Why UK small caps are ripe for the future

What have been the UK small-cap trends for the first half of 2019?

UK market trends in the first half of 2019 have been dominated by the Brexit debate. The March exit date came and went, and now the Conservative Party is selecting a new prime minister who may have a different policy. Overall, these uncertainties have been reflected in the weakness of sterling, although the FTSE 100 Index has risen in line with the recovery of many other international bourses. 

As yet, investors still don’t know how the Brexit differences can be resolved in parliament and the EU. If the UK remains part of a customs union, then most commentators anticipate sterling will recover. This would favor domestic stocks, as international earnings would fall in value. But if the UK exited the customs union it may be that sterling remains weak, and this would favor multinational stocks. Investors don’t know which way to jump.

The ambiguity isn’t a major problem for mainstream investors, as they can back both horses via an ETF or index fund, but there aren’t any micro-cap ETFs so many small-cap investors have tended to defer their investment purchases for now. Nobody wants to pick wrong, and then find they have the cost of changing horses in the next few months.

The absence of a steady stream of potential buyers means intermittent sellers have ended up determining the share prices of many smaller quoted companies. Many micro-cap share prices have actually fallen during 2019, even at a time when the mainstream markets have been rising.

So does all this offer opportunities?

As UK stocks appear overlooked at present due to Brexit anxiety, we believe most small and micro-caps are now standing at valuations that are well below international comparatives. This differential may start to close when there is greater certainty about Brexit, as asset allocators step up their UK participation.

But we are also at the early stages of a rising surge of takeover interest in UK corporates: valuations are so compelling that some aren’t waiting for the Brexit fog to clear. KCOM, Dairy Crest, Game Digital, A&J Mucklow, SafeCharge International, Earthport, Manx Telecom and others have already succumbed to deals. In some cases, the first bidder has been outbid by another – which is interesting, as contested bids tend to be rare other than when valuations are unusually low.

What about wider global macroeconomic pressures?

Asian and European economic indicators remain weak, US growth appears to be slowing and geopolitical tension continues to rise. In the absence of economic momentum, there are three reasons why investors will grow to love the vibrant and agile.

First, at times of unsettled markets when finance is scarce, access to risk capital for companies becomes particularly valuable, as competition for the best deals from debt-funded businesses falls back. Note that prior to globalization, smaller quoted companies as a group had a long history of outperformance of the mainstream indices.

Second, actively selecting across a wider-ranging opportunity set offers investors more individual stocks and sectors that can buck the broader trend. Alongside that, the returns from a broader range of sectors tend to be less closely correlated with the daily or monthly moves of the mainstream indices. Hence a small-cap strategy has scope to deliver both outperformance and diversification to investors.

Finally, it is also worth remembering that the UK is one of the few global centers where small and micro-cap companies thrive and can deliver premium returns. This is especially relevant, as returns on many other asset classes could be subnormal in future decades now that bond yields have reached ultra-low levels.