UK small caps: unlocking the potential of UK plc

Long-term outperformance of small caps versus large is an evergreen theme in UK equity investments. But due to a confluence of factors, the moment could be particularly timely, says Philip Rodrigs of Raynar Portfolio Management.

The IMF recently forecast the UK will be the fastest growing advanced economy in the world this year and has raised its GDP forecast more than any other country.

Despite ongoing threats from variants of Covid-19 and thanks to a hugely successful vaccine roll-out, both the IMF[1] and the CBI[2] forecast strong, sustained growth for the UK for the remainder of the year and beyond.

After a miserable 2020, with markets tumbling across the board, investors are understandably now keen to look into increasing equity exposure in order to continue to benefit from the subsequent rebound. For us, there is no better place to start than at the entrepreneurial end of the market – the UK smaller business sector.

The importance of stock picking

First, it’s important to know that not every smaller business will be successful over time. After all, there are nearly a thousand publicly traded companies on the lower end of the market, and many are still in their infancy and have little visibility when it comes to long-term performance.

As you’d expect, this means choosing the stocks that are most likely to thrive is a difficult task avoiding those investors who focus on the lesser choice among generally more established companies within the mid- and large-cap universes want. However, investors willing to take on the less-studied, smaller company sector, with its lower liquidity and therefore lower risk premium, will find that the top segment of winning small-cap stocks can generate very attractive returns.

Why? Well, a lot depends on the scale.

Scaling business models

The smaller a company, the greater its potential for growth: it is easier for a company with a turnover of £ 1 million to double its turnover than, for example, for a company with a turnover of £ 100 million.

But this does not only apply to sales growth.

Smaller companies also have greater potential for margin expansion through improved economies of scale than their larger competitors. They have greater potential to invest cash in transformative investment opportunities and a greater chance of re-rating as their illiquidity risk premium wears off as more investors pay attention to the company as market capitalization increases. And since their audience is usually smaller in the early days, they have a better chance of maintaining an upward trend as their increasing size sparks new interest.

The outperformance that these factors can create is so great that data from Numis Securities showed that £ 1 invested in the Numis 1000 XIC smaller business index from 1955 to the present accumulated to more than £ 25,000. That is far higher than the return for the corresponding indices for larger stocks over the same period (see chart below).

It goes without saying that investors who can identify an industry-leading small-cap stock at a cheap valuation and drive that winner into the mid-cap and beyond can generate truly transformative returns.

From consolidation to rapid growth

Long-term outperformance of small caps is an evergreen theme in UK equity investments. Right now, however, it is particularly timely as the industry is in a phase of consolidation.

This may sound counter-intuitive, but it could actually be an ideal entry point.

There is an old saying that is often attributed to the American author Mark Twain: “History never repeats itself, but it often rhymes”.

A look back at the past can therefore be a useful barometer. Previous cycles show an initial phase of very strong market appreciation, followed by a phase of consolidation before a subsequent phase of appreciation.

As data from Numis Securities shows, the rise, breather and lingering rally pattern were a feature of the last two market rallies in March 2003 and March 2009 after the global financial crisis, and the current cycle, which began in March 2020, rhymes with it it.

With that in mind, we can rest assured that the chances are that the second bullish phase of a traditional market rally may be just around the corner.

While many UK small caps continue to trade at a discount to their global competitors, once the true extent of the UK economic recovery is realized, the next earnings season will likely help with that, and companies will step up the delivery of strong earnings reports – it could well be a step in catalyze the next phase of growth.

Hence, we see a great opportunity in acquiring quality small-cap names that are positioned to benefit from a rebound in domestic spending – like Safestyle, Brickability and Studio Retail – ahead of potential catalysts.

Long-term outperformance

Sixty-five years and counting is more than enough time to dispel any doubts about the correctness of a trend. This is how long UK smaller companies have structurally outperformed their bigger brothers, so it will always be a good time to make a long-term investment in the sector. However, some good times can be better than others, and we believe that such timing is obvious. After a summer of consolidation, we look forward to the rest of 2021 and 2022 with enthusiasm.

Philip Rodrigs is the founder, portfolio manager of Raynar Portfolio Management

[1] Source: https://www.imf.org/en/Countries/GBR [2] Source: https://www.cbi.org.uk/articles/uk-economic-outlook-all-systems-go/

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