Consider UK small caps for long-term gains

UK small caps could be a way of making longer-term gains says Darius McDermott, managing director of Chelsea Financial Services.

Consider UK small caps for long-term gains

If you want to make money, buying things when they are cheap and selling them when they are expensive is a tried and tested method! In the world of investing, though, it’s pretty hard to find assets that are cheap right now. One area you could look at is UK small caps.

After the Brexit vote last June, Britain’s largest companies surged ahead as Sterling plunged, pushing the FTSE 100 to record highs. Our smallest companies, however, were sold off as investors worried about a weaker economy. The theory goes that small companies are much more likely to be domestically-focused, and so shrinking growth at home would have a greater impact on their profitability than our larger companies which earn much of their revenue overseas.

The end result is that UK small caps now sit at their widest discount relative to large caps in 17 years. I would emphasise it’s not necessarily that smaller companies are cheap relative to their own history – in fact, they have merely come back down to their long-term valuation averages – but they are presenting a more attractive entry point for the long-term investor than we’ve seen in a while. And small caps are an area of the market where it definitely pays to take a long-term view.

For example, the last time UK smaller companies were so significantly sold off was back in the global financial crisis. In 2008, they lost a whopping 41% of their value1. But if you’d happened to have bought in when they bottomed out in November of that year, you’d by up 352% today2. The FTSE 100 has risen a measly 140% since then in comparison3. So while there are undoubtedly concerns for the UK economy as negotiations begin to leave the European Union—and small caps may face further challenges—getting some exposure in your portfolio now could turn out to be a profitable play down the track.

Apart from valuations, there are other factors that make UK small caps appealing in the current environment. For one thing, the fall in the pound means some of these companies are becoming attractive takeover targets for overseas investors who may want to snap up UK intellectual property and technology at good prices.

Secondly, the UK is beholden to a raft of complicated regulations imposed upon it by the European Union that smaller companies struggle to have the resources to comply with. Many of these may be able to be unwound after Brexit, which could help to create a more competitive environment for small caps.

Thirdly, it is worth highlighting that there are a lot of really excellent quality companies further down the cap scale. Our big names may have received a currency-related boost last year, but ultimately many of the FTSE 100 firms are not well positioned to outperform over the long run.

For a very high conviction investment in UK smaller companies, I like the Unicorn UK Smaller Companies fund. It has around 40 quality stocks and avoids more volatile sectors like oil and gas, mining and biotechnology. Manager Simon Moon looks for lasting competitive advantages and this has helped the fund deliver growth of 78% since his tenure begun in 2013, beating its benchmark by more than 20%4.

At the other end of the spectrum, Marlborough UK Micro Cap Growth is heavily diversified with around 200 holdings. Its weighting to disruptive technologies and companies in niche markets epitomises the growth focus one wants from a smaller companies investment and the fund has delivered returns of 554% since it launched in 20045.

 

1 FE Analytics, Numis Smaller Companies ex. IT, TR in GBP, 01/01/2008–31/12/2008

2 FE Analytics, Numis Smaller Companies ex. IT, TR in GBP, 24/11/2008–04/04/2017

3 FE Analytics, FTSE 100, TR in GBP, 24/11/2008–04/04/2017

4 FE Analytics, Unicorn UK Smaller Companies vs Numis Smaller Companies ex. IT, TR in GBP, 29/03/2008–04/04/2017

5 FE Analytics, Marlborough UK Micro Cap Growth vs Numis Smaller Companies ex. IT, TR in GBP, 04/10/2004–04/04/2017

 

Please remember, no news or research item is a recommendation or advice to buy. Every Investor is not responsible for accuracy and may not share the author’s views. If you are unsure of the suitability of any investment for your circumstances please contact an adviser. All investments can fall as well as rise in value so you could get back less than you invest; and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.

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