Valuations of quality UK smaller companies have rarely looked so compelling and falling rates should help
Over the long haul, small-caps have historically outperformed large caps, fuelling the research highlighting the so-called ‘small-cap effect’ – the idea that smaller companies offer higher risk-adjusted returns than larger ones. Unfortunately, the higher interest rate environment of recent years has proved tough for the stock market’s small fry, who’ve spent more than a decade lagging more sizeable corporate siblings.
But with a central bank interest rate cutting cycle underway, the prospects for small-caps looks promising as lower borrowing costs should provide a tailwind for growth-oriented portfolios.
As Deutsche Numis pointed out in a 17 September note, ‘valuations remain relatively cheap despite superior earnings growth prospects.
‘This creates a compelling backdrop to invest in small-caps, particularly given the potential for a broadening of market returns away from the US mega cap tech stocks.’
Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors, believes since investors have been stuffing huge sums of cash into Big Tech stocks across the pond, attractive investment opportunities have been created elsewhere with US small-caps looking especially compelling.
Deutsche Numis also noted that while small-caps have rallied off recent low valuations, ‘they continue to offer value with global small-caps trading on an historic PE ratio of 17.7 times, a 19% discount to the MSCI AC World. In the UK, small-caps trade on a circa 6% discount to UK large caps, and a 15% discount to global small-caps, which we believe offers value and should continue to fuel mergers and acquisitions activity’.
WHY INVEST IN SMALL-CAPS NOW?
Nish Patel manages The Global Smaller Companies Trust (GSCT), a diversified portfolio offering a simple way to access growth companies around the world.
Patel says: ‘Smaller companies benefit more than larger companies when interest rates are cut because they generally have lower access to capital and are more exposed to floating rate debt. As interest rates fall and credit conditions loosen, these smaller companies benefit disproportionately.’
He also observes that falling UK interest rates have historically helped consumer spending. ‘A more favourable back drop for UK consumers will benefit smaller companies more than larger companies given that they derive more of their revenues from the domestic economy.’
Among UK small cap investors, Strategic Equity Capital’s (SEC) manager Ken Wotton believes post-election optimism has given way to pre-budget anxiety over concerns adverse tax changes could damage market prospects. Yet Wotton takes a more ‘glass half full’ view. ‘Politically the UK has flipped from a post-Brexit pariah to a relative safe haven amongst developed markets,’ he explains. ‘Recovering economic growth, reducing inflation and falling rates provide a long-awaited supportive backdrop for UK smaller companies. Global equity investors may soon follow the lead of global private equity funds in seeing the UK as a relative safe haven with high-quality companies trading at bargain prices.’
THE VALUE MANAGER’S TAKE
Richard Staveley manages value-focused small cap trust Rockwood Strategic (RKW), whose stellar 266.5% ten-year share price total return has left it as just one of three UK Smaller Companies trusts trading at a premium to net asset value (NAV).
‘As Ed Chancellor describes in his brilliant book “The Price of Time”, interest rates reflect exactly that,’ remarks Staveley. ‘As such, for smaller companies, whose quantum and rate of future growth in profitability is generally much larger than maturer large companies, the factor of time influences their valuations. Falling interest rates or low interest rates therefore tend to lead to higher valuations for perceived “growth assets”, such as small companies, as the price of time is less.
‘However, if interest rates are being cut aggressively to tackle perceived incoming weaknesses in the economy, as small companies tend to be more fragile, less diversified and when compared to larger companies, respond more poorly to recessionary conditions, they tend to then underperform.’
Staveley believes the ‘goldilocks’ scenario for UK small-caps would be ‘a measured and incremental run of interest rates cuts to a level near the neutral rate, ideally at a stimulative setting.’ He highlights Facilities by ADF (ADF:AIM), a fast-growing UK company exposed to the film and TV industry, as a recent Rockwood Strategic pick poised to benefit from falling rates.
