Could now be the time for UK smaller companies?

The UK smaller companies sector is showing tentative signs of recovery as investors increasingly search for growth opportunities outside of big US tech. Against positive expectations of falling interest rates and what looks to be a stable period in UK politics could there be further to run?

Short term market moves are unpredictable but there could be opportunities for long term investors. UK consumer and business confidence is on the up. Many smaller UK businesses offer a better way to capitalise on positive economic signals than the internationally facing larger companies that dominate the broader market.

In addition, the downward trajectory of UK interest rates, expected to begin shortly, could offer relief to more indebted businesses and make borrowing for growth more attractive.

The more stable political and economic situation following a spell of volatility could also be appealing for international investors. The UK may increasingly be viewed as an inexpensive ‘safe haven’ provided the new government’s tax and spending plans are appropriately received. Specific policies from the new government may either help or hinder individual companies and sectors, but some stability and clarity should also allow businesses to better plan for the future. The Labour party has also made supportive comments around fostering economic growth and reinvigorating the UK’s capital markets.

But the most compelling argument is one of valuation. Even within the context of an inexpensive UK market, smaller companies are cheap relative to larger ones, despite frequently being able to maintain their growth potential regardless of the economic backdrop.

What are the risks of UK smaller companies?

Smaller businesses can be less diversified or have more reliance on a narrower range of suppliers and customers than large blue chips. They can also be more susceptible to changes in sentiment because they are usually less ‘liquid’ – or easily tradable – than larger company shares, and this can lead to bigger share price moves.

Typically, smaller companies are closely tied with the performance of the domestic economy. Should this take a turn for the worse, for instance if consumer sentiment deteriorates and the important services sector faces headwinds, then smaller company shares would likely suffer. While the pressure of inflation is now easing on households and the jobs market remains resilient, this cannot be taken for granted. It is also worth noting that the UK tax regime can have an impact and, as always, is subject to change.

The stealth rise in UK smaller company shares

While investor focus has remained on US markets, notably the technology-enabled giants, a meaningful rise in the value of UK smaller companies has gone largely unnoticed. In 2024 to date the average fund in the Investment Association UK Smaller Companies sector has matched the rise of the average fund in the North American sector – both have risen by around 12%.

However, some investors are starting to take an interest. According to new research we commissioned, 35% of DIY investors have increased their exposure to the FTSE 350 index of large and mid-sized companies. Meanwhile, 28% have increased their exposure to smaller companies via the Alternative Investment Market (AIM)*.

Past performance of the average UK Smaller Companies fund over the past five years

Past performance is not a reliable indicator of future returns. Figures are shown on a % total return, bid to bid price basis with net income reinvested; Source: FE Analytics, data to 30/06/2024

The upturn in fortunes for this part of the UK market has partly been down to corporate and private equity buyers. Increasingly, they have been capitalising on low valuations to snap up complementary businesses. This activity has helped shine a spotlight on the sector, underscore the value to be found and brighten overall sentiment.

A new idea from our Collectives Research Team

Funds investing in smaller companies should ideally be large enough to be efficient and lower cost but small enough to react quickly to opportunities. It’s also an area where knowledge and skill combined with a sound selection process can make a big difference to long term returns.

One fund that stands out to us is WS Gresham House UK Smaller Companies. Managed by the experienced Ken Wotton, we believe it is something of a hidden gem. What’s more, through Charles Stanley Direct it is available with a low annual management charge of 0.4%, making the broader ongoing charges figure 0.5%. This is superb value for a fund of this type and much cheaper than the standard units available on other platforms.

Gresham House might not be a household name, but they are highly respected investors in both market listed companies and private businesses. This crossover means they apply a private equity perspective to public markets focusing on high quality businesses that have strong management, market positioning and business models. They also consider the potential strategic value of the business to potential trade or private equity buyers.

The managers also take a hands-on approach, engaging directly with management to provide input into strategic decisions to help maximise shareholder value. In particular, they are attracted to businesses with high and sustainable margins, strong cash generation and a good record of investing for growth. The process leads to avoidance of companies in financial distress, deep turnaround situations, or those in challenged sectors.

A focus on higher quality businesses with exposure to structural growth themes leads to heavy exposure to sectors such as healthcare, business services, media, and technology. The fund has a concentrated portfolio, typically of 40-50 holdings, which adds to the risk of an already more adventurous area. The fund will not invest in the particularly economically sensitive sectors (oil and gas, metals and mining, banks, real estate), nor in loss making businesses.

The fund has a strong long-term record, although past performance is not a guide to the future, and it remains an appropriate size for investing in this more niche area. It also offers superb value for a specialist active fund for investors through Charles Stanley Direct. We are pleased to welcome it to our Preferred List of fund ideas for new investment.

* Research carried out between 05/07/24 and 10/07/24 by Censuswide with a sample of 1007 UK ‘DIY’ investors.