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BLOG: Can UK smaller companies continue to defy Brexit uncertainty?

Written by: Darius McDermott
Investors may be surprised at how well the UK’s smallest companies have performed in the three years since the EU referendum and the introduction of the “B word” which now dominates UK politics: Brexit.
BLOG: Can UK smaller companies continue to defy Brexit uncertainty?

On the face of it, our smaller companies were set to be the big losers, given their perceived reliance on the domestic economy for revenues, when compared with their more globalised larger peers.

But UK smaller companies – and in particular the funds that invest in them – have defied expectations.

The stock market index of UK smaller companies has returned 22.7 per cent since 24 June 2016. This is respectable – but less than the stock market index of our 100 largest companies, which has returned 38.8 per cent.

However, if you picked the right smaller companies in which to invest, you would have done better: the average fund in the Investment Association UK Smaller Companies sector has returned 45.5 per cent.

One of the main attractions of smaller companies for investors is that they have a better chance of outperforming their large-cap peers over the long-term, due to having more room for growth: it is easier for a small company to double in size, than a big one like BP or HSBC, for example.

Over 10 years this can be illustrated very clearly: The FTSE Small Cap ex IT index has produced a compound return of 12.6 per cent per annum – with dividends re-invested – some 2 per cent per annum ahead of what the FTSE 100 has returned. And again, the average UK Smaller Companies fund has done better, with annualised returns of 14.5 per cent.

Unloved and avoided

But all this has been forgotten in recent years, and smaller companies have taken a back seat in the UK thanks to ongoing Brexit negotiations. They have been very unloved and investors, for the main, have avoided them.

There is rationale for their resilience. I recently read an article from one manager who believes there are a number of companies in the UK small-cap index that are also very global in nature in terms of their revenues. However, there is also an argument for saying the past three years have been little more than a “phoney war” between the UK and the European Union and that the terms of the divorce will be where the pain is truly felt.

The fact is, the attitude towards UK companies generally is still very pessimistic and, as a result, the valuations of some companies are lower than they should be. UK smaller companies are more vulnerable to economic shocks, but any sort of sensible Brexit deal could bring a number of foreign investors back to the UK and may result in the outlook and sentiment towards smaller companies moving quickly.

The case for active management – as demonstrated in the numbers above – is arguably at its strongest in the smaller companies’  market given there is a greater focus on individual businesses as opposed to sectors or macroeconomic trends. It’s also worth remembering that, for every small company that succeeds, another may fail. So investing in the right company is important.

Fund picks

Thankfully, there are a number of excellent small-cap managers to choose from such as the Marlborough Special Situations fund managed by Giles Hargreave, which holds around 200 stocks to reduce individual risk and has returned 386.2 per cent in the past decade: annualised this equates to 17.25 per cent.

By contrast, the Unicorn UK Smaller Companies fund typically holds around 40 holdings to ensure it captures strong performance from its best ideas, with individual companies accounting for up to 5 per cent of the entire portfolio. It has achieved annualised returns of 16.9 per cent over the past ten years, which cumulatively is 374.9 per cent.

My final fund option actually focuses on companies the UK’s tiniest listed companies. The Liontrust Micro-Cap fund uses the same process behind its UK smaller companies offering and targets companies which demonstrate a strong distribution network for their services, high recurring revenues and/or a strong brand.

The team also looks for director ownership of at least 3 per cent of the company. There are around 300 companies below £150 million which satisfy these criteria and the fund will ultimately hold around 60 stocks. This fund has a shorter track record, as was launched in 2016, but over the past three years it has annualised returned of 18.6 per cent and, since launch has cumulative returns of 60.9 per cent – some 19 per cent more than the average IA UK Smaller Companies fund and 40 per cent more than the FTSE Small Cap ex IT index.

Darius McDermott is managing director of FundCalibre & Chelsea Financial Services

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