The outlook for the UK equity market feels gloomier than ever. Headlines about rising core inflation, mortgage rates, government borrowing costs, and predicted interest rates reinforce the message that much more pain will be inflicted on British companies and consumers over the next year or two.

The oil majors and miners that were propelling the market higher are being undermined by falling commodity prices. The banks are simultaneously berated for profiteering and sold off on fears that bad debts will impact on their earnings. The overwhelming pessimism is particularly evident in the valuations of small and medium-sized companies.

Often, in these situations it can be helpful to go looking for the counter argument. Fortunately, I recently got the chance to catch up with Gervais Williams to talk about Miton UK MicroCap (MINI ), which finds itself in the eye of the storm.

MINI was launched in April 2015. It focuses on UK companies with market valuations of £150m or less at the point of investment. Institutional investors, the big wealth managers and overseas investors rarely venture into this territory, which is largely the domain of the private investor. Decent investment research is hard to come by and so mispricing is more likely. Williams and co-manager Martin Turner believe that diversification is important in this part of the market and hence the investment trust is managed with well over 100 holdings.

With a market capitalisation of just £52m, you might expect that MINI would be overlooked too. However, it is used as a subcontractor by some larger investors. They can feel comfortable about making an investment in the trust because it offers regular annual redemption opportunities to sell their shares at a price close to net asset value (NAV). This helps keep any discount in check.

Williams feels that the UK market has been the victim of a long-term vicious spiral. As economic conditions have been unfavourable to the UK, domestic investors saw more opportunity in international stocks, and the UK became a smaller part of global indices making it easier for overseas investors to ignore. He thinks that there has been a race to the exit.

Even as UK indices had a better time of it recently, domestic investors seem to be taking advantage of the opportunity to switch into bonds, cash or international stocks. Retail flows out of UK equity funds have been relentlessly negative since August 2021.

UK valuations are now well below international norms and small company valuations are even cheaper. The AIM All-Share index has only been lower in the wake of the collapse of the technology bubble in 2000, the depths of the 2008 financial crisis and during the brief Covid-panic of March 2020.

Williams is by no means looking at the economic outlook through rose-tinted spectacles. He points to past inflationary periods and sees the potential for a halving of companies’ profit margins over coming years, as was the case in the 1970s, for example.

However, remarkably, even against an awful economic backdrop, smaller companies outperformed medium and large caps by a wide margin over that decade. Perhaps this reflected a greater ability to reinvent themselves and adapt to market conditions than more cumbersome large companies. Gervais thinks that there is a relatively high proportion of growing companies exploiting structural growth trends within MINI’s universe, which might make them better able to thrive in an economic downturn.

With inflation proving hard to tame, quality – in balance sheet strength and pricing power, for example – is important. As interest rates rise and growth falters, stronger companies can take advantage of those in distress, capturing market share and buying businesses from the receivers.

In a higher interest rate environment, investors are drawn naturally to cash generative and dividend paying companies – hence the shift in sentiment from growth to value. This is good news for the more value-biased UK stock market – Williams thinks that overseas investors have picked up on this and are perhaps more positive on UK equities than domestic ones.

If, as Williams expects, domestic investors do begin to re-embrace the UK market, there will be a greater inclination to look to exploit the undervaluation of its smaller companies. As these start to outperform once again, he thinks we could see a switch to a virtuous circle as, fearful of missing out, investors start to close underweight exposure to this part of the market, reinforcing the trend of outperformance. He also thinks that this trend, once it gets going, might persist for many years.

James Carthew is head of research at QuotedData.

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