Written by Ken Wotton, lead manager of the UK Smaller Companies fund at Gresham House
Global equity markets face an array of challenges – including ongoing conflicts, geopolitical tensions, central bank policy uncertainty, and the lingering impact of inflation and higher costs on consumers and business demand.
But periods of heightened uncertainty are not unprecedented for the UK markets. Investors have navigated through periods of significant upheaval, such as Brexit and Covid-19, which have shaped perceptions of a sluggish domestic economy. Negative sentiment has particularly affected the UK small caps, which continue to trade at a considerable discount compared to larger counterparts.
Despite the challenges, there are several reasons to be optimistic about the UK small-cap space – especially as the agile demeanour and niche positioning of small caps often enable these companies to better navigate through broader economic headwinds.
Small-cap superiority
Over the long term, academic studies have shown smaller companies significantly outperform larger peers. Analysis of market corrections over many years suggests the recovery of small caps from market downturns can be stark and rapid, driven by improving risk appetite and the return of investment to the sector.
For example, during the trough-to-peak recovery from the severe Covid-driven downturn, smaller companies surged 121% as markets reversed the lockdown-induced losses and thrived into 2021. In comparison, the FTSE All Share gain was just 58%.
While macroeconomic and geopolitical issues periodically drive negative sentiment into markets, the returns from smaller companies over the longer term can be substantial for patient investors.
Policy assistance essential
Looking back to last year, a dearth of liquidity at the smaller end of the UK listed market kept valuations low and M&A activity high – further hollowing out quoted equities. High-growth UK smaller companies chose to list on overseas markets in pursuit of higher valuations, strong earnings performances were not reflected in UK smaller company valuations, and private equity increased its share of future UK value creation instead of domestic stakeholders – notably the growing millions of UK citizens saving for and living into retirement.
We believe policy towards UK equity markets has a key role to play in unlocking the growth potential of the wider economy. According to Peel Hunt research, 92% of City professionals have called for incentives to increase investment in mid and small-cap companies. More broadly, 96% say we need to reinvigorate UK equity culture.
There is also increasing momentum and a building consensus behind the view that decades of government policy and regulation have contributed to reduced pension fund and wealth manager allocations to UK equities. This trend must be reversed. The Mansion House compact, calls for a British ISA and reforms to UK listing rules, are just a few of the potential routes to attracting more capital to the UK market. If executed effectively, this could have a material impact over time.
Listed revival imperative
We strongly believe listed markets are a critical component of the overall capital ecosystem that can stimulate economic growth in the UK. The UK venture capital market, underpinned by the VCT sector, has seen a dramatic revitalisation over the past decade. In addition, the junior AIM market of the London Stock Exchange has been a major global success story over the past 25 years, supporting smaller companies with further growth capital as they expand and develop.
The ability to use listed markets to provide capital is essential to be able to offer VCs an exit route, enabling them to recycle capital back into earlier stage businesses without selling British innovation to overseas buyers.
During the pandemic, listed markets provided rapid and flexible support to recapitalise British businesses affected by lockdowns and reduced activity. This support was invaluable in allowing these businesses to recover and thrive. It is imperative government policy helps to ensure this valuable ecosystem remains healthy to support the wider UK economy.
Expect continued M&A
At the beginning of last year, we were questioning whether we were set for a bumper year of corporate activity – as we noted depressed UK equity market valuations, large, uninvested commitments to private equity funds, and fewer private-to-private deals. Although we saw subdued headline global M&A activity during 2023, this was largely due to the absence of large-cap deals. Indeed, most deal activity focused on UK small and mid-cap public companies. Only ten of the 40 bids in excess of a £100m equity value during 2023 had bid values of more than £500m.
Depressed valuations within the UK equity market – particularly at the smaller end – resulted in the average takeover premium increasing to about 52%, relative to a five-year average of 40%. Valuations for UK small-caps have become even more compelling relative to large-caps, global equities, and private market transaction benchmarks since the beginning of last year. For this reason, conditions remain favourable for takeover volumes to remain elevated, driving the potential for selective re-ratings across the market.
As takeover proceeds accumulate in UK small-cap portfolios, built-up cash balances will need to be reinvested. This influx of cash will create marginal buyers for UK small-cap stocks, potentially leading to a more general re-rating across the sector and narrowing the valuation gap.
