The unloved UK small cap funds that could make a comeback

It has been a difficult period for investors in UK small cap stocks with 96% of the open-ended funds operating in the sector losing money in the first seven months of the year. The problems posed by the pandemic and post-Brexit trade talks have taken a heavy toll, but a strong uptick in the performance in August could be a sign that buyers are starting to return.  

Of all the developed markets the UK has been one of the worst affected by the coronavirus, with the country suffering a higher rate of excess deaths than many of its European neighbours and the economy shrinking dramatically under lockdown.

Thankfully, the level of economic activity has started to recover, although the risk of further restrictions and the uncertainty over whether an agreement will be reached with the EU before the end-of-year deadline have made investors nervous.

Adrian Lowcock, head of personal investing at Willis Owen, says that smaller companies are vulnerable to a downturn in the UK economy as they are more domestically focused than their larger peers, although there is a wide variety of businesses operating in the sector and not all will be affected in the same way.

“The biggest impact on smaller companies is often down to sentiment and changes in outlook amongst investors. Fears of a recession mean investors tend to take some risk off the table and reduce their exposure to the sector. Valuations are therefore suppressed.”

Small caps inevitably experience a higher degree of volatility than the blue chips and this will be magnified while the Brexit talks rumble on, but they have built up an excellent long-term track record of performance.

Over the ten years to the end of July the UK Smaller Companies sector generated an average return of 177.2% compared to just 83.1% by the UK All Companies sector, which provides exposure to the large and mid-cap stocks.

“Were we to get a second wave of coronavirus over the winter and/or a no-deal Brexit, then I’m sure in the short-term small caps would get hit hard, but for pragmatic investors I think this may offer up some real opportunities for those willing to embrace some risk and invest for the long-term,” suggests Ryan Hughes, head of active portfolios at AJ Bell.

A lot of the small caps are under-researched, particularly when you look at little further down the size scale, which creates opportunities for those managers who are selective and have a long-term approach.

“My discussions with fund managers are always enlightening, but in recent months some are genuinely excited at the quality of businesses they are able to invest in at low valuations because of the impact of the virus,” says Hughes.

A difficult start to the year

Small cap stocks tend to outperform larger companies over the long-term because they have greater growth potential.Most are more reliant on the UK economy and domestic consumer spending, but in recent months this has counted against them with the Brexit transition period, recession and many other unknowns all weighing on the outlook.

According to data from FE Trustnet, only two of the 51 funds in the UK Smaller Companies sector made a positive return in the first seven months of the year and both managed to shoot the lights out. They were: LF Miton UK Smaller Companies with a gain of 29.5% and MFM Techinvest Special Situations which was up 13.8%, although it is currently in the process of being merged into the Marlborough Nano-cap Growth fund.

It has been a real roller coaster of a ride for investors in the Miton fund, which was the worst performer in the sector in 2019 with a loss of 13%. The high volatility is probably due to the fact that about 80% of the portfolio is in stocks listed on AIM, yet the recent uptick hasn’t been enough to stop the assets under management shrinking from around £200m in mid-2018 to just £59m. 

Rob Morgan, an investment analyst at Charles Stanley, says that the UK is relatively cheap and under-owned by global investors.

“The situation is pretty binary and if there was some really good news the rally would be rapid and sharp, especially among the small caps. However, without a decent outcome on Brexit it’s hard to see a catalyst to unlock the value that exists.”

The safest way to take advantage of the current uncertainty would be to pick some small cap funds to monitor so that you are ready to step in if the volatility throws up a buying opportunity. The investment trusts could be particularly attractive if the discounts widen out.

Another option would be to drip feed some money into the sector on a regular basis over the next few months. This would reduce the risk of bad timing and even out the purchase price so that your investment would benefit from pound cost averaging.

The best small cap funds

When it comes to the open-ended funds, Lowcock recommends Merian UK Smaller Companies, which is managed by Dan Nichols. He says that the team are well resourced and have a deep understanding of the small cap market, with unprecedented access to information on companies in this space.

He also likes Artemis UK Smaller Companies, which is run by Mark Niznik and Will Tamworth. According to Lowcock, 

“They look for stocks with strong business franchises and conduct thorough research of the companies, particularly looking for strong returns on capital, predictable earnings and solid balance sheets. I like the consistent approach, which has been reliably applied by the managers.”

Hughes recommends that ‘core’ investors look at Franklin UK Smaller Companies, which is now run by Dan Green. He says that the firm has a bias towards higher quality smaller companies rather than the speculative elements of the market, and at £250m the fund is small enough to be nimble. 

