With the notable exception of Warren Buffett, it is a rare thing for one fund manager to reference another and yet, a year after the UK’s full lockdown, it feels appropriate for us all to listen another highly successful investor.
Nick Train, who has managed the Finsbury Growth & Income investment trust for more than two decades, gave us all some good advice recently. In an update to the trust’s shareholders, he said: “I dislike having to recommend patience to investors, who have had to exercise this virtue for many months already; but I do recommend it still.”
If ever this was true, it has never been more so than for UK equity investors – whether they are invested predominantly in large-cap global companies listed on the London Stock Exchange, or small and mid-cap investments where I invest for the Strategic Equity Capital investment trust.
‘Small-cap effect’
While I have only had six months managing the trust, I have nearly two decades of analysing and managing money in what is always one of the most dynamic parts of the UK equity market. History tells us the so-called ‘small-cap effect’ often comes into play at this point in an economic cycle. True – the current economic backdrop for the UK economy may be unlike any other we can point to because of the pandemic but, as the vaccine roll-out continues, we are likely to see a recovery from the low of last year in terms of GDP.
Video interview with Ken Wotton: Watch ‘Unloved UK holds opportunities for ‘smart money’’ here
How best to play this? I would argue with a patient approach and long-term holdings in a portfolio of well-run UK businesses. This is the approach I have been following since taking over the portfolio last September, alongside my co-manager Adam Khanbhai. Indeed, we are following an approach I have successfully applied for a number of years to the two open-ended funds I manage at Gresham House.
I traditionally operate with a low annual portfolio turnover and with a focused group of companies, many of which I have known since they were private businesses. This approach requires patience – but this patience has traditionally paid off and I believe will do so again.
Why UK equities now?
A common question I am asked by investors is why UK equities now – and why the part of the market that Adam and I focus on? Well, the UK stockmarket has been out of favour with international investors for some time, not least because of Brexit. On most comparisons the domestic market now looks very cheap and, within the UK, smaller companies themselves stand at a discount to larger companies, offering considerable value
Allied to this, UK smaller companies represent a structurally attractive part of the public markets. Academic research demonstrates that smaller companies in the UK have delivered substantial outperformance over the long term.
This is partially because there is a large number of under-researched and under-owned businesses that typically trade at a valuation discount to larger companies and relative to their prospects. A highly selective investor with the resources and experience to navigate this part of the market successfully can find exceptional long-term investment opportunities.
Attractions of smaller companies
There are a number of attractions to investing in smaller companies:
* Inefficient markets: Smaller companies remain under-researched and below the radar for many investors, thus creating an opportunity for those willing to devote time and resource to this area.
* A large investment universe: Most UK listed companies are in the smaller companies category and are listed on the main market or AIM. Two-thirds of UK listed companies have a market capitalisation below £500m, offering a large opportunity set for smaller company specialists.
* Valuation discounts: Such discounts, typically reflecting lower profiles, a lack of research and less liquidity, present attractive entry points at which the intrinsic worth of a company’s long-term prospects are undervalued. Investors experienced in navigating this part of the market can uncover hidden gems.
* M&A activity: Smaller companies often offer strategic opportunities within their niche markets and can become attractive, bolt-on acquisitions to both trade and private equity buyers. These buyers provide an alternative source of liquidity and realisation of value for smaller company investors.
Although considerable uncertainty remains in the UK, and so represents a challenging backdrop for investing, some compelling opportunities are developing. In this new environment, a patient investment strategy focusing on long-term holdings in a portfolio of well-run UK businesses has the potential to thrive.
Ken Wotton is the lead fund manager of the Strategic Equity Capital investment trust
