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What has survived Gordon Brown, the financial crisis and the Brexit referendum? Answer: UK small cap

What has survived Gordon Brown, the financial crisis and the Brexit referendum? Answer: UK small cap

Henry Lowson, Senior Fund Manager

From Gordon Brown to Theresa May, from the credit crisis to Brexit, the world in 2017 is dominated by different challenges and concerns than 10 years ago. The past decade has not been a smooth ride for investors, but looking back at the performance of UK smaller companies, it is clear that this asset class has outperformed its large cap counterparts in the UK equity universe.

Relative performance of FTSE indices

Source: Thomson Reuters Datastream as at August 2017.

For some, this outperformance might come as a surprise; we look in further detail at the reasons why UK smaller companies have generated strong long-term performance, and why we believe that UK small cap should be considered as part of long-term asset allocation.

Small companies, large universe

The UK small cap universe numbers over 1,250 companies and is spread across a variety of industries and sectors. Unlike the FTSE 100, the FTSE Small Cap ex-IT Index has a lower concentration in the mining, oil & gas and financials sectors, and a greater concentration in industrials and information technology, and so is arguably better diversified than the larger index. Indeed, there is less concentration risk, as the largest stock in the FTSE Small Cap Index is typically less than 2% of the index. By comparison, the largest stock in the FTSE 100, HSBC, is around 7.9% of the index*.

With a large investment universe and a spread of differentiated business models, there is significant potential for active small cap managers to diversify their portfolios and find undiscovered gems.

A common misconception regarding UK smaller companies is that they offer only exposure to the UK domestic market. In fact, nearly half of the FTSE UK Small Cap index company sales are exposed to overseas markets**. Although the small cap index suffered in the immediate aftermath of the Brexit referendum as investors flocked towards the large-caps in the FTSE100 (with a greater weighting towards overseas earnings), UK small cap stocks recovered strongly as they continued to report positive earnings results and upgrades. In particular, industrials, healthcare and technology sectors performed well. 

An inefficient market

The inefficiency of markets, particularly in smaller companies, has been compounded by the structural decline in analyst research and resources, as regulatory pressures have resulted in shrinking commission pots for investment banks. As a consequence, it is now often uncommercial to dedicate the necessary analyst resource to the smaller end of the market, where share volumes and liquidity are traditionally lower than in the large cap area. This can mean that some stocks are undervalued not because they are bad companies, but because they are relatively unknown. As bottom-up active stock pickers, the challenge for us is to uncover these attractive opportunities.

With less research, fewer funds dedicated to smaller companies, and investors focusing increasingly on benchmark-driven strategies, our skill lies in our ability to identify and analyse areas of the market that are perhaps off the mainstream radar. We seek high quality companies that can grow their earnings and cash sustainably over the long term. We combine top-down sector and thematic analysis with bottom-up fundamental analysis of companies to find these investment opportunities at attractive valuations. We typically meet around 500 companies per year, and use these meetings, together with our market experience and a wide network of analyst research, to source potential ideas. We aim to identify companies where not all the good news has been reflected in the share price and where positive optionality exists for company earnings and their respective valuations to be substantially higher on a 3-5 year view.

UK Small Cap at RLAM

For more information about RLAM’s approach to investing in UK smaller companies, visit: http://www.rlam.co.uk/Home/Intermediaries/Products/Equities/RL-UK-Smaller-Companies-Fund/

*Source: FTSE as at August 2017. **Source: RLAM as at September 2017. Past performance is not a guide to the future. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the manager’s own and do not constitute investment advice. Investment in smaller companies may be riskier and less liquid than larger companies, which could mean that their share prices and therefore fund performance is more volatile.

This article was provided by Royal London Asset Management and does not necessarily reflect the views of Citywire

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