The UK economy looks increasingly precarious. The recent ‘targeted fiscal event’ has sent the pound sliding, gilt yields rising and confidence to rock bottom – by Cherry Reynard

With recession looming, it has also proved a tough moment for UK smaller companies, which were already battling poor sentiment. Smaller companies managers are no strangers to volatility, but how are they steeling themselves for the problems ahead?

The FTSE Small Cap sector is down 19.8% for the year to date[1], compared to a fall of just 6.3% for the FTSE 100[2]. The large cap index has had the tailwind of rising commodity prices, which has pushed up earnings for energy and mining companies, which are well-represented. The index also holds plenty of companies with international revenues, where the weak pound has flattered their income.

The small cap sector has not been able to draw on any of these supports. In common with previous cycles, risk-averse investors have sold out in search of greater liquidity, less exposure to the UK economy and perceived safety. Only one trust has made positive returns over the past 12 months and the worst-performing trust is down 50.8%[3].

Is weakness real or illusory?

The question for investors today is whether that weakness is real or illusory. Are small caps uniquely vulnerable to a weaker UK economy and significant decline in sterling? George Ensor, manager of River & Mercantile UK Micro Cap, says that while the UK economy is undoubtedly a difficult place to operate, the weakness is more perceived than real. He adds: “There are a lot of challenges. The fiscal bail-out could be equivalent to 10% of GDP over next few years. It will ease the cost of living crisis, but the question is what it does to inflation. The cost of capital is rising, but this is a sentiment problem first and foremost.”

Operational difficulties for many smaller companies have been far less pronounced than their share price falls. The small cap sector continues to wrestle with the age-old view that it will inevitably struggle when the domestic economy is weak. Abby Glennie, abrdn UK Smaller Companies Growth Trust and abrdn Smaller Companies Income Trust, says: “Many of our holdings continue to trade very well. Watches of Switzerland, for example, has reported strong earnings, but its share price has been hammered because of sentiment.”

Perception of domestic focus is false

Equally, the perception that small companies are uniquely focused on the domestic UK economy is persistent, but false. Stuart Widdowson, manager of the Odyssean Investment Trust, says around two-thirds of the revenues from companies held in the portfolio come from abroad. However, even those companies that are predominantly UK-based may have an interesting, disruptive niche and can grow irrespective of the situation in the broader economy.

Glennie agrees, believing the UK versus international is a false distinction. She says: “We have a mix of international and domestic – around 50/50, which is not dissimilar to the benchmark. There are some great UK-only businesses that can still thrive in spite of the UK’s problems. It’s not true that because smaller companies are more domestically-focused they will necessarily struggle. They can be nimble.”

She gives the example of Telecom Plus, owner of Utility Warehouse. It is benefiting from a number of energy companies going bust. It also has a unique ‘friends and family’ sales model, which is working well at a time when family incomes are squeezed. The trust also holds veterinary practice CVS, where there is pricing power because people don’t tend to cut spending on their pets.

Weak sterling – UK assets look cheap to international buyers
The weaker pound may make UK-generated revenues less valuable to international buyers, but it also makes smaller companies look cheap for Dollar-based private equity or trade buyers. Widdowson says: “We always try to work out who an alternative owner of the business might be. That means if the stock market doesn’t value the company properly, there will be alternative buyers at a premium to the current share price.” In the 18-stock Odyssean portfolio, they have seen seven takeovers in the past two years at a premium of almost 50%. The weak currency may see this trend accelerate.

Stock selection remains vital

Nevertheless, there are vulnerable companies and, more than ever, careful stock selection is vital. Widdowson says: “It is important not to overpay. That gives a margin of safety. We care about valuation. At a time of inflation, we want to ensure companies have good franchises, that they are not dependent on a single supplier or customer and don’t have many competitors.” He gives the example of Spire Hospitals, the largest provider of private hospitals outside the M25.

He adds: “The key is the risk of permanent capital destruction. Good businesses with good franchises with a reason to exist, that are difficult for other people to copy, not too much power to their customers, not too much power to their suppliers, these companies will see it through. The risk of capital destruction is in those me-too businesses with no pricing power. We don’t position our portfolio for this particular recession, but for any difficult time.”

Ensor agrees, saying valuation is important and investors need to look at the implied growth over the next five years. He says valuations for some long duration growth companies could be vulnerable in an environment of rising rates and is being careful to avoid those areas.

Have UK small caps bottomed out?

Is it possible that smaller companies could already have hit their floor? Widdowson says: “A lot of the day to day movements are driven by flows. There’s a lot of smaller company UK OEICs with outflows. Open-ended managers become forced sellers and there have been some aggressive moves in share prices. No-one has inflows, therefore there are no natural buyers.” He believes share prices may have hit their lows and now just need buyers to come back.

History suggests that these periods of weakness provide an opportunity for investors. Ensor says: “Looking at previous extreme lows going back to 1986, the next 12 to 36 months have tended to deliver pretty good returns. There have been positive returns four out of five times over one year and five out of five over three years. We’re being told how tough it is – but the price is what a company is worth through the cycle.”

There may be further pain to come. There is likely to be continued bad news on the UK economy and investors are unlikely to relinquish their long-held belief that smaller companies are vulnerable at a time of economic stress in a hurry. However, investors can be reassured that this is more sentiment than reality and fund managers are not panicking in the face of a potential recession.


economic and political review

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