Following a sharp drawdown in the immediate aftermath of the UK’s decision to leave the European Union, UK smaller companies have staged a strong recovery in performance. Sterling’s initial depreciation benefitted the earnings of larger companies with a higher proportion of their revenues coming from overseas, thus leading to their outperformance relative to their smaller, more domestically focused counterparts through the end of June 2016.
The picture since then, however, is somewhat different. The FTSE Small Cap excluding investment trusts index has outperformed the FTSE All Share index by more than 10 percentage points in the 12 months to the end of June.
Investors Withdraw Cash Despite Gains
The Brexit referendum clearly increased the uncertainty surrounding the UK economy, and investors have responded by withdrawing money from the small cap space in the 12 months since the vote. Aggregate net flows from open-ended UK small-cap funds have been negative in each quarter since the referendum, with investors pulling more than £1 billion out of small cap funds over the 12 months to the end of June.
This is a classic example of poor investor timing. The bounce back has seen the strong performance of UK small caps and the even-better performance of active funds in the sector. For instance, the average UK small-cap fund has outperformed the index by almost eight percentage points in the one-year period to the end of June.
The turnaround began in the second half of 2016 as the average fund started to outperform the index, and this outperformance has accelerated so far this year, with positive stock selection within a range of sectors driving those active returns relative to the index.
For example, Fevertree Drinks (FEVR) has been one of the largest individual stock contributors to fund performance this year; it has been a popular pick among small-cap fund managers over recent years and it has continued its strong run with a rise of more than 50% year to date. The average fund’s underweight position in oil and gas has also proven beneficial for active returns; the sector has given back some of its gains from last year given the overall weakening in the oil price.
Over the longer term, the returns figures indicate that active UK smaller companies funds have, on average, added value over the index for investors, with outperformance by the average fund over the index of almost three percentage points per annum, on average, over both the 10- and 15-year periods.
3 Positively Rated Small Cap Funds
Underneath those figures, however, there remains significant dispersion between the returns of the best and worst performing funds within the sector, underscoring the importance of robust fund selection. Here we highlight some of the UK smaller companies funds rated positively by Morningstar fund analysts.
Daniel Nickols is an experienced small-cap investor who has managed Old Mutual UK Smaller Companies for more than a decade. His involvement goes back even further to 2001 working alongside the previous manager, Ashton Bradbury. He is supported by the well-resourced small- and mid-cap team at Old Mutual. The fund incorporates a top-down element alongside bottom-up stock analysis, and the manager has a flexible investment approach with no rigid bias towards value or growth.
Instead, he looks to respond to the prevailing economic and market conditions, selecting stocks and positioning the portfolio accordingly. The bottom-up research conducted by Nickols and the team seeks to identify companies with the potential be re-rated as a result of strong growth and greater financial stability. The fund holds a Morningstar Analyst Rating of Gold.
River & Mercantile UK Equity Smaller Companies is managed by Philip Rodrigs, who officially assumed responsibility for the fund in September 2014 from Dan Hanbury having joined River & Mercantile earlier that year. Rodrigs had previously built a strong track record as manager of Investec UK Smaller Companies. An initial quantitative screening helps to identify stocks worthy of further fundamental analysis, and stocks can be categorised as growth, quality, recovery or asset-backed.
Rodrigs will invest across all four categories to build a balanced portfolio but the fund generally tends to have a tilt towards growth. The manager and the team will create scenarios to assess a stock’s potential before an investment decision is made. The fund will typically include significant allocations to stocks lower down the market-cap scale and to AIM-listed stocks. The fund holds a Morningstar Analyst Rating of Bronze.
Liontrust UK Smaller Companies is managed by Anthony Cross, who provides a wealth of experience in investing in UK smaller companies, with support from Julian Fosh, who brings over 20 years of investment experience, and Victoria Stevens and Matt Tonge, who both joined the team in 2015. Cross has managed the fund since January 1998 and was joined by Fosh in May 2008.
The investment process focuses on the importance of the intangible assets of a company, emphasising intellectual capital, distribution channels, and repeat business. This typically leads the fund to have a natural bias toward the less capital-intensive people-focused businesses, such as support services, technology, and media. The fund holds a Morningstar Analyst Rating of Bronze.
