Inflation and interest rates remain a primary consideration for many in the UK – whether as a result of the pain of higher mortgage rates and squeezed household budgets, or the pleasure of increased wages and higher returns on risk-free assets.
Speaking in South Africa last week, Bank of England chief economist Huw Pill said that in order to get to grips with inflation, the Bank’s policymakers favour a ‘Table Mountain’ rather than a ‘Matterhorn’ approach to base rates, meaning they are likely to remain higher for longer rather than declining swiftly from their current 15-year peak. But what does this mean for the UK equity market, and particularly for listed smaller and mid-cap companies?
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Richard Bullas, Leeds-based lead portfolio manager of the FTF Martin Currie UK Mid Cap Fund, is optimistic on the outlook for the FTSE 250, pointing out that the index has tended to perform strongly following a peak in interest rates.
Between 1985 and 2022, the average index return after rates have reached a cyclical high has been 12.3% over one year (2.1pp ahead of the FTSE All-Share Index), 20.3% over three years (+5.5pp) and 31% over five years (+10.9pp). Therefore, a peak in the cycle could signal a reversal of the recent underperformance of UK mid caps, which declined by 17.1% between 1 September 2021 (broadly, the end of the ‘Covid rebound’) and 31 July 2023, compared with a 15.7% advance in the FTSE 100 and a 9.0% increase in the FTSE All-Share.
“The recent small- and mid-cap sell-off has been really quite savage in a historical context,” says Bullas. Furthermore, mid caps currently trade at a significant 12-month forward P/E discount both to their own history and relative to large caps, which also tends to point to superior return potential over the long term.
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“The FTSE 250 forward P/E is under 11x, compared with a 25-year average of 14x,” says Bullas. “That is 25% below the long-term average, and historical data shows that investing at 10x P/E can produce double-digit annual returns over the subsequent 10 years.”
He adds that while the current low valuation may reflect concerns over earnings sustainability given the economic environment, he and his team are seeing greater corporate resilience than the numbers suggest. “Companies are handling the slowdown really well and cost inflation is starting to reduce,” he explains. “The market seems to be expecting a global financial crisis-style collapse in earnings, but we don’t see that.”
Further down the market0cap spectrum, Bullas’s colleague Dan Green, lead manager of the FTF Martin Currie UK Smaller Companies Fund, is also finding opportunities in lowly valued companies. “The majority of our recent buys have been in the sub-£300m market-cap space,” he says. “That’s where people have been exiting, leaving good companies on illogical ratings. We are investing where the crowd is running away, and when the market turns, it could come back like a coiled spring.”
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Analyst coverage is scant for smaller UK companies, and has declined substantially in recent years: while on average there were previously 11 analysts covering each company in the £500m-1bn market cap bracket, Green says there are now five, and for companies smaller than this, the number is even lower. This means there is less of an established consensus regarding smaller company valuations, which is a source of opportunity for an active manager.
UK equities have been in the wilderness for some time now, with 23 straight months of net retail outflows (to end-June 2023) from both UK All Companies and UK Smaller Companies funds, according to the Investment Association. And while history may suggest strong performance in small and mid caps following a peak in interest rates, Pill’s ‘Table Mountain’ analogy may make that ‘peak’ harder to discern until rates begin to decline.
However, in such a situation, fortune may favour the brave: Bullas reports an uptick in client enquiries about Martin Currie’s small- and mid-cap funds, although he concedes that investors are reluctant to call a bottom in the market.
“People are waking up to the fact that it is going to turn at some point, and when it does, it is going to be quick,” he says. “However, they may be willing to miss the first 5% or 10% of the turn. There is a long way to go back to fairly valued, so returns in the next three to five years could be very good.”