“For those wanting a bit more risk, the Tellworth UK Smaller Companies fund run by Paul Marriage is an interesting choice. It has struggled this year as around 70% is in companies below the £500m market cap, but he is a highly experienced manager who knows company management teams across the UK and this could be an opportune time to add some unloved small caps,” says Hughes.

Darius McDermott, MD of Chelsea Financial Services, prefers Marlborough UK Micro Cap Growth, which he describes as one of the standout funds in the sector.

“The Hargreave Hale team is renowned for its small cap expertise and it has consistently delivered exceptional performance for investors over a very long period. The team has a proven capability of adding value through stock selection as a result of their company meetings and diligent research.” 

Alternatively, McDermott highlights Liontrust UK Micro Cap, which applies the team’s proven ‘economic advantage’ investment process to the sector and only invests in companies that are already profitable. McDermott says that it’s rare for a smaller companies fund to have such a well-defined and disciplined framework and the alignment with management, focus on capital-light businesses that can scale quickly and emphasis on company meetings are all very sensible.

Small cap investment trusts

One of the best performing small cap investment trusts this year is the £165m Oryx International Growth Fund (LON: OIG), which has benefited from high weightings in Healthcare and Technology. Its ten largest holdings include EKF Diagnostics, which is contributing towards Covid testing, and Ergomed, which has been helping in trials of therapies for the virus.

The biggest losses this year have tended to come from trusts with a value or cyclical tilt as they have been hit hard by the slowdown in the economy and the continued uncertainty around the pandemic. A prime example is the £950m Aberforth Smaller Companies Trust (LON:ASL), which is down around 20% in the last six months.

Aberforth’s managers believe that the holdings in their trust are now exceptionally cheap after enduring the most difficult start to a year for small-cap value stocks since the data for their Numis Smaller Companies index was first collected in 1955. At the end of June the portfolio’s PE ratio was just 6.1, which was around 40% cheaper than the benchmark as a whole.

“Aberforth is worth considering if you are looking to be more contrarian and more positive on the UK domestic economy. It has undergone a period of significant underperformance, but could be an ideal vehicle for those wanting to specifically position for better news on the UK economy and on Brexit as it contains more of the most unloved and under-owned areas,” says Morgan.

Aberforth is one of Numis’ recommendations for the year, as is the £746m Henderson Smaller Companies Trust (LON:HSL). The latter is managed by Neil Hermon, who has built up a strong track record by investing in companies with good growth prospects, sound financial characteristics and strong management that are trading at a valuation that does not reflect these strengths.

The analysts at Winterflood recommend the £595m Standard Life UK Smaller Companies Trust (LON:SLS), which has an exceptional long-term performance record under the stewardship of Harry Nimmo, who follows a quant-driven, systematic investment approach. This has enabled him to capture the growth potential in the sector, while navigating the inevitable periods of volatility.

Another option is BlackRock Smaller Companies (LON:BRSC), which Morgan describes as an outstanding investment trust that has fallen out of favour. He says that it has a great performance record that it has achieved with unusual consistency and is on a higher than normal discount of 13% compared to the 12-month average of just three percent.

The immediate outlook for UK small cap funds will depend on the course of the pandemic and whether we get an agreement in place with the EU before we leave at the end of the year. It is going to be a volatile few months, but longer term investors may well be able to take advantage of the price action to pick up some bargains.

FUND OF THE MONTH

Small cap funds tend to be attractive for those looking for long-term capital growth, but some also offer rich pickings for investors who want an element of income. One such is the Montanaro UK Smaller Companies Investment Trust (LON:MTU), which pays a quarterly dividend equivalent to one percent of NAV (roughly four percent per annum), part of which is paid out of capital.

 Montanaro is not exactly a household name, but it is actually one of the largest independent small cap managers in the market. The firm invests in quality growth companies and does its own research in-house based on detailed fundamental analysis and site visits.

“Montanaro UK Smaller Companies is run by Charles Montanaro, who has a huge amount of experience. It is currently yielding 4.5% and is on a discount of more than ten percent and could add some real diversification for income seekers,” explains Hughes.

It is quite a concentrated portfolio for this part of the market with just 47 holdings, of which the ten largest positions account for about a third of the assets with names such as Liontrust Asset Management, Big Yellow Group and Dechra Pharmaceuticals. The majority of the investments are in companies valued at between £250m and a billion.

MTU held up pretty well during the sell-off with a loss of 8.5% in the year to the end of March, compared to a fall of 25.9% in the index. Year-to-date the shares are down around 20%.

Since the launch in March 1995 the trust has generated a cumulative share price return of more than four times its smaller companies benchmark. Consensus estimates suggest that the portfolio offers a forecast return on equity of 15% in 2021 and EPS growth of 24.7%, which bodes well for the future.