UK small caps: Depressed for a reason, or at the cusp of a multi-year supercycle?

The host of headwinds battering UK smaller companies has prompted a crisis of faith among investors. Is the sector down and out or on the cusp of a supercycle?

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UK small caps have been “battered, bruised and beaten” during the past few years due to a torrid combination of political missteps, fears of a looming recession and a particular vulnerability to the economic ramifications of the Covid pandemic.

According to data from FE Fundinfo, the average fund in the IA UK Smaller Companies sector has lost investors 7.6% during the past three years, with an average maximum drawdown – which measures the most money an investor would have lost had they bought and sold at the worst possible times – of 37.6%. In contrast, the average global equity fund is up 17.9% over the same time frame, with a drawdown of just 18.1%.

Even UK equity funds that invest further up the cap spectrum have achieved a markedly better risk-return profile relative to their smaller counterparts, with an average total return of 14.5% from the IA UK All Companies sector, and a maximum drawdown of 17.7%.

Only nine out of 47 UK small-cap equity funds have not lost money over three years while, on the closed-ended side, AIC data shows that the average investment trust in the IT UK Smaller Companies sector is trading on a 10% discount to its net asset value.

See also: Marlborough’s Lall: The growing UK small caps being thrown out with the bathwater

“Other than at extreme times, it’s hard to remember UK small caps being so disliked,” says Jonathan Winton, sole portfolio manager of the £566m Fidelity UK Smaller Companies fund and co-portfolio manager of the £2.7bn multi-cap Fidelity Special Situations fund.

Alexandra Jackson, manager of the £47.7m Rathbone UK Opportunities fund – which also invests across the cap spectrum – adds that UK small caps have not traded as cheaply since the global financial crisis in 2008.

For investors who believe in mean reversion, now is arguably one of the better times to seek opportunities within UK small caps. But could this be a fool’s errand, if the underlying drivers deterring investors are here to stay?

See also: UK investors to increase exposure to real assets in 2024

“A significant increase in inflation, and the level of interest rates, has led to the concern that the economy is likely to enter a recession,” Winton explains. “Smaller companies tend to be more sensitive to economic conditions, and so there is a concern their businesses will suffer disproportionately.”

To read more, visit the January edition of Portfolio Adviser Magazine