Also weighing in is William Tamworth, co-manager of Artemis UK Smaller Companies Fund (B2PLJL5), who is starting to see early signs of green shoots if not yet a full recovery in sentiment. ‘Confidence encourages consumers to spend and investors to invest and the budget could trigger a quick mood shift,’ says Tamworth. ‘Once it is out of the way the government rhetoric might switch from “we have inherited an unimaginable mess” to “look what a good job we are doing fixing it”. Further interest rate cuts could help, too, and given investors’ negative positioning and consumers’ high rate of saving, we could see a sharp bounce back in consumer spending and in UK small-caps.’
One of the managers of WS Amati UK Listed Smaller Companies (B2NG4R3), David Stevenson, stresses that a mere 4.4% of UK pension assets are held in domestic equities.
‘It’s likely that most, if not all, UK pension assets are represented by large, blue-chip stocks, which tend to have significant overseas operations,’ he informs Shares. ‘A shift in government policy to encourage allocation to UK small-caps would not only offer far more direct support to the UK economy, but would be a great investment strategy for the pension funds to pursue. Everyone knows how relatively cheap the UK stock market is - clearly evidenced by the frenetic activity seen around share buybacks and company bids.’
ELEPHANTS DON’T GALLOP
While riskier than large caps, investment sage Jim Slater once said ‘elephants don’t gallop’, meaning small companies have the capacity to grow much faster than big ones. For example, it is far easier for a £50 million market cap to get to a £200 million valuation than it is for a £50 billion company to quadruple in size. Along with the capacity for growth there are several positives which come with investing in small cap companies.
A streamlined management structure enables most small-caps to respond quickly to business opportunities and a niche focus can allow them to grab market share even when the size of the overall market is shrinking.
Many small cap companies have a strong innovative streak in contrast to their larger, more entrenched counterparts. Because many small-caps will fly under the radar of big institutional investors and are generally less well researched, there are probably more of these opportunities in this part of the market.
WHAT ARE THE PROS BUYING?
Small-caps Strategic Equity Capital’s Wotton has been buying include the recovering wealth manager, Brooks Macdonald (BRK:AIM), ‘which trades below half the rating of private peers’, as well as consultant Costain (COST), ‘benefiting from a tailwind in infrastructure spending’ and also Iomart (IOM:AIM), the IT managed service provider ‘poised to gain from AI-driven demand for cloud computing capability’.
Artemis’ Tamworth says the fund is overweight consumer stocks like online greetings cards leader Moonpig (MOON), admittedly a FTSE 250 constituent, but also small-cap sofa seller DFS Furniture (DFS) and AIM-listed package holidays play Jet2 (JET2:AIM). ‘It is not so much a macro call that we are making here, it is more that we can buy these companies on very depressed valuations because of the years of negative sentiment around the cost-of-living crisis and impending recessions,’ says Tamworth. ‘Should this sentiment change, we see scope for a significant re-rating.’
James Henderson, co-manager of investment trusts Henderson Opportunities Trust (HOT), Lowland (LWI) and Law Debenture (LWDB), notes consumers have been paying down debt, curtailing spending plans and putting off home improvements and small-scale building projects. But if rates come down, the freeze should thaw and small-caps should be a beneficiary.
One name he favours is UPVC window and door manufacturer Epwin (EPWN:AIM), which has reduced its cost base, focused on efficiency and should see operating margins improve once demand picks up. ‘Weaker competitors have retreated as consumers have cut back on their spending but there is a replacement cycle which means spend cannot always be deferred,’ says Henderson, while stressing Epwin has a growing dividend and currently yields a juicy 4.5%.
THREE SMALL-CAPS TO BUY NOW
Property Franchise Group (TPFG:AIM): 421p
Market cap: £268 million
After taking over Belvoir Group and GPEA earlier this year, the Property Franchise Group (TPFG:AIM) is the largest multi-brand property franchisor in the UK with revenue in the first half to June more than doubling compared with last year.
The group now manages more than 150,000 rental properties through a network of 1,900 franchisees and licensees together with 300 mortgage advisors.
Chief executive Gareth Samples told Shares recently trading was ‘at least in line with market expectations’ for the full year and the firm raised its interim dividend by 30%.
