UK smaller companies: “the prevailing, extremely negative positioning and sentiment only enhances the opportunity”

The AIC UK Smaller Companies sector has a history of strong performance following economic and market downturns.

For example, Lehman Brothers collapsed on 15 September 2008, triggering a sell-off and escalating the global financial crisis. However, an investment in the average UK Smaller Companies trust at the end of September 2008 would have delivered a return of 39% three years later and 134% in five years’ time. If you had held the average UK Smaller Companies trust from 30 September 2008 to now (21 September 2023), a period of nearly 15 years, you would have received a return of 316%.

With 26 investment companies to choose from, trading at an average discount of 12.4%, UK small caps could be well positioned to deliver for investors when market sentiment turns.

UK Smaller Companies: performance and discounts

Share price total returns (%) to 21/09/23

Source: theaic.co.uk / Morningstar

To discuss the challenges and opportunities in the UK Smaller Companies sector, a media webinar was held today by the Association of Investment Companies (AIC) featuring George Ensor, Portfolio Manager of River and Mercantile UK Micro Cap, Ken Wotton, Portfolio Manager of Strategic Equity Capital and Amanda Yeaman, Co-Manager of abrdn UK Smaller Companies Growth.

What are the opportunities and challenges of investing in UK smaller companies in an economic downturn? How are you navigating these?

Ken Wotton, Portfolio Manager of Strategic Equity Capital, said: “Investing in smaller UK companies during an economic downturn presents challenges due to the uncertain operating environment those companies face. However, challenging economic times are when the best businesses and best management teams can use agility and effective execution to take market share and create the platform for long-term future growth. This means investments made in the current environment have the potential to be long-term winners and drive very attractive long-term investment returns.”

George Ensor, Portfolio Manager of River and Mercantile UK Micro Cap, said: “Following 24 consecutive months of outflows from open-ended UK small-cap funds, the key challenge is the current investor aversion to illiquidity. Whilst our closed-ended structure protects us from having to fund any redemptions, our investments are significantly impacted by this backdrop. The usual waterfall of capital that prevails in an environment of normal risk sentiment drives mid-cap funds to seek alpha in small caps and small-cap funds to seek additional returns in micro-cap opportunities. This process – which has supported our strong long-term returns – has worked in reverse over the last two years, impacting performance significantly in 2022.

“This backdrop – one where UK small caps are trading at a significantly lower relative valuation to the wider UK market than they did in the financial crisis – creates a phenomenal investment opportunity for the next three to five years. UK smaller companies gained 500% – an annualised return of 15% – from March 2009 to September 2021, doubling the total return of the wider UK market. The prevailing, extremely negative positioning and sentiment only enhances the current opportunity.”

Amanda Yeaman, Co-Manager of abrdn UK Smaller Companies Growth, said: “Sticking to a process allows us to remain focused on selecting companies that we believe will be winners over the long term. Recently, markets have been top-down driven and share prices haven’t been driven by fundamentals, which means good underlying performance hasn’t been rewarded. This has been frustrating to see for our companies that are fundamentally doing well. Having said that, the macro environment is improving and the fixation with inflation in the UK is already declining. This is good news for our holdings as it allows smaller companies to shine based on fundamentals, with positive earnings momentum becoming more important as a driver of share prices.”

How is your portfolio of UK smaller companies faring in the current challenging economic conditions?

George Ensor, Portfolio Manager of River and Mercantile UK Micro Cap, said: “UK smaller companies have experienced net downgrades this year, albeit not the big earnings recession that many had expected. Downgrades have been particularly prevalent in the more interest rate sensitive sectors – real estate, housebuilding, consumer discretionary – and debt-funded companies which have experienced a rapid increase in their cost of finance. Earnings in energy, healthcare, financials and tech have held up better and, with the exception of energy, we are overweight these sectors. Portfolio earnings have outperformed the market over the last 12 months.

“However, given our strategy to exploit valuation inefficiencies and growth opportunities in micro caps, the challenge we have had over the last couple of years has been a massive de-rating of our portfolio company earnings. We have experienced de-ratings in excess of 60% of the peak valuation multiples from 2021. The rapid increase in interest rate expectations – which likely peaked in July with the market pricing rates going as high as 6.5% – has been the key driver of this and the subsequent improvement in the core rate of inflation should support equities from here.”

Amanda Yeaman, Co-Manager of abrdn UK Smaller Companies Growth, said: “We employ a distinct investment process based around ‘quality, growth and momentum’. We stick to this process in all macro environments as it has been proven to deliver strong returns over the long term. The quality characteristics of the companies we hold have helped them navigate the challenging backdrop well, delivering resilient earnings and dividends. However, our style of investing (quality, growth and momentum) has been out of favour in recent times and so share price performance has been more challenging. We believe that the companies we hold can ride out challenging times, often emerging stronger as a result of these conditions.”

Ken Wotton, Portfolio Manager of Strategic Equity Capital, said: “Our process focuses on finding less cyclical and more financially resilient businesses that can grow and deliver our target returns even if the wider economy remains challenging. We are conscious of the enhanced risks in the current environment and are relentlessly focused on assessing the underlying fundamental risks facing our portfolio companies and how they are addressing and mitigating these. Overall, we therefore feel comfortable with our portfolio despite the difficult backdrop.”

