Business is booming.

Time to buy UK small-caps?

Could now be a good time to buy UK small-caps? Don’t all rush to type “no” in the online comments section — I’m well aware that 2022 was a stinker of a year for small companies, but more optimistic stockpickers might hope to find a few rubies in the dust.

Research shows that smaller companies put in a market-beating performance when measured over many years. However, in rate-hiking cycles, they are punished as investors question their growth potential and economic resilience — plus their ability to keep paying dividends.

This helps explain the very sorry-looking numbers in this week’s annual update to the Numis Smaller Companies Index, which has faithfully tracked the bottom 10 per cent of the UK’s fully listed market by value since the mid-1950s.

The NSCI index returned -16.3 per cent last year, falling to -17.9 per cent if you exclude investment companies, one of the worst years on record. There was an even steeper -31.1 per cent decline for companies listed on the Alternative Investment Market. Holding Aim stocks in your portfolio may have reduced your inheritance tax liability — just not in the way you envisaged.

Many small-caps now trade at multiyear valuation lows, prompting Alex Newman, my colleague on the Investors’ Chronicle, to comment that active stockpickers “have a large hunting ground to venture into”.

You don’t have to look very hard to find small companies trading at or below book value, or on single-digit forward earnings multiples. Clearly, careful stock selection is required — there’s every chance they could get even cheaper in the short term.

A striking feature of the Numis report this year was its list of “fallen angels” — 45 companies that have been squeezed out of the mid-cap or large-cap indices and now rank among the small. Comprising 26 per cent of the NSCI’s weighting at the start of 2022, this is a record-breaking proportion.

“This has impacted the structure of the index as gaining so many losers has brought in more value-orientated companies as opposed to the growth stocks the small-cap world is famed for,” say Paul Marsh and Scott Evans of the London Business School, who compile the index.

The pair have looked at what happened in previous years when high numbers of shrunken angels fluttered down into the index.

Intriguingly, there were two occasions when the small-cap index benefited greatly from this — after the bear market of 1974, and again in 2009 after the financial crisis. Holding the fallen angels in those years added 10.6 and 6.2 per cent respectively to index performance. Evans asks: “Could we be on the cusp of the third occasion of massive outperformance?”

Although the academics stress they’re in the business of analysis rather than predictions, Marsh is of the view if the wider market has a good year in 2023, the fallen angels could have an even better one.

“Many of these companies have been beaten up, become more highly geared as a result and therefore higher beta,” he says. So, higher risk, but the potential for higher returns if things turn out to be better than people are currently expecting.

Tempted? While plenty of funds use the NSCI as their benchmark, it’s not possible to buy a tracker that follows the index (indeed, the few small-cap trackers that are available to UK retail investors tend to focus more on mid-caps).

There are some active funds and trusts (more on these later) but if you’re tempted to stock pick, alongside the investment fundamentals, consider what could be the catalyst for a re-rating.

“You can have good news and cheap stocks, just not both at the same time,” says Russ Mould, investment research director at AJ Bell.

It’s possible that the weak pound will flush out more overseas raiders in the year ahead, but otherwise, investor patience will be required.

Looking at the full list of the fallen, his eye was immediately drawn to housebuilder Redrow. “It’s trading below book value, has net cash and a long history of providing returns on capital — but there’s unlikely to be great news in the property sector for some time,” he says.

The same goes for the Reits (real estate investment trusts) on the list, including Shaftesbury, which owns great chunks of London’s West End, and office specialist Great Portland Estates. “The main attraction of property companies is the yield, so if bond yields and interest rates go down, commercial property could potentially look more attractive — but again, it’s a waiting game,” he adds.

Savills, the upmarket estate agent, is a proxy for the prime property market, and could rebound if transactions exceed expectations (I note its new email signature pleads “If it’s the right home, it’s the right time”).

Plenty of consumer-facing stocks took a battering in 2022. You could argue that some, such as soda and tonic maker Fevertree, had far too much fizz in the price to begin with but could others be oversold? Domino’s Pizza and Deliveroo have rising food price inflation gnawing at their margins — but wealthier consumers downshifting from restaurants to takeaways could yet spice things up.

Online retailers Asos and THG (formerly The Hut Group) had a particularly torrid year. Asos has a new chief executive, and shares rose 15 per cent last week after better than expected Christmas trading, whereas THG saw its shares crash 18 per cent this week following its fourth profit warning in a year.

“Profit warnings are like cockroaches — there’s never just one,” says Mould.

Another fallen angel to have issued a warning recently is recruiter PageGroup, which looks a good candidate on paper (net cash, and a leader in its field) even though the UK jobs market is softening. “You know a business like that will come back at some stage, but the question is whether the share price reflects how long you might have to wait,” is Mould’s view.

If you don’t have the risk appetite to target individual stocks, you could try going long or short on some of these in FT Money’s annual stockpicking competition (deadline this Sunday, and nothing to lose but your pride).

Alternatively, a number of active managers offer UK smaller companies funds including Premier Miton, Franklin, Tellworth and Amati. There are also several investment trusts from providers including Abrdn, Aberforth, BlackRock and Montanaro. All have slightly different strategies — some focus more on growth, others on income (note that Aberforth is more focused on value investing).

Finally, be aware that “small” means different things to different managers — some will run their winners, so you will be buying into mid- as well as small-cap stocks, and others explicitly target mid-caps too.

Even if you think the answer to my original question is “not yet”, a small-cap themed idea definitely deserves a place on your watch list.

Claer Barrett is the FT’s consumer editor and the author of ‘What They Don’t Teach You About Money’.

Source link

Comments are closed, but trackbacks and pingbacks are open.