Why the tide may be turning for UK smaller companies

After a challenging 2022, the tide may be turning for UK smaller companies. Our analysis shows the FTSE SmallCap Index (excluding Investment Trusts) has begun to outperform the FTSE 100 and the FTSE 250 in recent months and, with the prospect of easing inflation, the stage may now be set for a strong bounce back by smaller companies.

The chart below shows that over six months to 21/06/23, the FTSE SmallCap (ex-IT, Total Return) returned 4.5%, while the FTSE 250 (ex-IT, Total Return) returned 1.1% and the FTSE 100 (Total Return) returned 3.0%. Over three months the three indices returned 4.8%, 0.4% and 1.4% respectively and over one month the returns are 0.5%, -3.3% and -2.3%.

We believe that the conditions may now be in place for a robust and sustained rebound by the UK’s smaller companies.

Brightening economic picture

Last year’s sell-off was caused by a number of factors. Rising interest rates made it more expensive for smaller companies to borrow to finance their growth, while higher market volatility increased liquidity concerns, driving investors to seek shelter in large caps.

Slowing growth and forecasts of recession also deterred investors from holding smaller companies, which tend to be more sensitive to adverse macroeconomic conditions. In addition, a weaker pound was more of a headwind for smaller, domestically focused companies, which are often importers, while it flattered the overseas earnings of larger global players.

Now though, we believe interest rates are approaching their peak, market volatility has fallen to pre-pandemic levels, the UK has so far managed to avoid recession and the pound has been strengthening against the dollar. So, the macroeconomic backdrop is looking significantly more positive for smaller companies – clearing the path for a strong period of outperformance.

Highly attractive valuations

In addition, UK smaller company valuations are looking highly attractive, which has resulted in a flurry of merger and acquisition activity. Deutsche Bank has agreed a deal to buy the broker Numis; overseas companies are in the process of acquiring restaurant operator Fulham Shore and car dealer Lookers; and a private equity house has made a bid for smart meter and housing maintenance company Sureserve.

As the chart below shows, the P/E multiple for the Numis Smaller Companies Index excluding investment companies (NSCI XIC) more than halved between 2022 and the beginning of this year, when it reached a level only slightly higher than in 2009 when the world was still experiencing the aftermath of the Great Financial Crisis.

If we look at small-cap P/E multiples relative to large caps then valuations are at an even more pronounced discount. The line chart shows the NSCI XIC P/E multiple at a discount of more than 30% to the FTSE All-Share (excluding investment companies).

Strong rebounds after sharp falls

Our analysis shows that when the FTSE SmallCap (ex-IT) Index has fallen substantially further than the FTSE 100 – then historically it has bounced back to significantly outperform the blue-chip index over the next two years.

We compared the performance of both indices since the FTSE SmallCap was created in 1988 and focused on periods where they have fallen sharply from a two-year high point. While the FTSE SmallCap has proved more volatile than the FTSE 100, in most cases the scale of its falls have been no more than 22% greater than the blue-chip index.

The chart above shows that on only four occasions in these 35 years has the FTSE SmallCap (ex-IT) fallen over 22% more than the FTSE 100. That was twice in the 90s, once in 2009 and then again in November 2022. On the previous three occasions, the FTSE SmallCap (ex-IT) Index went on to deliver an average return of just over 42% over the next two years, while the average return from the FTSE 100 was significantly lower at 27%. The average annualised outperformance of the FTSE SmallCap ex-IT Index versus the FTSE 100 over these two-year periods was 7.3%.

A rare long-term opportunity

Marlborough has three funds focusing on the growth potential of the UK’s smaller companies: Marlborough Special Situations, Marlborough UK Micro-Cap Growth and Marlborough NanoCap Growth.

Co-managed by Eustace Santa Barbara and Guy Feld, who work with one of the UK’s largest and most experienced smaller companies investment teams, all three funds have exceptional long-term performance track records.

The funds invest in quality smaller companies, with robust balance sheets, high-calibre management and strong long-term growth prospects. These are exactly the type of businesses that we expect to lead the way in an improving economic environment.

While many of these companies are currently on significantly reduced valuations, we are already seeing clear signs of increasing investor interest in UK smaller companies – and markets can move quickly. Investors who leave it too late may find they have missed out on a rare long-term opportunity.

Sheldon MacDonald, 23/06/23

Risk Warnings
Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds. Our funds invest for the long-term and may not be appropriate for investors who plan to take money out within five years. The funds will be exposed to stock markets and market conditions can change rapidly. Prices can move irrationally and be affected unpredictably by diverse factors, including political and economic events. The funds invest in smaller companies which are typically riskier than larger, more established companies. Difficulty in trading may arise, resulting in a negative impact on your investment. The funds invest mainly in the UK therefore investments will be vulnerable to sentiment in that market which may strongly affect the value of the funds. In certain market conditions some assets may be less predictable than usual. This may make it harder to sell at a desired price and/or in a timely manner.

Regulatory Information
This material is for distribution to professional clients only and should not be distributed to or relied upon by any other persons. It’s provided for general information purposes only and is not personal advice to anyone to invest in any fund or product. Information taken from trade and other sources is believed to be reliable, although we don’t represent this as accurate or complete and it shouldn’t be relied upon as such. Calls will be recorded for training and monitoring purposes.

Issued by Marlborough Investment Management Limited, authorised and regulated by the Financial Conduct Authority (reference number 115231). Registered office: PO BOX 1852 Lichfield, Staffordshire, England, WS13 8XU. Registered in England No. 01947598. Investment Fund Services Limited (IFSL) is the Authorised Corporate Director of the Fund. IFSL is registered in England No. 06110770 and is authorised and regulated by the Financial Conduct Authority. Registered office: Marlborough House, 59 Chorley New Road, Bolton, BL1 4QP. Copies of the Prospectus and Key Investor Information Documents are available from www.ifslfunds.com or can be requested as a paper copy by calling 0808 178 9321 or writing to IFSL at the registered office above.