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Comment: Why UK small caps have a promising future

Comment: Why UK small caps have a promising future

UK smaller companies underperformed last year following the June 2016 Brexit vote, when companies deriving their earnings in the UK were sold off indiscriminately.

They looked oversold and set for a repricing, and this has happened to some extent. But broad opportunities to invest in the UK small-cap sector remain.

The Numis Smaller Companies index has outperformed the wider equity market by 4.7% in the year to the end of May. Yet smaller companies still trade at a discount to the FTSE 100 index.

UK smaller companies are currently undervalued as a result of sentiment. The domestic nature of the small-cap index causes people to underestimate the dynamic nature of the companies.

Not feeling the love

Smaller companies should trade at a premium to the wider market at this stage in the cycle, yet they remain unloved for three main reasons.

First, at a macro level, there are fears UK households are highly leveraged. However, employment looks set to stay relatively tight and wage growth should come through against a backdrop where housing activity (mortgage loan growth and transactions) is muted.

Second, Brexit negotiations have created uncertainty. But last month’s UK election result could lead to a softer Brexit, benefiting domestic companies.

Third, the credit cycle may be of even greater concern, so it will be crucial to keep a close eye on consumer debt. But there seems little point trying to time the market. Instead, there should be a focus on targeting good businesses with strong returns on capital that hold to strict valuation discipline.

Peak pessimism

The current consensus is greater political uncertainty and lack of direction on Brexit will lead to a negative outlook for the UK. But so far the situation does not look catastrophic: there has not been a slowdown in UK gross domestic product (GDP) since Brexit nor a reduction in investment.

Inflation has risen in the past, but we look close to the peak and this will start to fall as unemployment remains low and the UK consumer continues to spend.

So there is insufficient evidence for a UK recession or a dramatic fall in UK GDP growth.

Small businesses can be nimble, quickly aligning to trends, adapting to new technologies or regulation and government policy. Investors need to account for the small company effect: as a small company takes market share it becomes a bigger business, can increase efficiency and become more profitable.

These structural changes allow small companies to grow at a much faster rate than the underlying market. In particular, there are opportunities where the UK has a critical mass of expertise and knowledge.

Small players to watch

Take data companies such as YouGov, Ascential, GB Group, First Derivatives and GlobalData. Understanding data is critical to improving client service in retail, financial services and manufacturing. These companies invested heavily in understanding ‘big data’ as a result of the internet and making clients’ businesses more efficient.

The UK is a world leader in building retail brands. Britain has been at the forefront of online retailing and this has accelerated opportunities to exploit the global market. Hotel Chocolat, Joules, Ted Baker, Gear4music and Warpaint London are examples.

Healthcare services are under huge strain as Western populations age. Businesses such as Totally, Clinigen and Vectura seek to reduce the cost of healthcare.

As the globe becomes a smaller place and face-to-face contact becomes less frequent, people need to meet tighter regulation, and protect themselves from fraud and violence. Companies in this area include GB Group, Shearwater, Blancco, and Photo-Me.

UK pensions reform has made saving for a retirement more complex. Companies that could benefit from this changing market include Xafinity, Brooks Macdonald and Just.

Sterling suffered a dramatic fall following the UK referendum on EU membership. But the worst of the cost inflation seems to have come through.

Sterling had a further slight fall after the UK election failed to provide a majority government. However, from here, any strengthening in the currency could provide a tailwind to UK smaller companies. The outlook remains solid for 2017 and 2018.

James Thorne is manager of the Threadneedle UK Smaller Companies fund

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