you’re thinking about how to use your £20,000 individual savings account (ISA) allowance as the 2023-24 tax year draws to a close – or simply pondering your broader investment strategy – what might an improving UK economy draw you towards?

One answer is clearly going to be the UK stock market, which has chronically underperformed other international markets in recent years. But it’s important to recognise that most of the large companies listed on the UK market actually have very limited exposure to the fortunes (or otherwise) of the UK. FTSE 100 companies are almost all businesses with a global geographical footprint – their activities in the UK often only account for a small proportion of their revenues.

Instead, investors now feeling more bullish about the prospects for the UK should focus on funds with holdings in small and medium-sized companies if they’re looking for vehicles with the potential to deliver against such optimism. These businesses will typically offer a purer play on the UK economy.

It’s also worth noting that small and mid-cap stocks have underperformed their larger counterparts in recent times. The FTSE 100 Index is up by about 15% over the past years; the FTSE 250 and FTSE Small Cap indices, by contrast, fell by around 5% and 3% over the same period.

Companies in these benchmarks have been hit harder by UK problems such as rising interest rates and slower growth. Many are now trading on historically low valuations. So much so that they’re getting snapped up by buyers such as private equity funds, to the benefit of their shareholders. In the latest such deal, wealth management company Mattioli Woods this week agreed to be purchased for a sum valuing at 34% above its share price.

Investment trusts offer an enticing way to pursue this opportunity. For one thing, valuations of investment trusts with medium- and small-cap holdings have also been knocked by negative sentiment to this part of the market in recent time. Shares in Mercantile Investment Trust and Schroder UK Mid Cap Fund, both of which are focused on mid-cap stocks, currently trade at discounts of 12% and 15% respectively to the value of their assets. The average investment trust invested in UK smaller companies sits on a discount of 11%.

Another plus point is that the structure of investment trusts is well suited to this part of the market. Smaller companies, in particular, can be illiquid, with relatively few investors buying and selling at any one time. Investment trusts cope with illiquidity very well because they don’t need to trade their portfolios to respond to inflows and outflows of funds from investors.

It's also the case that many of the investment trusts specialising in small and mid-cap stocks have long-standing management teams with extensive expertise and experience. This is especially important given that coverage of many of these stocks by market analysts is much patchier than with the largest companies. Investors need old hands capable of spotting the diamonds in the rough.

None of which is to guarantee that small-cap and mid-cap stocks are set to soar in the months ahead. But it is noticeable that both have seen stronger performance in recent weeks; that recovery could accelerate over the rest of 2024 if the UK economy strengthens as the OBR now suggests it will. And there’s always the promise of M&A activity too.

In which case, investment trusts are a good starting point as you think about how to play this theme, whether inside or out of your ISA.