Insight

Seeking big opportunities in UK Smaller Companies

Seeking big opportunities in UK Smaller Companies

Whilst the shape of the UK economy shouldn’t be the defining factor to a firm’s performance over time, it can certainly make a difference to the smoothness of the ride.

Jonathan Brown and Robin West consider the outlook for the UK economy and why they believe UK smaller companies that can grow organically (using their own resources) are well positioned to capitalise on both the ups and downs of the macro-economic environment1.

Macro matters

Political and economic uncertainty defined 2019 for UK equity investors. The lack of visibility over our future trading relationship with the European Union and a paralysed minority government weighed particularly heavily on the UK smaller company sector due to its greater exposure to the domestic economy. Insecurity has seen the sector shunned, with international investors particularly reticent to invest. Companies which source their revenues from the UK have underperformed companies with substantial interests outside the UK despite underlying corporate earnings stability.

Meanwhile, Sterling weakness has increased costs for many domestic businesses. The UK Smaller Companies equity sector, notwithstanding the UK General Election bounce in share prices, has been trading more cheaply than its 20-year average.

“We believe the year 2020 is set to be different”

We believe the year 2020 is set to be different. The recently published Deloitte CFO Survey showed the largest increase in optimism in the survey’s eleven-year history for Q4 2019.2 This is a clear signal of business sentiment changing in the wake of the election.

There are also some encouraging signs of robust underlying data – record employment has been achieved alongside real wage growth. The new Government is also committed to increasing fiscal stimulus with the Chancellor’s Spring Budget set for March 2020. These factors should help consumer confidence.

Our longer-term view for the global economy, however, is more cautious. In more recent weeks, it has become apparent that coronavirus, or Covid-19, could pose a serious challenge to global economic growth. It’s a fluid situation but concerns over the impact of the outbreak have intensified. The effect on the global economy will become clearer as companies outline how an exogenous shock such as this affects their business by way of disruption to global supply chains and forcing customers to stay at home.

So far, the impact on western economies has been limited, but how far the virus will spread and how deep its economic impact remains difficult to quantify. What is clear, however, is that the virus is exposing the vulnerabilities of globalisation itself.

It should not be forgotten that the main driver of financial markets, and share prices in general, is liquidity3 rather than the economy. So, whilst the short-term outlook for corporate profit growth has become more difficult, interest rates and the potential for more creative forms of economic stimulus, such as increasing government spending or quantitative easing, to name a few, should continue to be supportive for equities.

Investment process

We spend a significant amount of time meeting companies and prefer to invest in those with “self- help” characteristics. 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 company but can represent a very significant opportunity for a smaller business.

“…the smaller companies end of the equity market is an exciting place to be”

For stock pickers such as us, the smaller companies end of the equity market is an exciting place to be. Significantly lower stock analyst cover compared to larger companies allows you to find genuine mispricing, whilst a high proportion of founder-ownership encourages management to focus on long-term shareholder value creation.

Our analysis is focussed on the sustainability of returns and profit margins, which are vital for the long-term success of a company. We continue to look for businesses with ‘pricing power’ by assessing positioning within supply chains and having a clear understanding of how work is won and priced. It is also important to determine which businesses possess unique capabilities, in the form of intellectual property, specialist know-how or a scale advantage in their chosen market.

1Behaviour and performance of the economy as a whole. 

2Source: Deloitte, January 2020, https://www2.deloitte.com/uk/en/pages/finance/articles/deloitte-cfo-survey.html
The quarterly CFO Survey is an established survey of UK corporates’ sentiment and strategies, that gauges attitudes to valuations, risk and financing.

3The degree to which a security can be quickly bought or sold in the market at a price reflecting its intrinsic value.

Investment risks

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

  • Investors in smaller companies should be prepared to accept a higher risk than 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

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