The lettings market saw strong demand in the first half, and the forecast is for more of the same in the second half with above-inflation rent rises continuing into 2025.
Meanwhile, despite slower-than-expected activity at a national level, the group has seen underlying growth in sales and in financial services in the first half.
So far this year, agreed sales have increased by two thirds to a record £47.5 million in value, and underlying growth is expected to accelerate in the second half given the increase in listings on the major property portals.
Samples cites the sharp drop in mortgage rates since August – with NatWest (NWG) now offering a five-year fixed deal at 3.7% compared with 6% this time last year, for example – as being a major driver of fee income over the rest of this year.
Commissions from financial services such as mortgages and remortgages jumped more than seven-fold to £7.7 million in the first half and now represent a meaningful part of the business. [IC]
Concurrent (CNC:AIM): 112p
Market cap: £96.3 million
Colchester-headquartered Concurrent (CNC:AIM) is a developer and manufacturer of high-performance embedded computer products.
This includes so-called ‘single-board computers’ – a complete computer built on a single circuit board.
Concurrent provides this and other tech hardware for sectors like defence, aerospace and telecommunications as well as industrial settings where products need to be rugged enough withstand extreme temperatures, shock, vibration and other stresses. Defence dominates, accounting for 82% of revenue in the six months to 30 June 2024.
As well as supplying the kit, Concurrent provides support services to help integrate and manage these components and systems. The company has been quietly eking out impressive growth, bar in 2022 which was marred by supply chain issues.
Forecasts from broker Cavendish imply a compound annual growth rate of 10.9% in earnings per share from 2023 to 2027 – with the company transitioning from simply supplying components to providing a more bespoke offering.
Analyst Ian McInally says: ’There has also been a marked move towards modifying custom products for customers to provide tailored solutions, particularly so they can be integrated as part of whole systems. Increasing levels of non-recoverable engineering work is being undertaken for customers and Concurrent can support the integration of its products with these broader systems.
‘Working with partners, especially providing the modified products to make up these whole systems solutions, is a crucial part of the business strategy. Management believes it has identified a crucial competitive advantage in the market, given the time and level of support systems integration it can provide compared with larger competitors.’
The company pays a dividend, albeit a modest one, and Cavendish forecasts it will be sitting on net cash of £14 million by the end of this year. Robust cash generation will enable further organic investment and offers scope for M&A. Given the growth potential a 2025 price-to-earnings ratio of 18.4 times doesn’t seem unreasonable. [TS]
SDI (SDI:AIM): 50p
Market cap: £52.3 million
A casual glance at the share price chart might put a quick end to investors’ research into SDI (SDI:AIM), but that’s a mistake, in our view. This is a small cap company which has stuck to its largely successful knitting for years, and we expect its fortunes to significantly improve over time.
SDI is a collection of subsidiaries involved in the design and manufacture digital imaging, sensing and control equipment used in life sciences, healthcare, astronomy, manufacturing, precision optics and art conservation applications. It’s a buy and build model which closely resembles that of health, safety and environmental kit maker Halma (HLMA), a constituent of the FTSE 100, buying good value businesses which add consistent cash flow and profits to the overall company.
Not only does SDI’s growth stretch back multiple years, it has been high-quality growth. Gross margins typically run at around 60% to 65%, high for a manufacturing business, while returns on investment and operating margins are in the double-digits and above industry averages.
The end of the pandemic has tossed many a challenge at SDI as customers de-stocked after a prolonged spell of over-ordering. Higher borrowing costs haven’t helped either, but both issues now seem set to improve. This leaves substantial upside on the table, partly as SDI continues to find attractively priced acquisition targets to supplement organic growth, and from a change in market mood.
This is a stock which has previously traded on a 20-plus PE (price to earnings), now just 12. History is on its side, we believe. Over the last 10 years, SDI has grown turnover from £7 million to £65.8 million in the year to 30 April 2024 and adjusted operating profit from around £57,000 to £9.6 million. The share price has increased from around 10p to over 200p at its peak, yet today is available at 50p. Not for long, we suspect. [SF]