The outlook for UK small caps

The outlook for UK small caps after Brexit 

Despite all of the noise and the constant, intense, newsflow of the period since June 2016, when the Brexit vote happened, the market has behaved in quite a traditional way, according to Harry Nimmo, who manages about £2.5bn in UK smaller companies assets at Aberdeen Standard Investments.

He says that just as small caps began to underperform relative to larger companies in the years immediately prior to the global financial crisis, as the market was by then reaching its peak.  But small caps then performed excellently, and beat larger companies in the years after the crisis. 

Nimmo says the small caps underperformed against large companies in 2018 and 2019, again as the market was reaching the peak of its cycle, before sharply underperforming from March 2020, when the onset of the pandemic brought the previous cycle to a close, while the discovery of the first Covid vaccine instigated the start of the new cycle, and the period where small caps perform best, in November 2020. 

But while the impact of traditional market cycles on the performance of small cap shares has been strong, Nimmo believes that, in the UK at least, something more profound is happening.

He says the waves of technological and societal change that are happening in the UK and globally are rapidly making the FTSE 100 index of large companies “a wasteland” stuffed with companies “in sectors such as traditional banking, oil and mining” which Nimmo believes are structurally likely to lose out in a changing world, with the beneficiaries being the smaller companies that are unencumbered by legacy issues, such as digital banks and retailers.

Dan Green, who runs the UK Smaller Companies fund at Franklin Templeton, says 2020 was an “unusual” year in markets because, typically, when there is a cataclysmic market shock, “investors flee to safety, which should be bad for smaller companies, as those tend to be less liquid, and often have less established business models. 

But, Green says, “the opposite happened. The theme of 2020 was that people were looking for the next trend, and small caps are where lots of the most technology can be found, the FTSE 100 has less than 2 per cent in tech, and some of that is in SAGE, which is not really a fast growing company.

“About 7 per cent of the small cap index is in tech, and on the AIM [Alternative Investment Market] that rises to about 15 per cent. The thing is, smaller companies can actually thrive in times of uncertainty, they are like speedboats, they can pivot quickly, while the larger companies are like tankers, they take ages to turn to new opportunities.” 

Victoria Stevens, UK small cap equity manager at Liontrust, says technological stars of the future are not the only way to make decent returns from companies further down the market cap scale. 

Stevens favours companies where the management teams also own substantial stakes in the business, as, she says, this makes the companies “more resilient”, as they will have been run for the long-term.

She says many of those companies are found in less glamorous or exciting sectors, but continue to deliver strong returns in their area. 

Stevens says that while the strong performance of smaller companies in the second half of last year means returns from the sector as a whole are lower, the companies that have thrived will be buying those that have not.

She says: “A feature of recent months has been the number of companies coming to market to raise capital, but not capital to survive, capital to expand and buy rivals.” 

Nimmo says an irony of the small cap market is that “lower risk may be the way to higher returns, and that is the way we construct portfolios, with an element of the defensive in mind. We don’t want to own what I call ‘blue sky’ companies, those that are just an idea, and maybe haven’t made a profit yet.” 

Paul Marriage, who runs the Tellworth UK Smaller companies fund, says the domestic market has been “like the Millwall of investing since the Brexit vote, ‘no one likes us, we don’t care’, but the solution is not to buy oil companies, miners, or biotech, those are the casino end of small caps.

“The best small caps are probably a business on an industrial estate near you. But in recent years being underweight to the UK market has been rewarded.

“But since the Brexit deal the UK market has come in from the sidelines and become an investable market again, so people who were underweight stop being underweight, and that improves valuations, and then people move to small caps; in terms of the market cycle, that’s where we are right now. The retail investors are back in the UK market.” 

Richard Penny, who runs the Crux UK Special Situations fund, which invests in all parts of the UK equity market says that while “history indicates where we are now is a time where small caps are cheap, you cannot let history be a total guide on its own. But there are some opportunities down there if you are careful, for example, the house builder shares rose quite a bit, but then fell back again, even though the fundamental factors impacting their businesses have not changed. The hospitality sector is tricky right now, and it looks as though it will be a long slow crawl back for the share prices of those companies, although they look cheap compared to history.”

Jochem Tielkemeijer, client portfolio manager at Natixis, says the  outlook for smaller businesses relative to larger ones has been permanently altered by the impact of technology.

He says technological change makes it much easier to grow a business quickly, relative to history, and this reduces some of the natural advantages that larger companies have historically enjoyed. 

Stevens says that while the valuations (in cash terms) being achieved by relatively new companies can appear dizzying, this is a function of how much easier it has become to grow a business quickly, in a world where more trade is done online. 

Colin McLean, managing director and fund manager at SVM, says the events of the past year have permanently altered both the perception and the reality of smaller companies, and this means traditional arguments about the market cycle have become otiose.

He says: “UK small cap has undergone a transformation over the past 12 months, strongly outperforming large cap.  Smaller companies are no longer seen as just a cyclical - and often illiquid and poorly governed - asset class; investors have woken-up to the potential for disruptive growth. 

“In the aftermath of Woodford, more attention is paid now to share liquidity, but investors just need more care with portfolio construction, limiting size of holdings. There is a new dynamism in the sector; even small companies can dominate their niche and develop platforms with scalable growth. 

“Growth can be rapid at an early stage although more companies are remaining private for longer and delaying  a stock market listing. Some emerging businesses have taken market share from very big legacy businesses, such as many high street retail chains. 

“Fevertree Drinks is an example of a disruptor. The UK has lagged many international markets in the aftermath of Brexit, but we believe that the resolution of Britain’s trading arrangements will bring a return of investors.”

Aiming High 

When it was created in the early 1990s, the companies listing on the Alternative Investment Market (AIM) stock market, which is owned by the London Stock Exchange, was festooned with extra benefits.

The intention of policy makers was to compensate investors for the extra risks accruing from investing in a nebulous stock exchange, filled with companies many of which were at the earliest stage of development.

As a result, any shares held by an individual in an AIM listed company are exempt from inheritance tax, while rules about financial disclosure are also more relaxed.

While most of the companies on AIM count as small cap, there is no requirement for firms to leave the alternative market when they reach a certain size. 

Penny says the nature of the AIM market means that while there are opportunities for returns, “you have to go into it with your eyes wide open. There are a lot of frogs you have to kiss, before you meet that prince.

“The tax advantages mean there are a lot of retail investors in the market, and that helps with liquidity.”

Marriage says that in recent years the number of quality companies on AIM has risen, but is cautious on investing in the largest AIM companies, as it tends to be those which have risen most as a result of being bought by the retail investors keen on the tax planning angle. Those investors will get their return from paying less tax, and so are less concerned about buying more expensive stocks.

Green tends to prefer the AIM stocks that have large numbers of their shares owned by the company's founders. Such businesses are likely to stay on AIM as the founders then receive the tax advantages, but Green doesn’t think those companies, which are often quite large in size, are very well known.

He says despite the prominence of those companies, they don’t tend to trade at higher valuations than similar companies  

He says: “The biggest AIM stocks performed well in 2020 as a result of the retail investors buying them, but I think the greater value may be in the smaller, more neglected parts of that market.”

Stevens says she is “agnostic” as to whether the companies she invests in are on AIM or the main market, indicating that the more lax rules of the former are not a particular disadvantage. 

But her preference for owner managed businesses is validated to a greater extent on AIM, where many more such businesses exist because of the tax advantages for owners of remaining listed on that market.