Catching the wave
Why the early bird investors in the UK small-cap sector have
historically been well-rewarded…
Analysts:
Jo Groves
jo@keplerpartners.com
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Sometimes there’s no point in sugar-coating the truth: UK small-caps have endured the longest cycle of underperformance in several decades. A challenging macroeconomic environment and investor pessimism have taken their toll on UK equities and stellar returns on the other side of the Atlantic have only served to
accentuate this disparity.
That said, investors taking a longer-term view have historically been well rewarded, with the FTSE Small Cap Index chalking up a 25-year total return of 430% leaving the 215% return for the FTSE 100 in the dust and, for completeness, not far off the 450% (USD) return for the high-growth S&P 500 (as at 04/06/2024). What’s more, the worst periods of performance have historically led to the strongest subsequent periods of returns in the UK small-cap sector, as my colleague noted last year.
A strong finish for the UK small-cap sector at the end of last year raised hopes that the long-awaited recovery was underway but optimism dwindled when the sector headed down in the new year. Although the FTSE Small Cap Index has ticked up again in the last month, investors may be tempted to wait on the sidelines until a sustained recovery is underway. That said, to use a surfing analogy, if you wait for the perfect wave, you risk missing out on the best action.
The chart below looks at trough-to-peak gains in the FTSE Small- Cap Index following significant downturns. This shows the benefit of being an ‘early bird’ (or, indeed, long-term) investor with trough-to peak gains of up to 45% within the first three months of the subsequent recovery period.
The clouds are clearing
Macroeconomic issues have undoubtedly weighed on the valuation of UK equities, with investors taking fright at stubborn inflation, rising interest rates and falling GDP but the current outlook is starting to look more positive. The UK exited one of the shallowest recessions in history with a return to growth in the
last quarter, business and consumer confidence have improved and inflation is nearing its 2% target.
This leaves interest rates as the final hurdle and the UK small-cap sector has historically shown an inverse relationship to interest rates. While the era of ultra-low rates is firmly in the rear-view mirror, Bank of England Governor Andrew Bailey recently announced that rate cuts are “likely in the coming quarters”, which may provide the catalyst to a sustained recovery in UK small-caps.
Indeed, an improving macroeconomic backdrop has helped to drive the FTSE 100 to record highs in
recent weeks and investor enthusiasm is starting to trickle down the market cap spectrum. While small-cap
valuations remain below their decade average, the FTSE Small-Cap Index (ex-ITs) has delivered a year-to date total return of 11%, exceeding the 9% return of its large-cap peer (as at 04/06/2024).
Investors may have been eschewing the small-cap valuations on offer but corporate and private equity buyers have seized the opportunity to snap up UK companies at bargain prices, with Peel Hunt reporting that 10% of the FTSE Small-Cap Index was acquired by number (and 30% by market cap) in 2023.
Acquisitions have also proved a tailwind for the returns of BlackRock Smaller Companies (BRSC) with recent bids for portfolio companies Numis, The City Pub Group, Ten Entertainment and Ergomed at substantial premiums. By way of example, Deutsche Bank paid a premium of more than 70% (to the closing share price prior to the announcement) to acquire broking firm Numis.
Forging a path
The UK small-cap sector boasts a broad universe spanning a wide range of sectors which, combined with a lack of research, offers a fertile hunting ground for stock pickers. Roland Arnold, manager of BRSC, aims to unearth ‘hidden gems’ by focusing on high-quality growth companies with the ability to perform irrespective of the wider economic environment.
Bloomsbury Publishing, probably best-known for the Harry Potter series, ticks this box and is a long-term
holding of BRSC. The company has pursued an active policy of diversification to improve its resilience across
the economic cycle, including geographic expansion with North America now accounting for around 50% of revenue.
Bloomsbury has also broadened its offering across consumer and non-consumer markets, with academic,
professional and educational publishing offering higher and more predictable profit margins. On the digital side, the company has pursued an acquisition-led strategy, seeking to leverage the strong demand for digital resources which also contribute recurring subscription revenues.
A strong track record of revenue and earnings growth has underpinned the company’s five-year total return of over 200% (as at 03/06/2024) and is testament to the company’s ability to buck the downward trend of the wider market. Income accounted for more than 35% of total returns, illustrating the cash-generating quality of the business.
However, the cash-generative nature of many UK small-caps is often overlooked and underpins consistent income streams together with robust balance sheets to weather a downturn. The blue-chip roster of UK large-caps may be a honeypot for income-seekers but the MSCI UK Small Cap Index is trading on a dividend yield of 3.6%, not far behind the 3.8% of the MSCI UK Large Cap (as at 30/04/2024).
One such example is Gamma Communications, a provider of business-to-business communication services in the UK and Europe, and a top ten holding for BRSC. Gamma is highly cash-generative, with a consistent cash conversion rate of around 100%, and a strong balance sheet with a significant net cash position. As a result, the company has a progressive dividend policy and recently initiated its first share buyback.
Gamma has achieved a compound annual growth rate in EPS of 16% over the last five financial years, demonstrating its ability to deliver in challenging market conditions. It also boasts strong recurring revenue streams (accounting for c. 90% of total revenue) and a high gross margin thanks to an asset-light cloud software model.
While Gamma has enjoyed a year-to-date share price increase of more than 30% (as at 04/06/2024), Roland recently noted: “Despite the shares’ revaluation to a mid-teens price-earnings ratio this year, they remain significantly undervalued when compared to other companies with similar financial characteristics.”
As we know, past performance is not a reliable indicator of future success but investors keeping faith in the superior growth potential of UK small-caps may be rewarded if the long-awaited recovery comes to fruition. In the meantime, both Bloomsbury and Gamma demonstrate the value of active stock-picking to deliver returns through the economic cycle, with BRSC delivering a five-year NAV total return of 18% and a current dividend yield of 2.8% (as at 04/06/2024). BRSC has also qualified as an AIC ‘dividend hero’ thanks to 20 consecutive years of dividend growth.
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