UK smaller companies funds are going through a particularly painful patch. Having dropped 25% last year, they have continued to fall in 2023. While smaller company managers insist that they are cheap, until recently, there has been little catalyst for change. Are there any encouraging signs starting to emerge that might suggest a brighter future for the sector?
First, the bad news. Smaller companies have seen persistent outflows, with the Investment Association data showing negative net flows every month for the last 12. While they have stabilised at a lower level than that seen in August and September last year, there is no sign of these outflows reversing. Last month saw £93m of outflows from the IA Smaller Companies sector, higher than the six-month average, though lower than the £141m in outflows seen in August and September 2022.
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At the same time, discounts in the investment trust sector – another indicator of sentiment – are at near all time lows. The BlackRock Throgmorton trust, for example, is trading at a discount of 8.2%, compared to a 12 month average of 4.9%. Henderson UK Smaller Companies is trading at 13.1% versus a 12 month average of 12.1%. Aberforth is trading at a discount of 14%, compared to a 12-month average of 13.1%. While discounts were lower in late 2022, discounts on all but two trusts are still significantly lower than their five-year average (Strategic Equity Capital and Invesco Perpetual UK Smaller Companies).
Another problem for the sector has been the paucity of merger and acquisition activity. M&A activity has acted as a backstop for activity, but has been subdued in recent months. Consultants E&Y said in response to the latest M&A data from the ONS: “M&A activity in the UK remained subdued in the second quarter of 2023 as companies continued to contend with low-growth, high-inflation and rising interest rates. However, deals involving UK companies did accelerate after a very slow first quarter, pointing to further strengthening through 2023 and into 2024. In total, 450 cross-border and domestic M&A deals completed during Q2, down year-on-year from 526 deals completed in Q2 2023.”
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None of this suggests that a significant rebound in sentiment for the UK smaller companies sector. M&A may slowly start to come back and it is possible that the ARM IPO, scheduled for 13 September, will galvanise a flatlining UK IPO market. But this will take time. IPO activity has seen a 31% drop in 2023 for the year to date.
What might shift sentiment? Given that a lacklustre UK economy has been a key factor in the weakness of smaller companies, better news might help generate enthusiasm. While the UK economy is not flying, any recession appears likely to be shallow and short-lived. The UK economy was more resilient than expected in the second quarter, rising 0.2%, rather than the expected 0.1%. In particular, the consumer sector has proved more resilient than expected, in spite of rising interest rates.
Stuart Widdowson, manager of the Odyssean investment trust, says valuations are still the key selling point for the sector: “It’s not just cheap in relative terms, but it’s cheap in absolute terms. We’re not seeing any signs of the asset class being more loved, but anecdotally, we are seeing institutional interest picking up. People know valuations are cheap.”
He believes that at a time when it is possible to generate 5% risk-free return from a two-year gilt, investors recognise that they will need their equity allocation to work harder. “If we are at a trough multiples and trough earnings, this is a good entry point.”
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He says that even the smallest change in sentiment could shift performance quite quickly, given the long run of outflows. The trust has had interest from non-shareholders who have nothing in small caps at all and recognise that they will need to move back into the asset class at some point. However, he says that investors will need to anticipate it ahead of time: “Investors could find that they want to buy 5% of a specific small cap and the stock simply isn’t there.” Investors may find that they have missed the bounce while they’ve been looking for the best time to buy.
There are early signs of interest coming back into certain sectors – in life sciences, for example. Dr Paul Jourdan, CEO of Amati, says: “We saw a bid for Ergomed, adding to a reasonably long of list of bids we’ve seen this year. We’re expecting bid activity to pick up further. It’s interesting that the appeal of the life sciences sector remains for its long-term, non-cyclical characteristics. It’s a very resilient sector, and with an ageing population, the requirement only ever increases. There are significant short-term headwinds, but it’s interesting that there are strategic buyers coming in recognising the long-term opportunities available there.”
Widdowson is still focusing on companies that have “their future in their own hands”, where there may be self-help options, and on companies with a particular niche. These include industrial group Xaar, for example, which does ceramic tile painting, or XP Power, which is a key part of the semiconductor supply chain.
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The UK Smaller companies sector remains in the doldrums. M&A activity remains lacklustre, outflows are yet to reverse and there are few signs of discounts turning. However, there are glimmers of hope – reviving activity in certain sectors, a level of institutional interest, and an improving UK economy. It may be too soon to call the turn, but the sector may be closer to its nadir.
