Steven Fine, chief executive of Peel Hunt, said in the group’s recent results that a “switch had been flicked” on sentiment towards the UK. He highlighted the flotation of microcomputer maker Raspberry Pi as a sign that London’s capital markets were showing signs of recovery. In this, he echoes the views of a number of fund managers that have started to see a short-term revival for the UK’s unloved smaller companies.
Until a few months ago, the outlook for smaller companies had looked unrelentingly grim. Peel Hunt warned the FTSE Small Cap could ‘cease to exist’ if the current pace of de-equitisation continued. Private bank Coutts said in May that it was shifting £2bn from the UK market, confirming it would pivot away from its UK “home bias”. The dividend yield on the FTSE Small Cap had ticked higher than that on the FTSE 100, while net outflows from the UK Smaller companies sector were running at a consistent £80-£100m per month.
With hindsight, this may have been the capitulation point. Stuart Widdowson, manager on the Odyssean Investment Trust, says he saw sentiment change towards the UK’s smaller companies around six weeks ago. This is evident in the performance data, with the FTSE Small Cap delivering almost double the return of the FTSE 100 over the past three months (5.3% versus 2.7%).
The catalyst for this tentative bounce back appears to have been M&A activity and buyback activity. Scott McKenzie, fund manager at Amati Global Investors says: “In the last few months, companies have been doing lots of share buybacks. A number of the companies we own think their shares are cheap and have been buying them. The second factor has been the number of takeovers. These help validate small cap valuations.”
Continued outflows
However, there remain some major challenges. Outflows from the UK small cap market continue, even if they have moderated in recent months. The most recent month (April) saw another £57m leave the small cap sector. This was far lower than the £996m that left the UK All Companies sector but is hardly a ringing endorsement for small caps (data: Investment Association).
April’s figure was below February and March’s figure (£78m and £109m respectively), but the sector was seeing outflows at a similar level this time last year and there are few signs that selling pressure has eased significantly.
McKenzie says: “One of the big problems we’ve had has been the consistent selling. The outflows from UK funds have been really hurting, and that has a disproportionate impact on small caps because it’s illiquid. That’s not got any better.” The question is whether the stronger performance will galvanise investors and reverse this long run of outflows, or whether the impact of buybacks and M&A activity will ebb and the sector will continue its weakness.
Widdowson says that any reversal in outflows could have a significant effect: “Because liquidity has been so low, it can go the other way and move very suddenly. When the money comes in, where does it go? There are no sellers. This could bid up share prices pretty quickly.” He believes this is likely to happen this year, absent a major shock.
The pick up in IPOs could also bring greater confidence to the market. A recent report from think tank New Financial shows the number of smaller companies listed on London markets has dropped by around a third over the past 20 years – and accelerated significantly over the past decade. Any signs that company management teams have greater confidence in UK capital markets could bring investors back.
A chance of government could also restore some confidence. McKenzie says: “Politics won’t be a quick fix. The incoming government is inheriting a weak position and there are limits to what it can do. That said, business people will be willing to give them a chance.” The one advantage of the Liz Truss debacle is that it has shown the limits of bond market tolerance and is likely to prevent any indiscipline on spending. This should guard against a hike in bond yields, which would be damaging for small caps. A rate cut would undoubtedly be welcome, but the Bank of England remains very cautious on easing prematurely.
Earnings
McKenzie says that it has been a mixed bag on earnings for smaller companies. Parts of the smaller companies market have been more sensitive to a weaker domestic economy, for example, and higher interest rates. The UK consumer names, for example, have struggled. However, he still believes that sentiment is out of step with the operational performance of individual companies: “Sentiment has been awful for many years now. In the real world, most companies are getting on with life, and it’s nowhere near as bad as the headlines might suggest.”
Equally, the buyback and takeover activity has not been confined to one particular part of the small cap sector, or any particular size of company. While technology companies and wealth managers have been targets, there have been takeover bids across the market.
McKenzie has been taking more risk in anticipation of a revival in small caps. He adds: “We’ve pushed the beta of the portfolio, bringing in higher exposure to sectors such as financials, for example. We have bought into a number of wealth and fund management businesses – AJ Bell, Pollen Street, Brooks McDonald.” He says there continue to be high quality companies trading at bargain prices.
Widdowson believes the revival could become a self-perpetuating cycle: “The market rerates, that drives inflows, IPOs become more viable. The log jam of PE firms unlocks with more companies coming to the market.” It would be a welcome scenario for small companies managers who have had to be very patient.
