UK small caps and mid-cap stocks outperformed the overall market in 2023. But just one fund out of 72 in the EAA fund UK small-cap equity Morningstar Category managed to beat the index.
Finding the winners of tomorrow that are small companies today often implies that big expectations are embedded in their stock price, resulting in high valuation multiples. But growth investing has been challenged over the last couple of years as increasing interest rates have impacted the cost of capital and eventually valuations. The onset of inflation has also become a headwind for small caps as debt becomes more expensive to service. Plus, with higher input and labour costs, some companies might struggle to pass this increase on to consumers.
Morningstar Medalist Funds:
• VT Cape Wrath Focus
• FTF Martin Currie UK Smaller Companies
• Abrdn UK Smaller Companies
• Artemis UK Smaller Companies
Small Cap Funds See Outlflows
For the United Kingdom in particular, there has also been an overhang of continual outflows from active managers. This brings pressure on fund managers who must manage redemptions, with sometimes patchy liquidity. Exhibit 1 shows that, during the last five calendar years, UK small-cap funds saw net inflows only in 2021. That year, investors were willing to add risk as we came out of the coronavirus pandemic. But the positive sentiment quickly changed given the macroeconomic environment led by increasing interest rates and higher inflation.
This backdrop and the growth tilt of many small- and mid-cap managers explain why they struggled in recent years.
That said, the extent to which the average manager in the category leans to growth has subsided somewhat over the last three years.
Rather than growth managers actively tempering their exposure, this is more the consequence of growth stocks underperforming value over this period. As a result, the category’s style trail has moved toward the core part of the Morningstar Style Box.
AIM Stocks Underperform
A further aspect at play is the significant underperformance of the AIM Market (see Exhibit 3) over the last three years; this is an area where many managers allocate. Valuations got lofty toward the end of 2020, especially in companies that rallied during the covid lockdown but had less visible earnings streams or paths to profit. They suffered when growth sold off. They were further affected by a more recent overhang of tax advantages in AIM shares possibly being scrapped.
Ten years ago, interest from retail investors was spurred when it was announced that AIM shares would not be subject to inheritance tax relief. However, rumours that this could be abolished in the next UK election have further weighed on sentiment.
Winning Funds Have Value Tilt
So it’s not surprising that the winning funds of the last three years sit firmly in the value camp.
One of these, VT Cape Wrath Focus, is the only one to have beaten the index and peers during the 2023 calendar year. The fund has only £12 million under management and was launched in October 2016 by its manager Adam Rackley. He employs a value philosophy, looking for situations in which investors have overreacted to events and valuation no longer reflected company fundamentals. Within the peer group, this fund has the highest value bias and is among the lowest down the cap scale once funds dedicated to micro-caps are excluded.
A reflection of the approach is shown by the manager’s purchase of Future, a digital publishing company, in December 2023. This stock was widely held by small- and mid-cap managers in the late 2010s and into the 2020s, enjoying a meteoric rise. It drove the performance of many growth offerings, but things came to a head through a mix of high valuation, falling profits, and change of management. Growth managers then felt the pain on the downside as it remained in many portfolios.
Which Stocks Have Funds Been Buying and Selling?
Despite the large selloff in growth stocks, funds under full analyst Morningstar coverage have been sticking to their style tilts, and given our focus on long-term potential, we’ve maintained a high level of conviction in some of these strategies.
One fund that considers valuations and recognises market cycles is FTF Martin Currie UK Smaller Companies, which has Morningstar Medalist Rating of Bronze for its clean share class. It is managed by Dan Green, and he entered 2023 overweight in growth names. During the second half of the year, however, he was finding opportunities in more cyclical areas that he believed were undervalued such as Marshalls (paving stone manufacturer), FDM Group (global recruiter), and Keystone Law (full-service law firm). He also sold Bytes Technology Group, a stock widely held by growth peers. On a bottom-up basis, this made the portfolio tilt more toward cyclical and recovery-type names and contributed to the fund outperforming in the latter part of the year’s rally.
Silver-rated Abrdn UK Smaller Companies, run by Abby Glennie and Amanda Yeaman, employs a process that starts with a quant screen that focuses on earnings momentum, growth, and quality factors. Fundamental analysis then looks to identify companies with durable growth prospects, proven business models, and recurring earnings.
Portfolio turnover is usually fairly low, although a number of new ideas came into the fund in the fourth quarter of 2023 such as Chemring (solutions for aerospace, defense, and security markets), Premier Foods, Morgan Sindall Group (construction), Johnson Service Group (work wear rental and protective wear), XPS Pensions Group, and Volex (provider of electronic components). Over the short time frame since purchase, all have beaten their index to the end of January 2024, apart from Volex. Although some of these firms have a cyclical element, the fund as a whole still has one of the highest leanings to the growth style in the sector. This omnipresent aspect has contributed to performance suffering over the last few years.
Silver-rated Artemis UK Smaller Companies, managed by Mark Niznik and William Tamworth, is focused on companies with strong business franchises that are trading at multiples that are not aggressively high. The valuation awareness results in a stylistically more-balanced portfolio than many UK small-cap peers.
Part of the activity last year included buying what the duo terms derated growth companies, such as GB Group (identity and fraud prevention), Future, Gamma Communications (business collaboration solutions) and Alpha Group (financial solutions to global corporates) after significant falls. The feeling is that they are happy to own growth companies but only at the right price. In the second half of the year, some of the winners, such as Computacenter and Chemring, were trimmed, while new purchases were made in Hilton Foods, JTC (fund administration services), and Next 15 (data-driven marketing consultancy).
Jonathan Miller is director of UK manager research, Morningstar
