Investment outlook

2021: UK Smaller Companies - glass half full

2 December 2020
Jonathan Brown
Jonathan Brown
UK Small Cap Equities Fund Manager
Invesco: Outlook 2021 UK Smaller Companies (equities) - glass half full
Key takeaways
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We are optimistic in our outlook for UK Smaller Companies in 2021
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Reasons to be hopeful: in our view the potential for a successful Covid-19 vaccine looks promising, and on Brexit, we believe that the UK will reach an agreement with the EU by the end of the year
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We believe that the UK smaller companies market would benefit disproportionally from both scenarios given its strong domestic focus

The UK equity market, and the UK smaller companies market in particular, are the cheapest they’ve been since records began as investors have looked to avert the twin challenges of Brexit and Covid-19. The uncertainty surrounding the two has weighed on sentiment and put downward pressure on valuations, however, notwithstanding the likelihood of near-term volatility, there is a real sense of optimism as we look towards 2021.

We have long been hopeful that a vaccine could be ready by the end of 2020 and news in November of Pfizer’s vaccine breakthrough with German partner BioNtech delivered a much-needed boost. A vaccine is likely to reduce the mortality rate and lessen the fear around the virus, potentially a first step towards ending the pandemic, and accelerating the return to some version of normality.

As the UK nears the end of the Brexit transition period on 31 December 2020, the UK continues to negotiate on its trade relationship with the European Union. While uncertainties prevail, we believe that there will be a trade deal at the 11th hour and that this would benefit UK equities, and UK smaller companies in particular.

The UK smaller companies market is more domestically focused than the large-cap market (in terms of revenue), and is more heavily weighted towards travel, leisure and retail, and therefore consumer spending. These are also areas of the market which have been severely affected by Covid-19 restrictions.

The UK equity market is certainly cheap versus the US, and versus Europe and Japan too. While it’s been ignored for some time, we believe that a Brexit resolution would have the power to lead to renewed interest (and re-rating) in UK equities, which are arguably one of the most unloved and undervalued areas of global equity markets. We believe that the UK smaller companies market would benefit disproportionally from a Brexit resolution given its domestic focus.

The last time the UK equity market was as cheap as it is now — compared with the global average — was nearly 50 years ago (source: FT, 6 November 2020). So where does that leave the UK smaller companies market today? Volatility is likely to remain high for some time yet, however, as the period of uncertainty abates, we believe that there would be renewed interest in the UK smaller companies sector.

Aside from Brexit and Covid-19, the other key factor in determining stock prices this year has been the strong performance of growth stocks and those stocks perceived as having more defensive characteristics and which have been trading at very high valuations. We don’t feel that there is much potential for those stocks to re-rate further in terms of valuations.

We also think that bonds are looking incredibly expensive, while bond yields have plumbed to new depths, pushing some investors into expensive, faster-growing stocks in sectors like technology. Within this context we believe that equities overall look very attractive and that UK Smaller Companies stand to benefit the most from any improvement in confidence.

During these extraordinary times, we are currently taking a “bar bell” approach to constructing portfolios. The bulk of the portfolios is invested in defensive growth stocks i.e. stocks which should continue to do well regardless of the economy. We have also invested in stocks which we believe will do well in a broad-based recovery following the successful roll-out of a vaccine(s) and against the backdrop of a successful Brexit resolution.

We continue to favour stocks with “self-help” characteristics that enable them to grow independently of economy. This can include restructuring stories, where a fundamentally good business has lost its way, but has the potential to rehabilitate itself under new management. We also like businesses that have scope to roll-out a successful concept more widely, or companies that can consolidate a fragmented industry and derive a benefit from increased scale. We also seek companies that are exposed to higher growth niches within the wider economy. These niches are often too small to make a significant difference to a large cap but can represent a very significant opportunity for a small business.

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Investment risks

  • The value of investments and any income will fluctuate (this may partly be as a result of exchange rate fluctuations) and investors may not get back the full amount invested.

    Investing in smaller companies may result in a higher level of risk than investing in larger companies. Securities of smaller companies may be subject to abrupt price movements and may be less liquid, which may mean they are not easy to buy or sell.

Important information

  • This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.

    Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.