Small mercies: Resilient returns within UK small cap sector

The sector has taken a serious hit of late – but can Ken Wotton of Gresham House and Liontrust’s John Husselbee see a brighter side to the story?

John Husselbee and Ken Wotton infront of a picture of the River Thames looking up river towards Southwark, London and distant Tower and London Bridges in dawn light. London, UK


According to the Investment Association (IA), £1.6bn flowed out of equity funds during July, versus net inflows of £893m into fixed income funds as investors continue to adopt a risk-off attitude.

Reflecting this stance, the top-selling IA sector for the month was the Short Term Money Market, with net retail inflows of £513m, while the IA Corporate Bond sector was the second-highest seller, racking up net retail sales of £495m.

It’s no surprise the UK smaller companies sector is closer to the bottom of the sales charts, given its more volatile and risky nature. In July, the £13.3bn sector was subject to redemptions of £85.4m, with net outflows in the first seven months of the year totalling just over £1bn.

A quick look at performance suggests why investors may be cautious. According to FE Analytics, year to date the IA UK Smaller Companies sector is down 26.3%, over double the loss experienced by the IA All Companies sector, -12%.

In this month’s head to head, Portfolio Adviser speaks to Ken Wotton, managing director, public equity, at Gresham House, who will present the case for holding UK small caps, while John Husselbee, head of multi-asset at Liontrust, details how the asset class fits into his current asset allocation.

Ken Wotton

Managing director, public equity, Gresham House

British stocks are facing a barrage of headwinds, with surging inflation, rising interest rates and an escalating cost-of-living crisis weighing heavily on sentiment. But this is nothing new for UK markets. Indeed, after Brexit, Covid-19 and the war in Ukraine, investors may be thinking UK equities are forever ill-fated.

In particular, UK small caps have been trading on a discount to their larger, better-known peers for the past decade. However, we believe now is the time to double down on these businesses. The longer-term opportunity within British small caps is extremely compelling at present.

There are scores of high-quality resilient businesses on offer, and the agile demeanour and niche positioning of smaller caps may allow these companies to navigate more smoothly through broader economic headwinds.

Additionally, the fall in valuations and current sterling weakness relative to the US dollar has made them attractive to foreign investors. As such, investors could see holdings acquired at highly attractive multiples over the coming months.

The case for resilience

To make the case, here are three high-quality small-cap stocks with attractive long-term growth characteristics we believe will generate resilient returns moving forward.

Sabre Insurance is a motor insurance company we have held since March 2019, which dominates the premium and hard-to-insure vehicle categories. Due to its specialism, it is a high-margin business relative to the insurance industry and pays a substantial dividend. Moreover, its competitive advantage lies in proprietary data processes and intellectual property, leaving Sabre Insurance less vulnerable to wage inflation.

At the start of 2022, new regulation came into play to prevent insurers from charging automatic fee increases for existing clients. Although many relied on this as an added source of profitability, Sabre Insurance did not have this policy in place – leaving it more competitively positioned in the market.

As insurance prices are raised to compensate for the change in regulation, Sabre Insurance will also be able to benefit. We have recently added to our position, as we believe there could be material capital growth ahead for the company.

Next up is Telecom Plus, the UK’s only multi-utility provider, supplying residents and businesses with gas, insurance, electricity, landline and broadband connectivity – all in one bill. While other utility suppliers incur central business costs for providing only one utility, Telecom Plus’ costs per utility are lower on average. This affords the business a structural advantage, which Telecom Plus can pass on to customers, guaranteeing them the cheapest deal on the market.

The company is also supported by a favourable competitive environment. The recent surge in energy prices caused many structurally flawed competitors to go bust, while the industry regulator was forced to limit the number of new entrants.

Finally, Inspired Energy is a leading UK corporate energy services and procurement specialist operating in the UK. We first invested in the business in 2011, having built strong conviction in the company’s management capability and structural growth potential. By working closely with management and key stakeholders over the years, we had identified the opportunity to shift the company’s focus from lowering energy bills to reducing carbon emissions – to capitalise on the growing sustainability agenda.

Leveraging the wealth of data and analysis it has collected to date, Inspired Energy is now building out its offering with a new business arm, which provides ESG data and analytics for businesses conducting supply-chain evaluations. Due to the profit recovery potential and long-term structural growth opportunity tied to this expanding sustainability offering, we invested further in the company during the Covid dip and now hold a significant stake across our strategies.

John Husselbee

Head of multi-asset, Liontrust

As investors take fright over inflation, interest rates, recession and war, smaller companies have taken quite a hit this year, relative to their profits – more so than their large-cap counterparts. In fact, this is one of the worst periods for companies at the lower end of the market-cap spectrum that I can remember since the start of my 35-year career.

As readers will know, recession fears can be particularly damaging for smaller companies, given their propensity to lack scale, cash reserves and be less geographically diversified. When investors are fearful, they often seek safety in big, familiar household names.

But in spite of this backdrop, we maintain our faith in the ‘small-cap premium’, the concept that, over time, smaller companies can generate higher returns than their blue-chip peers, therefore making better long-term investments.

So, what will we need to see for a recovery in small caps? A recovery in markets generally, of course, and a sense among investors that the peak in inflation and interest rates is in sight, which will likely get them buying again. The trend towards ‘deglobalisation’ as the world splinters, and as companies and governments focus more on security of supply, should also favour smaller companies, although it is important to stress that we view this as a generational shift, and not a change we expect to see in the short term.

As our investors and regular readers of Liontrust’s missives will know, we have positioned our multi-asset portfolios for three long-term calls: global ex US equities are more attractive than the US; small caps should outperform large; and value should outstrip growth – all running contrary to what happened for most of the 2010s.

While we remain confident in these allocations, outperformance will not come all at once, so it is sensible to retain prudent diversification rather than making a significant gamble that one particular thesis pays off.

We continue to hold a blend of asset classes and styles rather than relying on any one portfolio element and believe this will help us deliver on suitability over the long term. In our annual strategic asset allocation rebalancing across our funds and portfolios earlier this year we implemented a fall in allocations to UK equities, including small caps.

It is important to state that these moves are not tactical but rather how the data dictate we can best achieve our volatility targets. In our quarterly tactical asset allocation scorecard, where each asset class is assigned a rating from one to five, with one most bearish and five most bullish, UK small caps are scored a four.

Cutting through market noise

Once market corrections have played out, our view is that indiscriminate selling will have created a rich seam of opportunities in UK smaller companies. But in such an environment, choosing the right asset classes and fund managers will prove invaluable for investors.

It will be important to have an investment process that can cut through the market noise and respond to market nuances, investing in a diversified range of asset classes, styles and funds that will provide steady returns with neither reliance on any one scenario playing out nor wholesale shifts in allocations.

Once inflation has stabilised, we anticipate seeing a return to greater diversity of returns from asset classes, with equities providing the driving force in terms of real returns. Our portfolios are well positioned for the opportunities we envisage coming through over the next decade, which will likely be markedly different from those seen over the last one.

Adam Lewis is a content editor at Bonhill

This article first appeared in the October edition of Portfolio Adviser Magazine

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