A golden opportunity

Why the UK small-cap sector looks set to shine by Jo Groves

The so-called ‘father of value investing’ Benjamin Graham observed: “In the short run, the market is a voting machine. In the long run, it is a weighing machine.”

It’s fair to say the voting machine has served up a large majority for the magnificent seven in recent years, with investors flocking into US mega-caps for a share of their eye-catching returns. In contrast, investors have largely eschewed UK small-caps which have struggled to shake off the malaise of higher-for-longer interest rates.

That said, over the longer term, the weighing machine has historically rewarded the higher earnings growth potential of small-caps: the UK small-cap sector has delivered a higher return than its large-cap peer in 13 of the last 20 years, with an average outperformance of 15%. This highlights the benefits of accepting short-term volatility in the quest for superior long-term gains.

And on that note, the tide finally seems to have turned, with the UK small-cap sector taking its place among the highest-returning Investment Association sectors with a year-to-date return of 10%. This wasn’t far behind the 12% return chalked up by the IA North America sector, powered to a large extent by the magnificent seven.
 

Here come the catalysts
 
One of the key catalysts driving the UK small-cap recovery is the improving macroeconomic environment in the UK, with the Consumer Price Index (CPI) finally hitting its 2% target (ahead of Europe and the US). This is no mean feat given the UK’s leading inflation index climbed to a 40-year high of more than 11% in 2022 and it’s provided the wriggle room for the Bank of England to trim base rates (with the prospect of another rate cut later in the year).

Other economic measures are also showing clear signs of improvement: the UK economy has returned to growth (after slipping into the shallowest recession in history) and unemployment is at its lowest rate in 50 years. The recent election has also put an end to political uncertainty and provided visibility of future government policy.

In addition to statistical measures of economic health, confidence indicators can often serve as an early signal of a turning point in an economic cycle. There has been a significant uptick in confidence in the UK in the last few months, with consumer and business confidence indices, along with manufacturing output expectations, hitting their highest levels in over two years.

While the era of ultra-low rates may be disappearing in the rear-view mirror, consumers and businesses seem to be adapting to the ‘new normal’ and the easing of inflationary pressures should prove a further boost for consumer spending. These catalysts are supportive for small-cap companies who are often more domestically-focused than their larger-cap counterparts.

The UK small-cap sector has historically also performed strongly when interest rates decline, driven by the availability of cheaper debt to finance growth and renewed investor appetite for higher-risk, higher-growth investments.

As shown in the chart below, both UK small-cap indices delivered attractive returns during the low-interest rate environment from 2009 to 2021. While rising interest rates have weighed on returns since early 2022, the reversal in the base rate should be a tailwind for the sector.

There are also signs of a possible shift in investor sentiment in recent weeks, with fears of a possible US recession and softening earnings outlooks for the magnificent seven triggering a market wobble in August, with the S&P 500 falling by 6% in one week alone.

Given that the current market cap of Apple alone exceeds the value of the whole UK equity market, even a small unwinding of the concentration of global capital invested in the US mega-caps could prompt significant inflows into other sectors.
 

Picking up a bargain
 
Despite the recent uptick, UK small-cap valuations remain well below long-term averages and other developed market indices. As shown in the chart below, the UK is currently trading at the lowest valuation of all the developed market indices, including a 24% and 36% discount to the MSCI World and US Small-Cap indices respectively.

The steady stream of takeover offers from corporate and private equity buyers is further testament to the attractive valuations of UK small-caps. According to Peel Hunt, the average premium for takeovers of UK listed companies in 2023 was 50%, reinforcing the potential upside in current valuations.

The UK small-cap sector offers a broad universe for stock-pickers, with more than 1,000 small-cap companies across the main market and AIM. It’s also less widely-researched which can lead to pricing opportunities for active managers: the average number of analysts covering the ten largest FTSE 100 companies is 18, compared to less than six for the FTSE Small Cap Index (and coverage drops substantially thereafter).
 

Under the micro-scope
 
Despite the challenging macroeconomic and market conditions, active fund managers have proved their worth in uncovering attractively-valued UK small-caps, with all of the trusts in the AIC Smaller Companies sector achieving positive net asset value returns over the last five years. The sector is also currently trading on an average (unweighted) discount of 10% (as at 30/08/2024) which could provide a further boost to returns if the discount narrows.

By way of example, BlackRock Smaller Companies (BRSC) is currently trading on a discount of c. 9% and has delivered a five-year NAV return of 22%, including an 8% return in the last six months alone (as at 16/09/2024). The cash-generative nature of UK small-caps can also be overlooked by income-seekers, with BRSC currently trading on a dividend yield of 2.9%.

Manager Roland Arnold is a bottom-up stock picker who looks to exploit valuation opportunities in the smaller, less-researched end of the UK equity market. Roland looks for high quality companies with significant recurring revenue and strong cash generation, enabling them to adapt quickly to changing market conditions.

One strong performer has been XPS Pensions, a leading FTSE-250 consulting and administration provider to the pensions sector. It has over 1,400 clients and more than one million members under administration. The company has pursued a number of acquisition-led consolidation opportunities over the last few years, as well as harnessing the growth from regulatory changes in its core market.

XPS has a strong track record of revenue growth across all divisions, with more than 90% repeat recurring revenue, and delivered a consistent increase in EBITDA margins. The company is highly cash-generative, which helped to finance a 75% reduction in net debt in the last financial year together with a progressive dividend policy.

These strong fundamentals have provided the foundation for the company’s impressive share price performance, with a c. 60% and 160% increase in share price over the last one and five years respectively (as at 17/09/2024).

Another positive contributor in BRSC’s portfolio is Workspace which owns and manages 4.5m square feet of office space in around 80 locations across London and the South-East. The company has a 4,000 strong customer base of small and medium-sized businesses and has consistently achieved occupancy levels of around 90%, alongside an increase in average rent per square foot.

The share price of Workspace has risen by more than 30% in the last year (as at 17/09/2024). This was helped by strong full-year results, with robust demand for flexible office space in London and an attractive pipeline of new office developments.

These examples demonstrate the merit of active management in identifying companies that will prosper across the economic cycle. Given current valuations and the brighter macroeconomic outlook, the UK small-cap sector could provide a golden opportunity for alpha generation if the recovery continues to gain momentum.
 
See the full research on BlackRock Smaller Companies here >
 

Disclaimer
Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by BlackRock Smaller Companies. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.

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