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Are UK smaller-companies the investment opportunity of 2021?

Written by: Darius McDermott
Companies in the UK have had a hard time over the past four years. First, they had to deal with the ongoing uncertainty of Brexit… and then comes along a global pandemic forcing many of them to stop their activities completely.

The challenges facing the UK’s small and medium-sized businesses in particular were immense in the first lockdown – at one point figures suggested up to one million of these firms were in danger of going under by the end of April 2020.

The shares of these companies and the funds investing in them were also hit hard. The average UK smaller companies fund fell almost 40% during the global sell-off in February and March, as investors were spooked by the unknown nature of the pandemic.

But, as it did a few months after the EU referendum, their resilience has shone through once again. Year-to-date, the average fund in this sector has recouped the majority of those losses.

The 2021 opportunity

With central banks around the world actively supporting the global economy, there is hope for a stronger recovery in 2021 – and there are reasons to suggest UK smaller companies could be one of the big beneficiaries.

One of the big impacts of the pandemic will be the acceleration of changing trends in society, such as the importance of technology, increased working from home and a greater focus on health. This is a tailwind for small-caps as they are agile enough to take advantage of changes in society at a far quicker pace than many of their larger counterparts.

However, a recent research document from Marlborough Fund Managers highlighted two other specific catalysts for another upswing in performance for the sector.

The first is that mergers and acquisitions – an important part of the small-cap space when it comes to making profits – could well pick up as the combination of low interest rates and a weaker pound peaks the interests of potential buyers.

The second is that the valuation of UK smaller companies look extremely attractive going into 2021 from an investment perspective. In other words: their shares look relatively cheap.

Of course, the risk is higher with smaller companies, therefore an active manager is essential in spotting those firms capable of trading through a downturn and emerging on the other side in a position to take advantage of any subsequent upturn.

Below are four funds to consider:

1) LF Gresham House UK Micro Cap

This fund has been run by the same manager since 2009. He also has the benefit of being able to tap into a large team of investment professionals to take advantage of their private equity expertise and to find some truly unexplored ideas among the UK’s smallest companies. The fund avoids high risk sectors such as oil, mining and property.

2) LF Tellworth UK Smaller Companies

The two managers of this fund have an exceptional track record of investing in UK smaller companies. They predominantly look for companies with a differentiated product, high sustainable margins, management aligned with shareholders and a market leading position. A smaller portion of the portfolio will be made up of ‘self-help’ recovery stories.

3) Marlborough UK Micro-Cap Growth

Management of Marlborough UK Micro-Cap Growth fund is outsourced to Hargreave Hale, one of the best small-cap boutiques in the country. This portfolio typically holds around 250 companies to reduce stock-specific risk. Relatively small positions are taken initially and the managers will add to the stocks as their stories unfold.

4) Unicorn UK Smaller Companies

This is a very high conviction UK smaller companies fund with around 40 holdings. The manager looks for companies with lasting competitive advantages, experienced management teams and strong balance sheets. A large proportion of research is performed in-house – this allows Unicorn to identify companies often missed by brokers.

Darius McDermott is managing director of Chelsea Financial Services

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