Written by Stuart Widdowson, Managing Partner at Odyssean Investment Trust
As in many historic periods of market stress, investment horizons have shortened for many investors. The final stages of this process tend to be where selling is close to exhausted (perhaps awaiting a final capitulation moment) but a buyers’ strike prevents markets functioning.
Share prices can move materially on low trading volumes and the impact of short-term news flow is exacerbated. Fear is the predominate emotion. Valuation anomalies are ubiquitous.
I believe we are working our way through one of these periods for UK equities, particularly small and mid-cap companies.
Of course, recent tragic events in the Middle East, with the associated global political stability they bring, are causes for concern. Moreover, reckless borrowing of many governments is coming home to roost. The mini budget from over a year ago meant unusually the UK was a global leader in highlighting the profligacy of government and attempts are being made belatedly to tame the behemoth of state spending. The US government meanwhile continues to spend with three hands which is keeping inflation and interest rates elevated. One wonders in the future if this is a period that the economists of tomorrow will use as a case study of crowding out.
The conditions investors find themselves in today are not new. Although the timing and mechanism of change is not clear, it will come. It is inevitable.
So what of our sector? Why bother considering small and mid-cap equities with all of these uncertainties and the prospect of ‘safe’ mid-single digit returns from bonds and gilts?
The first reason relates to equities as a long-term inflation hedge. From 1954 to 2023, the UK Consumer Prices Index (CPI) has averaged 4.5% per annum. Large companies in the Deutsche Numis All Share Total Return Index delivered annualised returns of 11.3% per annum, beating inflation by almost 7% per annum. The Deutsche Numis Smaller Companies Total Return Index including AIM ex investment companies, has returned 13.1%, beating inflation by 8.5% per annum, almost 2% points per annum more than the Deutsche Numis All Share. Whilst this does not seem like much, over 70 years it means that smaller companies would have delivered more than 3x the return of larger companies.
Today, it is well reported that UK equities are perceived to be undervalued in absolute and relative terms. It is also notable that in this decade so far. As at the end of December 2023 CPI had risen by more than 5% per annum since the end of 2019. In comparison UK equities rose only 3% per annum and UK smaller companies had risen 0.4% per annum. Presented a different way, UK Smaller Companies have underperformed CPI by almost 5% per annum since the start of the decade, compared with a 70-year outperformance of 8.5% per annum.
What does that mean for potential returns from here – i.e. why would investors bother taking the incremental risk over fixed income products? We argue the prospect for outsized returns for long term investors in smaller companies look particularly strong at this point. From a top-down perspective, were smaller companies to merely match CPI’s performance this decade, that would imply a rally of 20% from the levels at the beginning of 2024. Were smaller companies to revert to their long-term outperformance of CPI, markets would rally c.37% from their starting point in 2024.
These top-down numbers are consistent with what other valuation methodologies are implying about the upside from small caps. As at the end of March 2024 Canaccord’s Quest valuation tool implied aggregate upside for UK Smaller companies of 47% to get to what it perceives to be fair value. Over the past 20 years, UK smaller companies have traded at a good premium to their Quest fair value, even prior to the zero-interest rate policy (ZIRP) period, implying further potential upside.
We see similar dynamics from a bottom-up perspective in our portfolio companies. Arguably we see considerably higher potential upside to fair value – as at the end of March 2024 the average portfolio company was trading at a 40% discount to the valuation implied by long term enterprise value to shares (EV/Sales) and price to book ratios, which are better indicators of fundamental value than price to earnings (p/e) ratios. Late last year, the CEO of a portfolio company (admittedly with a higher risk/reward ratio than the average smaller company) shared with us his view that, were they to consider raising capital, the cost of equity for his company was about 30%. Sensibly he said they did not need it at the current time. With long term returns from the asset class being in the low teens, this is yet another data point that there are cheap valuations today which augurs well for a period of above average long-term returns.
This scale of valuation upside we see today in our portfolio companies is also mirrored by recent takeovers of smaller quoted companies – there seem to be about two a week at the moment. Premia are typically in excess of 50%, even in situations where the buyer is a private equity house with negligible synergies and higher cost of debt than enjoyed in the ZIRP period.
The changing cost of debt Is also a consideration – we have lived through a period where the earnings yield (inverse of the p/e ratio) of key indices such as the FTSE 250 have been materially higher than the gilt yield. However, it is worth noting that in the period prior to ZIRP when interest rates historically were in the 4-5% range, the earnings yield of the FTSE 250 was at or even below the gilt yield other than periods of extreme market stress. This is rational – equities as a whole grow their earnings and yield over time ahead of inflation. Debt instruments don’t.
Are we calling the bottom of the market for small and mid-caps? No. Maybe we have seen the bottom or maybe it is still to come. But what we are highlighting is that valuations appear to be attractive for any investor with a long-term investment horizon.
Anecdotally sentiment towards UK equities is improving. Maybe the strong performance of UK Smaller Companies since March is a good sign of green shoots. When sentiment changes, the low liquidity which has exacerbated the bear market is likely to work in reverse – with open ended funds receiving inflows rather than outflows, and scrabbling to deploy capital into the shares of less liquid companies whose sellers are long exhausted. In our experience this can lead to a sharp re-rating of the market. We compare this to pulling a brick across a table with a piece of elastic – the pressure builds and nothing happens for a while, and then there is sudden movement.
According to Deutsche Numis’ data, it is notable that the long-term average annual return from UK smaller companies of 16.8% is about 3.7% points higher than the compound annual growth of 13.1% – i.e. missing out on the rebounds is very determinantal to achievement of long term superior returns from the asset class.
Over the long term, we do not see any reason why smaller companies with good management teams cannot continue to beat inflation, potentially quite materially, from this point. The entry valuations are undemanding as demonstrated above. But moreover smaller companies are nimble – they can respond more quickly to changing market conditions and performance improvement initiatives. In the words of investor and business writer Jim Slater, “fleas can jump, elephants can’t” – i.e. smaller companies have much better prospects of delivering GDP+ growth.
As ever it is impossible to forecast the particular triggers or catalysts for investors to look at our sector again. But sentiment will improve at some point as it did in the mid 1970s, the early 1990s, 1999, 2003 and 2009. With many of our portfolio companies benefiting from international sales, well capitalised US peers and trading at 40-50% discounts to conservative takeover valuations, we hope for the long-term future of the UK equity market that the reassessment comes before even more of better-quality quoted companies get bid for.