Could the discount on your company represent a long-term buying opportunity and why?

Amanda Yeaman, Co-Manager of abrdn UK Smaller Companies Growth, said: “It has been a difficult period and we have seen discounts widen across the sector – this has been the biggest de-rating we have seen for many years. However, this does provide a good opportunity to invest at discounted prices. The board has been proactive, and we have bought back 11% of the issued share capital since the start of 2022 which has stabilised the discount. To close it further we really need sentiment towards the UK to turn and for flows to follow. The valuation anomaly that surrounds the UK market in part reflects the misplaced belief that the UK is both a growth and inflation outlier relative to the rest of the continent and the long-term equity outflow picture, which is mainly caused by UK pensions reallocation over the last two decades to gilts.

“The growth narrative shifted on a quiet Friday at the end of the summer holidays with the ONS raising 2020 and 2021 growth by 1.7%, bringing the UK’s post pandemic growth back into the pack and above Germany. Whilst the inflation picture has continued to evolve through the summer, the most recent inflation print was the biggest undershoot in inflation expectations since the cost-of-living crisis began.

“We have learned to expect the unexpected in recent years, but the future certainly looks better than the past for the UK smaller growth companies. While markets have been volatile for a long time now, they will recover, and we believe that patient investors will be well positioned to reap the rewards. The trust owns some fabulous companies which have been delivering and valuations look very attractive. Current discount levels are an attractive opportunity for long-term investors who may benefit from the double whammy of NAV improvement and a narrowing of the discount when sentiment improves.”

George Ensor, Portfolio Manager of River and Mercantile UK Micro Cap, said: “Our investment strategy is focused on exploiting investment opportunities with a market capitalisation of less than £100m. We look to own these companies as they grow and benefit from their re-rating as their liquidity and investment appeal to the broader institutional investment community improves.

“This strategy has delivered excellent long-term performance, but it is an approach that is dependent on the outperformance of smaller companies, something that we have not seen in the UK for over two years. To manage our capacity, we have returned excess capital to shareholders when our net assets have exceeded our target capacity of around £100m. We have returned £77m over the last six years, meaning we’ve returned more capital than we raised at IPO (£70m). Given both our track record of returning capital – when performance has allowed for it – and the exceptional current value on offer within the portfolio, a discount of 18% seems an unjustifiable double discount and an excellent buying opportunity.”

Ken Wotton, Portfolio Manager of Strategic Equity Capital, said: “We have a high conviction portfolio of high quality smaller-cap companies where we believe there are clear catalysts for value creation and where we can support these with our active engagement strategy. The significant valuation gap between private market transaction multiples and the valuations of similar companies within our portfolios gives us a high degree of confidence in the value upside potential from the portfolio. The share price discount to NAV also offers a further potential boost to returns.”

What is your ESG strategy?

George Ensor, Portfolio Manager of River and Mercantile UK Micro Cap, said: “Sustainability analysis is integrated into our fundamental research process which means we look to evaluate all material stakeholder opportunities and risks when we consider an investment. We believe that a sustainable business is one that compounds value for all stakeholders over the long term.

“Kooth – one of our largest holdings – has a material positive social impact as a near nationwide provider of free digital mental health services for children and young people in the UK. Mental health is a growing issue in many countries and there are clear long-term benefits to both health and healthcare funding from early and cost-effective (digital) intervention. The company, which is already the clear market leader in the UK, has recently won the state of California and is currently in a pilot for the state of Pennsylvania.”

Ken Wotton, Portfolio Manager of Strategic Equity Capital (SEC), said: “At Gresham House we have a well embedded ESG and sustainable investment process with our ESG decision tool providing a consistent framework to assess ESG risks and opportunities. Although SEC is not explicitly seeking to be a sustainable or impact fund we believe the underlying portfolio companies are mitigating ESG risks effectively and in some cases are beneficiaries of these long-term trends. Inspired is an energy consultancy focused on assisting corporates to manage and reduce their energy consumption as well as providing support in ESG data gathering and reporting. Ricardo is a leading global environmental consultancy with particular focus on advising governments and corporates on the sustainability of infrastructure investments and the drive to electrification.”

Amanda Yeaman, Co-Manager of abrdn UK Smaller Companies Growth, said: “ESG is integral as part of the ‘quality’ screen in our investment process, and we evaluate ESG aspects we consider to be relevant for our holdings. We routinely conduct ESG specific meetings in addition to our regular company meetings.”

- ENDS -

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Notes to editors

1. The Association of Investment Companies (AIC) was founded in 1932 to represent the interests of the investment trust industry – the oldest form of collective investment. Today, the AIC represents a broad range of closed-ended investment companies, incorporating investment trusts and other closed-ended investment companies and VCTs. The AIC’s members believe that the industry is best served if it is united and speaks with one voice. The AIC’s vision is for closed-ended investment companies to be considered by every investor. The AIC has 347 members and the industry has total assets of approximately £264 billion.
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